Why small SMSFs are losing money: the $595b self-managed time bomb

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There is an army, 1 million members strong, marching its way across the nation, many of them headed for financial defeat.

'There are many other exotic investments, including the infamous story of an SMSF that owned a pride of lions, which they leased back to a circus!' 

An SMSF auditor from Deloitte

They are drafted by property spruikers and dodgy advisers who raked in billions a year in commissions for delivering the recruits, and the ranks are burgeoning.

David Murray believes balance caps on SMSFs can be difficult. Photo: Quentin Jones

Known as "selfies", these members of self-managed super funds have amassed $595 billion of assets.

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Fuelled by tax breaks, loose finance and inadequate regulation, that number is growing astronomically but that is not a marker of success.

Almost half the funds are not making money. Data is patchy, but what seems clear is the relationship between performance and fund size: smaller SMSF funds perform the worst.

Illustration: Simon Bosch

Going backwards

John Berrill, a financial services legal expert who has defended victims of fraud and inappropriate advice, says: "The jury is in – SMSFs with small account balances up to $250,000 are not sustainable."

He says one in four SMSFs have account balances of less than $250,000 and most are losing money.

"A huge number of ordinary Australians are simply not going to have enough money to live off in retirement from their SMSFs and are going to be dependent on the age pension unless something is done to fix the problem," he says.

Between 2010 and 2014, the bottom 10 per cent of SMSFs, those with balances of less than $100,000, have lost money every year since 2008, according to Australian Taxation Office figures.

Australian Securities and Investments Commission (ASIC) spokesman Gervase Greene told Fairfax Media SMSFs were a key area of enforcement for the regulator due to the growth in the sector, the potential for loss and the vulnerability of consumers.

Selfies have also hit the Reserve Bank of Australia's radar. It has said SMSFs could "introduce new vulnerabilities in the financial system, because it provides a vehicle for potentially speculative property demand that did not exist in the past".

Debate on oversight

The ATO figures reveal that 44 per cent of SMSFs have on average not made a return over the past seven years. Over the same period, APRA-regulated funds, including industry and retail funds, have on average returned 2.9 per cent.

The ATO numbers also reveal that in 2014, members of SMSFs were charged $5.48 billion in operating expenses, insurance premiums and interest expenses.

Its burgeoning size, now standing at a record $595 billion with 572,424 SMSFs and more than 1 million members, has triggered a debate on whether there should be a lower limit on the size of funds and more oversight.

On one side, ASIC argues that SMSFs with under $200,000 in assets are "unlikely" to be in clients' best interests.

Cap can be difficult

On the other side, are respected figures including Financial System Inquiry (FSI) chairman David Murray, who believes caps can be difficult.

"A cap is difficult as we don't know whether they aspire to be bigger or are running down to retirement with cash balances," Murray tells Fairfax Media.

The peak lobby group for SMSFs, the SMSF Association, doesn't support a balance cap on SMSF establishment.

"The choice to establish an SMSF and directly control superannuation should be up to an individual," its chief executive, Andrea Slattery, says.

Indeed, Treasury in its submission to the FSI mentioned "self-managed superannuation funds support consumer choice and should not be prudentially regulated".

It said: "A strong appeal of self-managed funds is that they allow individuals the opportunity and freedom to engage more closely with their retirement savings. Continuation of the light-touch compliance framework allows individuals to take greater responsibility over their decisions without being subject to the requirements of the prudential regulatory framework. This position should be maintained."

Debt-fuelled boom

Part of the "selfie" surge in popularity came in 2007 when the then Howard government gave the green light to borrow money. It put a rocket under a sector that is forecast to grow to $2.75 trillion by 2035, according to Deloitte.

With $24.4 billion of SMSFs allocated to residential property, according to figures at the end of March 2016, concerns are running high.

Murray recommended in the FSI report that SMSFs be stopped from directly borrowing for limited recourse loans in the interest of system stability.

The government did not accept the recommendation.

Limited-recourse loans increase risk into the super system. When limited-recourse loans were introduced in 2007, they set loose an industry of spruikers that encouraged people to make risky investments – some of which have blown up.

Murray told Fairfax Media: "SMSFs borrowing magnifies risk, notwithstanding the non-recourse nature of the debt."

SMSFs are big business. The sector inspired accountants to promote them as vehicles to accumulate and transfer wealth and minimise tax.

SMSFs have special rules that apply to SMSF members.

As one industry expert says: "SMSF members can make in-specie contributions, allowing the member to transfer shares, business real property to and from the fund without selling the underlying asset, while APRA-regulated funds only accept contributions in the form of money. In-specie transfers of business assets also attract generous capital gains tax concessions."

Unusual investments

SMSFs also hold the attraction of being allowed to hold special or unusual investments.

One SMSF auditor from Deloitte recently shared in a blog some of his "favourite investments" he had come across when auditing: "Certainly one of the more unusual investments was a piece of moon rock, reportedly brought back from one of the moon landings! There are many other exotic investments, including the infamous story of an SMSF that owned a pride of lions, which they leased back to a circus!"

Scant regulation and protections prompted PWC partner David Coogan to lodge a submission with the Productivity Commission in April encouraging it to "undertake a review of the area" with a specific view to considering the adequacy of SMSF consumer protections.

"Depending on the outcome of that review, it might be preferable for the regulation of individual SMSFs to be transferred from the Australian Taxation Office to the Australian Securities and Investments Commission," he said.

"Further, it might be necessary for the Australian Prudential Regulation Authority to be given an oversight and policy development role to prevent a build-up of systemic risks related to SMSFs [e.g. excessive leverage]."

Coogan isn't alone.

Broader concern

Ian Yates, the chief executive of COTA Australia, the peak body representing older Australians, said SMSFs was an area that needed attention.

"Super is a subsidised product and so governments and taxpayers all have a stake in making sure it is working," he said.

"We need to look at whether there should be minimum requirements that you can't set up a self-managed super fund below a certain level of investment," he said.

The SMSF Association disagrees. Andrea Slattery says the SMSF sector does not need another review.

"Both David Murray's Financial System Inquiry and the Cooper Review gave the SMSF sector a clean bill of health."

Slattery says ongoing moves to strengthen the ethical and education framework for financial advisors, and licensing accountants providing SMSFs advice will continue to improve consumer outcomes.

Question of protection

An analysis of the returns on some of the smaller funds raises questions about why nothing is being done to protect the retirement savings of these people.

Figures sourced from the ATO show that SMSFs with balances of between $1 and $50,000 lost 15.9 per cent over three years, torched 13.2 per cent over five years and blew 15 per cent over seven years to June 2014.

Over the same period, APRA-regulated funds returned 8.5 per cent over three years, 8.4 per cent over five years and 2.9 per cent over seven years.

SMSFs with assets between $50,000 and $100,000 went backwards over a three, five and seven-year period and SMSFs managing between $100,000 and $200,000 lost 3.3 per cent over seven years to June 2014.

The bigger funds, which represent the majority of dollars in the SMSF kitty, performed far better than their smaller counterparts.

Figures 'distorted'

But SMSF Association's Slattery says the ATO statistics on SMSF performance, especially for lower balance funds, can be misleading.

"Lower balance funds tend to capture newly established funds who can have significant set-up and advice expenses in their formative years. These costs distort the average ROA for these funds," she said.

Figures show that SMSFs with more than $2 million outperformed APRA-regulated funds over seven years but slightly underperformed them over the last three-year period.

It prompted Deloitte partner Russell Mason to question the appropriateness of setting up a SMSF with a small balance and little ability to grow fast. "The regulators should look at the promoters," he said.

Legal expert Berrill believes it has reached the point where the federal government should ban SMSFs for small account balances up to $250,000 or at least require any adviser or accountant to give a clear warning about the risks of setting up an SMSF with a small account balance and recommend against it.

Accountants' paradise

Their existence rests with the accountants that advised them to transfer their funds from APRA-regulated funds into a selfie, where they could feel they had more control over their savings than a retail or industry fund would offer.

When financial services reforms were introduced 12 years ago requiring financial services providers to hold an AFSL and comply with new obligations designed to protect clients, accountants were granted an exemption.

It meant they could provide tax advice to clients to establish an SMSF without being licensed or having to comply with personal advice rules.

Fast forward to 2012 when future of financial advice reforms were introduced, granting generous transitional arrangements to accountants which gave them until July this year to be licensed when giving advice to set up a SMSF.

From next month they will need to comply with the FoFA best interests' duty, the conflicted remuneration prohibition and the requirement to give a statement of advice.

The lack of regulation opened the sector up to abuse. As the sector grew like topsy and became big enough to start influencing the equities market and property prices, the government decided it was time to improve the rigour of the so-called gatekeepers – SMSF auditors.

New rules

To this end it introduced a new SMSF auditor registration regime in 2013 with ASIC responsible for registering approved SMSF auditors, setting competency standards – including a compulsory exam – and, where necessary, taking regulatory action.

By December 2015, the crackdown resulted in ASIC cancelling the registrations of 440 SMSF auditors for either failing to take a competency exam or failing the exam.

Despite the lax regulation, the regulatory framework for SMSFs is built on the assumption that people who set up their own SMSF are responsible for themselves.

Murray's Financial System Inquiry said: "The defining characteristic of the SMSF sector is that trustee members are directly responsible for each fund and must take responsibility for their own decisions."

Overall, compared with APRA-regulated funds, SMSFs are poorly diversified, with large allocations to cash, equity and property. An estimated 12 per cent of SMSFs invest in one asset class. Smaller funds tend to be less diversified, and the smallest funds are most likely to hold only one asset class.

Aussie stocks favoured

According to Credit Suisse analyst Hasan Tevfik, 40 per cent of selfies' holdings are in Aussie equities and they own 17 per cent of the market. He says SMSFs' preference for Australian equities with high dividend yields is becoming a problem for the sector.

"Owning high yielding, large-cap stocks didn't work so well in 2014-15 and is on track to fail in the current financial year," Tevfik says.

"If markets remain flat from here, selfies are expected to pick up more than $11 billion in Aussie dividends but will suffer a capital loss of more than $20 billion."

He says that given the poor returns selfies are currently generating in Aussie equities, many are beginning to rethink their almost singular focus on dividends.

Tevfik also notes SMSFs' exposure to Australian property is more like $147 billion – or a staggering 25 per cent of the entire SMSF sector – once you add in the funds allocated to commercial property, listed property and unlisted property.

Target for spruikers

There is also evidence that lax regulation of SMSFs relative to APRA-regulated funds has made it a honeypot for property spruikers and accountants, some of which have set up one-stop shops, convincing clients to transfer their retirement savings from an APRA-regulated fund to an off-the-shelf SMSF for a small fee then ongoing accounting and auditing services.

The pitch is that SMSFs are efficient and competitive and the members are both engaged and financially literate.

Property seminar host Ronald Cross of Park Trent Properties jumped on the SMSF gravy train. According to ASIC, Cross' Park Trent Properties advised 860 people to switch funds into an SMSF to purchase properties with large loans.

Over a period of five years, Cross' company wooed investors at his seminars with claim property investing through SMSFs was a get rich quick scheme.

Following action by ASIC, the Supreme Court of NSW restrained Park Trent from providing advice to clients to purchase investment properties.

The judgment against Park Trent states that the company's business model was reliant on "persuading relatively unsophisticated investors of the virtues of using their superannuation accounts to purchase investment properties and to establish SMSFs … Investors were influenced to make important decisions concerning their superannuation strategy with little or no genuine consideration of whether the decision took proper account of their individual financial circumstances. Some suffered financial loss as a consequence."

Park Trent is appealing the decision. Cross is not banned.

Wake up call from Trio

Sherwin Financial is another property spruiking SMSF shop that has run afoul of the regulator after its founder Bradley Sherwin sold SMSF products that funnelled clients into his related company, property financier Wickham Securities. When Wickham went bust, 400 of Sherwin's mainly well-heeled SMSF investors – including actor Peter Phelps – lost $60 million.

On April 1, selfies got a wake-up call into the lack of consumer protections offered to SMSFs when the Turnbull government confirmed there would be no compensation for SMSFs that had invested in Trio Capital, which went under in 2009 torching $170 million of investor money.

The Trio fraud destroyed the life savings of 300 SMSFs and members of APRA-regulated funds. But it was only the APRA-regulated funds that received some form of compensation.

Trustees of APRA-regulated super funds can apply to the government for a grant of financial assistance if a fund has lost money due to fraudulent conduct or theft. Grants are funded by an industry levy. SMSF trustees do not pay this levy and therefore don't have access to this compensation mechanism.

For some, this is all too real.

Source: Why small SMSFs are losing money: the $595b self-managed time bomb