What is an SMSF investment strategy and why is it needed?

What is an SMSF investment strategy?

An SMSF investment strategy is a formal document that explains how you’ll invest the SMSF’s money. It includes what you intend to achieve (your SMSF’s investment objectives) and the way in which you’ll achieve it – ie the types of investments you plan to make.

The law sets out a number of things trustees normally consider when deciding on their strategy – for example, risk, likely returns, cash flow the fund needs and whether the fund will hold insurance for members.

There's complete flexibility in how you design your strategy – there's no single right answer. This flexibility is one of the key advantages of running an SMSF, allowing you to tailor investments to your specific circumstances and goals.

Why does your SMSF need an investment strategy?

It’s a legal requirement

• Superannuation law requires all SMSF trustees to "formulate, regularly review and give effect to" an investment strategy for their fund. This isn't optional – it's a mandatory trustee duty.

Ensures proper investment governance

• Writing something down helps you keep yourself accountable for doing what you planned to do with your SMSF.

• Your fund's auditor will review your strategy each year – both to make sure it exists and that you’re following it.

Provides flexibility with responsibility

• Your investment strategy is not a fixed document – you can change it as your circumstances evolve. What works for you today might not be the best strategy for you in the future, particularly as members age or transition from accumulation to pension phase.
• Without losing flexibility – Your investment strategy is not a fixed document – you can change it as your circumstances evolve. What works for you today might not be the best strategy for you in the future, particularly as members get older or transition into retirement.

Six factors your investment strategy must address

There's no prescribed format for an investment strategy, and the law doesn't dictate exactly what should be included. However, trustees do have to consider six key factors:

1. Risk and return: How much risk the trustee wants to take and what that means for the returns (income and growth on the investments) they’re likely to get. This doesn’t mean SMSFs can’t invest in risky things, it just means it should be a conscious choice. Often the way this is expressed as part of the SMSF’s investment objective is a target return (say 3% pa above inflation) and how comfortable they are with bad years (eg the investment strategy might say the trustee is comfortable to fall short of their target or even go backwards 1 year in 5.
2. Diversification: This is about how the SMSF’s assets are split up – are all its eggs in one basket? Again, it’s fine for an SMSF to have a lot of money in one investment but it’s important this is done deliberately and after thinking about what that means for the fund’s risk.
3. Liquidity & cash flow: How easy it is to sell the fund’s investments and what income your SMSF will receive from them are important factors too. They impact whether the fund’s investments actually suit the expenses or benefits your SMSF will be paying. For some SMSFs, it’s fine to have assets tied up in illiquid assets that can’t be sold quickly. But for others that would be unsustainable – for example, funds that own a lot of property often have to review their investment strategy when the members start taking pensions.
4. Meeting liabilities: To some degree this brings all of the above together. The SMSF needs to meet day-to-day expenses and pension payments (its current liabilities) but it also needs to look to the future. What would happen if a member died? Would the SMSF need to pay out large death benefits and if so, how would it do that?
5. Insurance: This is life and disability insurance for the members rather than (say) insurance taken out on properties owned by the SMSF. Once again, it has to be considered but the trustee doesn’t necessarily have to actually take out insurance.
6. Fund-specific circumstances: Factors like the age of the members, when they expect to retire, assets they hold outside super will all influence the investment decisions made by the trustee and should be considered.

Neither the fund's auditor nor the ATO can review what's in your head—they need you to write down what you considered. What they're interested in is the fact that you actively considered all these factors, not second-guessing the choices you made.

How to create an ATO-compliant SMSF Investment Strategy

Step 1 – Take into account your fund's circumstances

Blindly following a template that simply repeats the six factors above will not be sufficient for compliance. Make sure your strategy is tailored where necessary and actively takes them into account.

Step 2 – Include asset allocation ranges

Trustees need to provide a way of demonstrating that their strategy has been implemented. Often, this is documented by explaining how much of their fund will be invested in different “asset classes”. Asset classes are different groups of investments that have similar characteristics and behave in similar ways in the market. More information about asset classes can be found here: Asset Classes.

The investment strategy will usually include minimum and maximum asset allocation ranges for each asset class.

Asset allocation ranges provide a quick way for you (and the fund's auditor) to check that the fund's investments are in line with its strategy. They demonstrate that the trustee not only has an aim (the objective) but also has a plan to achieve it.

Step 3 – Make sure the ranges aren't too wide

You need to make sure the asset allocation ranges are wide enough to allow for normal market fluctuations but not so wide to be meaningless. Ranges of 0 to 100% for each asset class would not normally be appropriate without also explaining why you needed such broad ranges to achieve your investment goals. 

Step 4 – Explain your diversification decision

There may be circumstances, after considering all appropriate factors, you decide to invest in a single asset class or even a single asset. In this case, to demonstrate you have considered diversification, you should acknowledge the risks associated with a lack of diversification and explain why you believe the potential fund returns will provide appropriate recognition of that risk.

Merely saying you have considered diversification is not enough.

Step 5 – Explain your liquidity decision

Things you need to think about and document include:

• Operating expenses: What level of cash is needed to cover the fund's regular operating expenses, loan repayments or investment commitments?
• Contribution changes: If the fund's cashflow from contributions reduces or ceases (for example, due to Government changes to contribution limits or changes to a member's personal circumstances), how will that impact the fund's liquidity?
• Pension payments: If members commence pensions with all or part of their balance, will the assets of the fund be sufficiently liquid to allow at least the required annual minimum pension amount to be paid?
• Death benefits: How will the fund finance a death benefit, particularly if the law says the death benefit must be paid as a lump sum and the fund's assets are not easily converted to cash? Trustees in this situation may decide to pay death benefits in-specie (by transferring all or part of a fund asset to the deceased's beneficiaries) rather than making payment in cash.

Your strategy doesn’t need to spell these out in detail but if it’s not obvious from your investments you should document how you’ve nonetheless decided your strategy is appropriate.

Step 6 – Don't set and forget

Your investment strategy should not be a "set and forget" document. It is not enough to just document an investment strategy, you also have to follow it.

Your auditor will check you’ve done this – for example if you’ve listed asset allocation ranges, they’ll check your investments line up to those ranges. It’s one of the benefits of quoting ranges in the strategy – it’s easy for the auditor to see you’re doing what you said you would.

It's worth highlighting that it is not illegal to invest outside the asset allocation ranges in your strategy. SMSFs are often in this position from time to time, particularly if there are large falls across the board in a major asset class such as Australian shares.

The important part is acknowledging that it's happening and what action you're going to take, which could include choosing to make no changes to either the fund's investments or the strategy in the short-term.

Step 7 – Regularly review

SMSFs have to regularly review their investment strategy and change it if it’s not appropriate anymore.

We recommend trustees review their strategy at least annually (as part of the normal year-end process of signing accounts and tax returns) and also whenever there is a major change to the fund's circumstances. For example:

• The fund starts or stops providing pensions
• A new member joins the fund or a member leaves the fund
• New classes of investment are made
• The fund's risk profile changes
• The fund borrows via a limited recourse borrowing arrangement

This review should be documented in the form of a trustee minute or resolution, detailing whether the strategy remained appropriate or changes were made. This documentation can then be provided to the fund's auditor.

Heffron's SMSF Investment Strategy template

For Trustees

Heffron does not provide investment advice, but we can assist with the SMSF documentation requirements you need to put in place once you have decided on your strategy. If we set up your SMSF and you have appointed us to manage your ongoing administration work (i.e. tax returns, financial statements), we will help you enter your investment strategy information into our Super Toolkit to produce the compliance documentation for your fund.

For Professionals

You can use the Heffron Super Toolkit even if you're not using our administration service. Simply subscribe to use our hassle-free solution to create an unlimited number of compliant SMSF Investment Strategies.

Follow this link to learn more about our SMSF investment strategy template and subscribe.

You may also be interested in...

• Asset Classes
  
• What are the rules about investing in SMSFs?
  
• Combine super for shared investing

This article is for general information only. It does not constitute financial product advice and has been prepared without taking into account any individual's personal objectives, situation or needs. It is not intended to be a complete summary of the issues and should not be relied upon without seeking advice specific to your circumstances.