One of the most important things the trustee of an SMSF does is invest the money.
There are some specific rules here and quite a few pages of legislation are devoted to explaining them. For example, SMSFs generally have to be careful about who they buy assets from (only some assets can be bought from members, family or other “related parties”). For assets like property, they also have to be careful about who they rent it to – generally the property can’t be rented to the member, family or other related parties unless it’s being used in a business. And there are some investments where the fund is only allowed to have a very small exposure (less than 5% of the fund).
But super law actually has some overarching requirements that are critical even if you think you’ve invested in line with the specific rules.
The first – and most important – is the “sole purpose test”. It’s the cornerstone of superannuation law that applies to all funds (not just SMSFs). In a nutshell, the sole purpose test is all about making sure super funds really are used to help members save for retirement or look after their family if the member dies. Everything every super fund does has to be consistent with that purpose. So this is not so much about what the investment is or who it’s being bought from, it’s all about why it’s being made.
, Joe has an SMSF and decides that it will make an investment in his friend's business. He doesn't actually hold out much hope for the business but he'd like to support his friend. He's been lucky over the years and has built up a large super balance so wants to use some of that money to help his friend. A decision like that isn't consistent with the sole purpose test at all. Joe isn't making this investment decision to secure his retirement, he's trying to help a friend. He's free to do that with his own money but not the money he's put into his SMSF.
The simplest way to stay on the straight and narrow with this test is to make sure investment decisions you make for your SMSF are always made as if the only thing that’s important is that the SMSF can support you in your retirement or protect your family if you die.
Super law also has a range of other standards that trustees need to live up to when it comes to everything they do for an SMSF. Some of these are particularly relevant for investing.
For example, any investments made by your SMSF must be kept entirely separate from assets you own in some other way (eg in your own name). Your SMSF should have its own bank account that’s quite separate to yours. It’s important to make sure that contracts like sale agreements and leases are always in the right name (the trustee of the SMSF) and the same applies for things like holding statements for investments such as shares. Any blurring of the lines leaves you exposed to failing to meet this standard.
Trustees must exercise the same care, skill and diligence as an ordinary prudent person. This is where it’s often useful to imagine you’re managing someone else’s money and you’re trying to maximise their retirement savings. Would you do what you’re about to do?
Super funds (including SMSFs) have to make investments on an “arm’s length basis” (ie, on commercial terms). This sounds easy - particularly if your SMSF is always dealing with people who are completely independent of you. But remember you have to think of your SMSF as being a completely separate "thing" to your own money. What if you're negotiating to buy two properties from an independent party - you're buying one personally and your SMSF is buying the other. The seller is happy to charge a little less for the one you're buying personally if you'll pay a little more for the one being bought by the super fund. While that deal might look commercial in aggregate, it's not if you look at the SMSF completely in isolation.
In some ways this example looks like an obvious problem – it would mean the SMSF ended up paying “too much” for its property which doesn’t sound like it lines up with the sole purpose test particularly well either!
But in fact even the reverse (with the SMSF paying too little for its property because you’re prepared to pay a little too much for yours) would be a problem. This time, there’s a tax consequence. When SMSFs end up doing “too well” out of a deal like this, the fund might have to declare all income on the property (including rent, capital gains when it’s sold) as “non arm’s length income”. That’s a disaster – non arm’s length income is taxed at 45%. And there are other ways your SMSF could end up with non arm’s length income. For example, if it owns a commercial property that it rents to your business, be careful that your business doesn’t pay an artificially high amount of rent. That would be non arm’s length income too.
Finally, you need to document how you intend to manage the fund’s investments. This document is known as an “investment strategy” and trustees of all funds are obliged to have one. There is no standard template for an investment strategy (although your administrator, adviser or accountant will be able to help you get started) but it should cover things like:
- What you’re aiming to achieve, how much risk you want to take and how you’ll manage your risk. For example, are you going to invest very conservatively so there’s very little chance that your fund will ever fall in value? Or are you likely to invest more aggressively in the hope of a better return over the long term – knowing that this might mean your fund goes down in value sometimes?
- The degree to which your SMSF should be spread out between different types of investment (often called “diversification”)
- How you’ll make sure your SMSF has enough cash coming in to pay its costs or things like pension payments once it gets to that phase
- What insurance is needed in your fund – should there be life insurance for the members? Insurance for long term disability? Or aren’t they necessary in your case?
And it’s not enough to just write this down and forget about it. Super law specifically requires that you also put it into practice and review it regularly to make sure it’s still right for your fund. So your auditor will want a good reason if your investments clearly don’t line up to what your investment strategy says or if your strategy is several years old and there’s no evidence you’ve ever reviewed it.
These overarching rules are critical and can often be forgotten in our focus on the long list of specific investment rules in super law.