I remember sitting in a finance lecture on superannuation, presumably paying little attention, until the lecturer suddenly decided to embark upon a tangential rant. Being an avid listener of talkback radio on the long drives to and from Monash University, Clayton, I had acquired a taste for the rhetorical art-form commonly known as ‘the rant’. I listened keenly.
The lecturer was arguing we require tighter regulation for self-managed super funds (SMSFs). He gave examples of his friends investing in high-risk asset classes such as derivatives and seemed exasperated that they could do such a thing without any person or agency possessing the power to stop it. This got me wondering: was my lecturer just being a finance-elitist unable to fathom that a lay person could manage their own money or did he have a valid point?
Why would someone use a SMSF?
As Westpac points out, the benefits of SMSFs include increased control and flexibility, the ability to use leverage to potentially increase the magnitude of returns and potentially lower management fees. Spruikers of investment products who may benefit from increased SMSF activity often seize on the management fees point. There is research to back up this claim, showing that managed funds, on average, take almost half of the customer’s investment return in management fees. Using this point, it is relatively easy to appeal to an individual’s natural desire for greater returns and make the case for SMSF. However, there is a salient point conspicuously absent from this discussion. What about the risks?
Don’t forget the risks!
One of the bedrock principles of financial economics is the positive relationship between risk and return. It is impossible to undertake even the most basic of studies in finance without coming across the capital asset pricing model (CAPM) and the security market line (SML). This can be seen below:
(Source: Fundementals of Corporate Finance (1st Ed.) by Parrino, et al.)
It is also known that if any asset is expected to generate risk-adjusted returns above or below those predicted by the SML, market forces will move the returns back towards the SML. In other words, it is not possible to earn higher returns without increased risk. Perhaps, the failure of my finance lecturer’s friends to understand this simple lesson was the source of his exasperation.
Risk in SMSFs
What is disturbing about spruiking SMSFs by emphasising the lack of management fees and the ability to leverage your investments is that all the focus is on generating superior returns. For example, when you heavily gear an investment portfolio you amplify the potential returns but you also amplify the risk and this is problematic in the sphere of superannuation. The guiding principle of superannuation, as set out in section 62 of the Superannuation Industry (Supervision) Act 1993 (Cth), is that the purpose of superannuation funds is to provide retirement benefits. Arguably, a SMSF that is heavily gearing or investing in high-risk asset classes is acting in contravention of this provision. Whilst the legality of high-risk strategies in superannuation is highly debatable, it is certainly not controversial to assert that heavily gearing or investing in high-risk asset classes runs against the spirit or public policy rationale of superannuation.
The public policy rationale for superannuation is for individuals to gradually accumulate wealth in a quarantined fund that they can use to fund their retirement. This is a sound and uncontested policy goal because society has an interest in individuals funding their own retirement so that scarce budgetary resources are not swallowed up by age pension payments. To put it simply (and rather crudely), the point of super is so retirees can enjoy a comfortable lifestyle using their own funds, not so all retirees can purchase a Mercedes or BMW.
There is nothing wrong with chasing high returns in any other sphere of investment. In any other sphere of investment, it is best that government plays a minor role, merely enacting laws to promote informational efficiency and balanced consumer protection. However, superannuation is different. The entire community has a stake in ensuring individuals earn sufficient returns to fund retirement.
SMSFs haven’t caused any problems yet though?
An argument against the concerns I have canvased thus far is that they are theoretical and have not yet manifested in reality. The answer to this is threefold. Firstly, SMSFs are relatively new. Secondly, just because no risks have yet materialised into a large-scale catastrophe does not imply we should abandon caution. The inherent risk in SMSFs formed the reason why the Australian Institute of Superannuation Trustees recommended that the government’s forthcoming Financial System Inquiry consider ‘the impact of failure of Self Managed Superannuation Funds on the funding of the age pension.’ Thirdly, these concerns are real and not merely speculative.
In its most recent Financial Stability Review, the RBA stated that ‘[c]hanges to legislation in recent years have permitted superannuation funds, including SMSFs, to borrow for investment, for example to purchase property.’ The RBA went on to state that ‘[t]he sector therefore represents a vehicle for potentially speculative demand for property that did not exist in the past.’ These sentiments were echoed by UNSW Tax Law academic Helen Hodgson, who stated that not only is this heavy gearing investment strategy adopted by SMSFs ‘pushing up the price of real estate, but it is exposing SMSF members to risk if property prices crash.’ This is helping fuel the recent housing boom which I recently wrote about.
It is naïve to disregard the inherent risk in SMSFs. A hit to the budget due to SMSF losses could easily materialise, especially if the property market moves southward. In this case, the consequences would be as grave as pointed out by Morgan Stanley Australia’s CEO, Steve Harker, when he stated that the ‘SMSF space is ripe for property spruikers and promoters, high-yield schemes and fraud. We’re talking about potentially $200 billion in superannuation savings being completely blown up’. Given the risk and the serious potential consequences, it would be prudent to institute regulations to mitigate this risk. Fortunately, the ATO, APRA and ASIC are monitoring the SMSF space and considering risk-mitigation measures. But perhaps a legislative response is required. I wonder if the laws which once curtailed leveraging for superannuation funds ought to be reinstated.