The Murray Financial System Inquiry Interim Report has called for scrutiny of SMSF gearing. Certainly any form of dodgy spruiking must be eradicated from all forms of consumer activity. But misunderstanding the variety of true risks and benefits involved with SMSF gearing is what led to the inept banning recommendation in the Cooper Report into superannuation. Sensible analysis of SMSF gearing must delineate between the benefits of ‘protected’ SMSF loan products, compared to newer, riskier SMSF lending technology which certainly should be under the microscope.
Analysis needs to understand the portfolio construction drivers of SMSF gearing. SMSF investors are often reacting to the failure of the actively-managed funds industry to adequately protect retirement savings from market crashes. Ken Henry has called this ‘sequencing risk’. Even the peak super regulator (APRA) stated in its 2009 review of superannuation that it doubted “the value of the active approach to risk management” because of fund under-performance which they saw as “more pronounced in down markets.”
Investment control is the main reason people set up SMSFs. Many buy and hold assets for the long term – the opposite of the high turnover trading of actively managed ‘benchmark aware’ managed funds. Increasingly they are turning to the apparent security of bricks and mortar and direct share investing, and use SMSF gearing to help. The buy and hold approach accesses a growing income stream from rent or dividends, insulating the capital value of the portfolio from the risk of loss that comes with high frequency trading.
All SMSF borrowing is limited recourse
SMSF gearing is required by law to be ‘limited recourse’ - it must not allow the lender to recover any losses from the general assets of the borrower. Think ‘jingle mail’ lending in the US housing market, where apart from selling the secured asset to cover any loan default, the lender can’t chase the borrower to top up any remaining losses. That can lead to systematic risks to the banking sector and that is why – at least in the case of SMSF lending against shares – loan providers typically embed additional protection mechanisms when they lend to SMSFs.
Properly used these protection mechanisms can actually reduce risk to investors. Take the case of ASX listed instalment warrants, which have been popular with SMSFs since their inception in 1997 (and disproving the urban myth that SMSF gearing has only been legal since 2007). In this multi-billion dollar market, the instalment warrant issuer charges a slightly higher loan interest rate and uses the excess to buy put options to cover its risk of loss in the event that the instalment loan is not repaid.
In the case of these instalment warrants, because the loan subsidises the cost of investment, the investor actually enjoys lower risk than if they purchased the share outright. Further, as long as annual interest payments are made on the instalment loan, the investor retains total control over the loan and hence controls when and if the underlying share is sold. SMSF property loans work similarly. As long as the loan interest is paid, the lender can never force the sale of the property against the wishes of the SMSF.
This avoids the problem with margin loans where the investor can be forced to sell shares into a falling market, even if loan interest is being paid, when the share prices falls sharply. Being forced to sell in down markets is termed being ‘short gamma’, and this is the problem which bedevils margin loans, many structured products, and traditional actively-managed funds.
Structural issues which need addressing
There are four structural concerns with SMSF gearing:
- An investor protection issue does arise with newer forms of SMSF gearing, such as the ‘stop loss’ style of instalment warrant, and the ‘equity lever’ forms of synthetic SMSF gearing. Both products are ‘short gamma’ and behave like margin loans. The product issuer doesn’t use put options to protect their loan, instead selling down shares when the market falls, in order to repay the loan prior to the share price falling below the loan amount.
- SMSF gearing is a form of derivative because repayment of the loan is optional. It should be regulated by requiring advisers to have competency to advise on derivatives, and the financial skills to assess the risk of higher break-even costs (because of interest payments) overwhelming the geared investment.
This highlights two other aspects of concern: the need for better professional education for financial advisers (critically noted by the Murray FSI); and the need for effective policing of the ‘investment strategy’ provisions of the SMSF rules (as yet ignored by the FSI).
- Under current rules for Registered Training Organisations (which can deliver vocational training to financial advisers, as well as to builders, nurses, etc), far more emphasis is placed on educational mapping than on the calibre of the teachers or course content. Registration of financial adviser education should be singled out for far better quality control than the current system allows.
- All SMSFs must have a comprehensive investment strategy, but this key financial statement isn’t properly regulated by the ATO which under current staffing arrangements isn’t equipped to do so. Expert investment analysis of the sort routinely conducted by APRA is needed to evaluate investment strategies.
SMSF gearing can reduce risk and is part of a DIY trend which seeks to avoid the problems that characterise the traditional funds management industry. Improved financial literacy and exposing the variety of SMSF gearing products and risks - coupled with better regulation of the financial advice industry - is a better way to move forward, compared with throwing the baby out with the bathwater by banning this important form of investment.
Tony Rumble was a consultant to the Ralph Review of Business Taxation and is Chief Executive of LPAC Online and Founder of SMSF Advice Solutions.
SMSF Professionals’ Association of Australia (SPAA) has published its Lending Guidelines for limited recourse borrowing arrangements (LRBAs) with SMSFs.