The Financial System Inquiry (FSI) has published its Interim Report. You can access the full report here.

The FSI was tasked with examining “how the financial system could be positioned to best meet Australia’s evolving needs and support Australia’s economic growth”.

One area of focus for the FSI was Superannuation, including Self-Managed Superannuation Funds (SMSFs).

The FSI noted that the establishment of SMSFs, and their investment decisions, have the ability to impact upon the stability of the financial system and the flow of funds ion the economy.

The FSI made the following observations.

  • There are currently more than 1 million SMSF members.
  • SMSFs hold approximately $559 billion in assets, which represents one third of all superannuation assets. This is 15 times larger than in 1997.
  • SMSFs have a higher allocation towards domestic equities, property, cash and deposits than APRA funds.
  • APRA-regulated funds have better access to foreign equity and wholesale fixed income markets, although product developments, such as exchange-traded funds and retail bonds, will make it easier for SMSFs to access such asset classes in the future.
  • SMSFs deliver members greater flexibility and control, better tax outcomes and (depending on fund size) lower fees.
  • The popularity of SMSFs has forced APRA funds to innovate and expand their investment offering to retain members.
  • The operating costs of APRA funds are high by international standards. These costs have not fallen despite the economies of scale arising from the consolidation of funds.
  • Direct leverage in superannuation funds is embryonic but growing, from 2.2% of funds in 2008 to 3.7% of funds in 2012. The average loan size is $357,000.
  • Continued growth in direct leverage by superannuation funds could create vulnerabilities for the financial system due to fund exposure to asset price volatility.
  • SMSF borrowing has been associated with poor financial advice (See ASIC’s 2013 review of the quality of advice to SMSFs).
  • The FSI expressed concerns about the cost effectiveness and ability to diversify of SMSFs with balances less than $200,000.

The FSI has invited further information from industry in relation to the following:

  1. whether there should be any limitations on the establishment of SMSFs;
  2. the costs benefits and trade-offs on restoring the prohibition on the ability of superannuation funds to borrow; and
  3. the introduction of stronger education requirements for practitioners providing SMSF advice.

The FSI’s comments in relation to the ability of SMSFs to borrow have been made without any regard to any evidence of losses to SMSFs arising from leveraged investment.  Whilst no hard data is available, our discussions with financial institutions in the SMSF lending space suggest that the incidences of default by SMSFs on loans to finance acquisition are negligible.

The ability to make leveraged investments, when based on sound professional advice, enables SMSF trustees to access the accumulation benefits of capital gains and income generation to provide for their retirement.

Our experience also suggest the credit policies set by lenders for loans to SMSFs are conservative, in terms of minimum fund balance, low LVRs and the requirement for the trustees to obtain independent legal and/or financial advice.

The FSI notes that superannuation policy lacks stability and should not be subject to frequent changes. Whilst there may be merit in improving the education and training of advisors providing advice to SMSFs, in view of the lack of evidence to suggest any detriment to SMSF from borrowing, regulatory stability favours the continuation of the ability of SMSFs to borrow.

Without gearing, many SMSFs would not be able to invest in real estate, causing an undesirable asset mix within the fund.  In any event, many would argue that historically real estate has performed more consistently and profitably than the main alternative investments of shares and cash deposits.