ATO focusing on investment strategy diversification requirements – what do trustees and auditors need to do? | Heffron

The ATO recently identified approximately 18,000 SMSFs who hold 90% or more of their assets in a single asset or a single asset class. The ATO is concerned that these funds may not have met their investment strategy requirements and has reminded trustees that failure to do so can result in an administrative penalty of $4,200. 

So, what do these trustees and their auditor need to do to avoid penalties being applied?

The superannuation law requires all SMSF trustees to “formulate, regularly review and give effect to” an investment strategy for the fund.

There is no prescribed format for an SMSF investment strategy but it must take into account the whole of the fund’s circumstances and address at least the following six key factors:

1. the risk involved in making, holding and realising the fund’s investments, having regard to the trustee’s objectives and expected cash flow requirements,
2. the likely return from the fund’s investments having regard to the trustee’s objectives and expected cash flow requirements,
3. the composition of the investments as a whole, including the extent to which they are diversified or involve the fund being exposed to risks from inadequate diversification,
4. the liquidity of the investments having regard to the fund’s expected cash flow requirements,
5. the ability of the fund to discharge its existing and prospective liabilities, and
6. whether the trustees should hold insurance that provides cover for one or more members of the fund.

You may wonder why the Government requires SMSF trustees to have an investment strategy. 

The aim of an investment strategy is to protect members’ retirement benefits by minimising the risk generally associated with reckless, ad hoc or uncoordinated investments.

Developing and implementing an investment strategy is one of the superannuation law covenants (the standards of behaviour expected of trustees). Failure to comply with this covenant may result in trustees being sued by members who have suffered some loss because of an investment. However, trustees are legally protected if they can demonstrate the investment was made as part of a properly formulated and clearly communicated investment strategy (along with complying with all the other covenants). Trustees who make investments without due consideration to the fund’s investment strategy effectively forfeit their right to this protection. Whilst trustees of SMSFs are generally also the members, this does not guarantee that one won’t sue the other at a later date if they are unhappy with the fund’s investment performance (eg on relationship breakdown).

Must an SMSF’s investments be diversified to comply with the superannuation law?

No. The superannuation legislation does not require diversification, but rather that trustees consider it. There may be circumstances where, after considering all the appropriate factors, the trustees decide to invest in a single asset class or even a single asset. However, in order to demonstrate they have nonetheless considered diversification, trustees should generally be able to explain why any lack of it is appropriate for the fund’s circumstances.

In considering the fund’s assets and its diversification needs, it is expected that trustees will reflect on:

• the overall risk profile of the members,
• the asset allocation of the members outside the SMSF,
• the inherent risk associated with any lack of diversification,
• whether the likely return from the fund’s investments will compensate for any increased risk,
• the fund’s liabilities (eg if the fund has borrowed via a limited recourse borrowing arrangement), and
• the fund’s liquidity needs (eg where members have commenced pensions with all or part of their balance, the assets of the fund will need to be sufficiently liquid to allow at least the required annual minimum pension amount to be paid).

So, why is the ATO suggesting SMSFs with 90% of their investments in a single asset or single asset class may have breached the law?

The ATO is not suggesting that these trustees have done anything wrong. In fact, the ATO is unlikely to have ever seen the fund’s investment strategy. They are simply asking trustees to review their investment strategy and, given the fund’s apparent asset concentrations, make sure the strategy complies with the law.

Specifically they have asked trustees to provide written evidence of how they considered diversification and its associated risk. This is a little bit like the ATO occasionally asking taxpayers to provide a copy of a receipt for the deductions they’ve claimed.

What do trustees need to do and when?

Trustees who have received the ATO letter need to review the fund’s investment strategy and document why they consider the fund’s chosen asset allocation is appropriate taking into account the factors listed above. This may be in the form of an update to the fund’s investment strategy, an addendum to the investment strategy or a minute etc.

There is no need for immediate action by trustees. They simply need to have this document ready for review by the fund’s auditor as part of the fund’s next audit.

As part of our administration service, we’ll be working with our SMSF trustees to help them write down why they invested the way they did, and making sure this meets the auditor’s expectations.

Even trustees who didn’t receive the ATO letter but are heavily weighted in one asset/asset class may wish to take this opportunity to “beef up” their investment strategy document. This does not necessarily mean they should rush to completely replace their investment strategy document, rather they could simply minute some additional context to supplement their existing documentation.

What do auditors need to do?

Auditors have been advised if one of their funds has received the ATO letter. For these funds, the auditor will need to request and review the trustee’s document detailing how they considered diversification taking into account the factors listed above.

If the auditor believes the diversification issues have been appropriately considered (remember diversification is not compulsory; a lack of diversification simply needs to have been thoughtfully considered), then no further action is needed.

However, if the auditor was not able to sight a document appropriately detailing how the trustees considered diversification taking into account all the factors listed above, then the auditor will need to:

• issue the trustee with a management letter explaining the problem and asking that they rectify it,
• qualify their audit report if they consider the issue is material, and
• using the trustee behaviour tests, decide whether to lodge an Auditor Contravention Report (ACR) for the fund. An ACR would not normally need to be lodged if this is the first time the trustee has been notified of a contravention of the investment strategy requirements.

Where an ACR is lodged, the ATO may consider applying an administrative penalty on the trustees.

Where auditors are reviewing funds which did not receive the ATO letter but whose assets are heavily weighted in one asset/asset class, we suggest auditors also review the fund’s investment strategy to see if it provides detail of the trustees’ deliberations re diversification and, if necessary, request further detail. This will hopefully mitigate any litigation risk for the auditor should investments ultimately fail.

Is the ATO implying investment strategy templates should not be used?

No. SMSFs require a great many documents and not surprisingly using standardised templates is common practice. This is not inherently inappropriate. What the ATO is highlighting is that where a fund is taking action that is perhaps slightly unusual (for example, concentrating its investments in a single asset or asset class), it is prudent to consider whether the template alone is sufficient to ensure it reflects the serious consideration given by the trustees in making the decision. The ATO’s current action is perhaps a valuable reminder of one circumstance where expanding the normal documentation would be appropriate.

In summary, given the downturn in property markets, the ATO’s focus on diversification has been expected for some time. Whilst a “beefed up” investment strategy document will allay the ATO’s concerns and avoid trustee penalties, unfortunately it will not alter the investment outcome for those trustees who’ve suffered poor investment results.

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