The Financial System Inquiry Final Report (released on Sunday 7 December 2014) recommends that direct borrowing by SMSFs be prohibited.  This initiative has the potential to prevent individuals who set up self-managed funds from doing just that – self-managing.

Most people set up their SMSFs so that they can personally control their fund’s investments and avoid the costs and inefficiencies of intermediaries.  In many cases this was a reaction to substantial losses through managed investment schemes, and the significant fees charged by large APRA regulated superannuation funds.

A fundamental rule adopted by most of these funds was to achieve a diversity of assets.  The most usual asset classes are shares, cash, and real estate.  However, without gearing most funds will be forced to access real estate exposure through managed funds, or restrict their portfolio to shares and cash only.

Many Australians are more comfortable investing in real estate compared with shares or other third-party controlled funds.  This view has been reinforced by the significant losses incurred by many SMSFs from shareholdings following the GFC.  Whilst share movements can be volatile, real estate values are, on the whole, more predictable and stable.

So what aspect of gearing concerned the authors of the Murray report?

Click here to view the table.

Removing an SMSF’s ability to directly borrow is tantamount to banning direct investment in real estate.  Whilst no one can tell the future, most Australians have found that they have profited more consistently and more reliably from real estate than from other asset classes.  Direct borrowing allows investors to invest in assets they understand well.

There are some reports of mis-selling of gearing including the establishment of funds which have no assets other than the geared real estate.  There will always be instances of mis-selling whether or not direct borrowing is available.  However, the risk of mis-selling could be addressed by imposing some reasonable controls on SMSF borrowing, such as requiring an SMSF’s equity in the real estate to comprise no more than 50% of the fund’s assets and total borrowings (being limited to, say, 80%).  Such controls would provide adequate buffers to ensure that any fall in real estate values is most unlikely to require a call on member guarantees and ensures that the balance of the fund remains (that is so long as the share market has not performed worse than real estate!!!).

Another option to address concerns in relation to the misuse of LRBAs would be to remove the ability of SMSFs to borrow funds from related parties, which are often provided to fund up to 100% of the purchase price of the property.  Such loans account for the majority of the small percentage of LBRA related contraventions identified by the ATO.

It appears instalment warrants will still be available.  This is a much less efficient method to effectively invest in geared real estate.  These were emerging before borrowing was permitted in 2007.  Warrants impose another layer of fees and expenses which is contrary to the thrust of the Murray report to reduce fees.

Further, the report emphasises the need for increased competition in the superannuation sector. Banning the ability for SMSFs to use leverage to build wealth inside the fund is likely to be a disincentive to the establishment of SMSFs, resulting in reduced competition and associated downward pressure on fees.

If the government does make changes, we recommend that direct borrowing is still available subject to restrictions of the kind discussed above.  It would also be important to ensure that there are appropriate transitional provisions so that funds that have exchanged contracts to purchase real estate prior to the new law being passed are not prevented from borrowing.  In addition, existing funds and must be able to refinance existing loans.

There is already commentary that the government may not proceed with the recommendation to prohibit direct borrowing.  Certainly, in the absence of any evidence of any losses resulting from the ability of SMSFs to use leverage, it would be appropriate for the government to defer its consideration of any changes to superannuation until 2020, when the Productivity Commission will conduct a fuller review into the superannuation sector, including the government’s Stronger Super reforms.