Step 1 Set investment objectives
You need to be confident that your SMSF will be the foundation of your retirement needs. To gain that confidence you need to set achievable investment objectives. In setting your SMSF’s investment objectives the areas to consider include:
- How old are you and any other members? Are you in accumulation or pension phase? If the former, how many years until retirement? Do you want a lump sum benefit or an income stream? How much income will be required?
- What level of investment risk are you and any other members prepared to accept? Will you have a “high growth” strategy with possible higher risk, or must the portfolio be more balanced? Will assets be diversified and which asset classes will be selected or avoided?
- What contributions do you and other members expect to make to your SMSF? Higher contributions might mean you can target lower risk strategies. Lower contribution levels might mean you have to take on higher risk strategies.
- To what extent are you expecting your SMSF to contribute to retirement needs? The more reliance on your SMSF to fund your retirement indicates how much risk you might want to take. If you have substantial benefits accumulated, you might want to take less risk leading into retirement. If you have smaller amounts accumulated, you might need to take more risk to meet your objectives. But, the level of risk you want to take is a very personal decision
- Taxation of investments and investment income may also be relevant, particularly the value of franked dividend income from Australian shares.
The answers to these questions should help you determine the investment objectives, which should be measurable, achievable and able to be communicated to the members of the fund.
Investment objectives can be described in many ways. Some examples are:
- The SMSF will outperform inflation by 3% per annum over the long term,
- The SMSF will keep pace with inflation while minimising the risk of a negative return in any one year
- The SMSF will target a fund value in 10 years’ time of $XX.
Step 2 Define asset weightings
You’ll need to decide where to invest your funds and allocate monies across the various asset classes. The investment strategy should clearly state the types of asset classes you want to invest in, such as shares, cash, fixed interest and property as well as the percentage weightings (that is, the percentage of the fund that will be invested in that asset) and benchmarks for each asset class.
Different SMSFs will choose different asset class weightings based on their members’ investment timeframes, their level of risk, their need to protect capital, and potentially, their medium-term investment perspective. A fund that is prepared to take on more risk and has a longer investment timeframe is more likely to have a higher proportion of ‘growth’ oriented assets, such as shares and property, while a fund where capital protection is important will most likely have a higher proportion of ‘income’ oriented assets such as cash and fixed interest securities.
The percentage ranges for the various asset classes should be set wide enough to allow for day to day market variation, although not so wide as to render them useless as a monitoring tool.
A good example of how you might decide on your asset allocation is to follow the model used by larger superannuation funds. Larger superannuation funds typically estimate what they expect to earn from each asset class over the medium to long term as well as the risk of negative returns from each asset class. This provides a basis for deciding on what asset allocation will make it likely that the objectives will be met while reducing the risk of poor or negative returns.
The example below illustrates the concept of using expected returns to define asset class weightings. In this example, the fund wants to achieve a return of 3% above inflation over a ten year period, before tax. The trustees decide to weight the assets classes to target a return of around 4% above inflation which provides a buffer in the event of periods of poor investment returns.
* The Return over Inflation for each asset class is calculated by multiplying the Excess Return by the Asset Class Weight
Step 3 Detail any other specific rules
After the asset allocation has been set, the final step is to detail any other investment rules or restrictions you wish to impose on the fund. These rules can help with diversification, assist in keeping the fund liquid or strengthening the probability of delivering strong after-tax returns.
Examples of these rules could be:
- “For the Australian shares portfolio, the trustees must ensure that there are at least five different securities from different sectors in the portfolio.” (Diversification)
- “No single asset or security in the fund will represent more than 25% of the fund’s total assets.” (Single asset risk)
- “The Fund will ensure that, at all times, it has at least 5% of the SMSF’s value in a cash deposit with a Bank available within 24 hours’ notice.” (Liquidity)
- “The Fund will look to take advantage of dividend imputation by having a preference for companies that pay fully franked dividends.” (Tax efficiency)
- “The Fund will not invest in collectibles such as works of art, rare coins, stamps etc. or other assets where a market value cannot be readily established. (Defining what assets the Fund can’t invest in).
What else should I consider?
Your investment strategy should be properly documented, as a written document will make it much easier to demonstrate to the fund’s auditor (and potentially the ATO) that the trustees have considered all the relevant issues.
If the SMSF is to invest in a single asset or predominantly a single asset (such as business real property), it is advisable for the trustees to formally record in the minutes of a meeting that they reached the decision after having considered the relevant issues. These would include the:
- investment objectives of the fund
- expected return from the asset
- need for diversification given the investment timeframe and level of risk of the asset
- need for liquidity given the age of the members and the expected time when benefits would start to be paid
- fund’s ability to meet ongoing operating expenses from the investment income on the asset
Notwithstanding what is written in the investment strategy, the trustees must always comply with the SIS Act and Regulations. A breach of one of these rules could lead to your SMSF being deemed ‘non-complying’ by the ATO. An intentional or reckless breach could further leave the trustees being liable to both civil and criminal penalties.
Trustees are also required to consider whether the fund should hold insurance cover for one or more of its members.
This requirement doesn’t mean that your fund must hold insurance, it just means that you need to consider whether to do so, or not. If you decide not to hold any insurance cover, it is a good idea to formally record this decision in a trustee minute every year, the same minute that you should make after reviewing the adequacy of your investment strategy.
Keep your strategy up-to-date
Your investment strategy needs to be reviewed at least once a year, preferably more often, and whenever the personal circumstances of any of the members change. Other triggers for review include:
- a new member joining the fund or a member leaving the fund
- the fund buying a major asset
- the fund buying a new type of asset
- a limited recourse loan being taken out by the fund
You should also review the strategy where unexpected events have occurred such as the death or disablement of a member and when the personal circumstances of any of the members change to ensure that it is still appropriate.