There’s risk and then there’s risk

The Financial System Inquiry (FSI) report’s recommendation to remove borrowing from superannuation was predicated on an objective of “prevent[ing] the unnecessary build-up of risk in the superannuation system and the financial system more broadly”.

It would therefore be interesting to explore what exactly what is meant by risk.

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If you were to ask many SMSF members today what they perceive to be their biggest risk, I expect it would be the risk of having inadequate savings to live on in retirement.

Obviously one way of failing to have enough would be to lose it all on an ill-judged investment.

Another way of failing to have enough would be not achieving high enough investment returns. This is why conventional wisdom would be to encourage today’s 20-year-olds to steer clear of investing entirely in cash even though it feels safe.

Unfortunately nothing in life is ever simple – gearing in super could act positively or negatively on the “I won’t have enough” risk.

Leverage can magnify the impact of a bad investment. This is the risk that is usually highlighted and certainly the one on which the FSI comments are based.

But it is also a wealth creation tool that our community often uses to maximise investment returns.

It allows investors to take advantage of opportunities involving large assets that would otherwise be inaccessible.

It allows funds to purchase a large asset without selling everything else they own and compromising diversification.

So which is worse? Allowing some people to blow themselves up by gearing or preventing lots of people from maximising returns by prohibiting gearing?

If we continue this train of thought about the risk of catastrophic failure, there is one glaring omission in the FSI report.

That is the unique position occupied by business real property as one of the very few assets an SMSF can lease to a related party with impunity, even if it is pretty much the only asset owned by the fund.

When it all goes horribly wrong, this is also leveraging the outcome – the business owner faces the loss of a major personal asset (the business), loss of income (their job) and often a material fall in value of the fund’s major asset (the property) because its tenant is unable to pay the rent.

But this concession has not been attacked. Why? I suspect because while it is clearly a risk, it’s either one that has been around for so long policymakers are used to it or feel it can’t be taken away.

Or perhaps they simply assume that it won’t affect enough people to warrant heavy-handed legislative intervention.

Again, which is worse? Allowing some people to blow themselves up by putting all of their eggs in their own business basket or preventing lots of entrepreneurs from maximising their retirement savings on the back of a sound investment where they know the tenant will take good care of the asset?

Then of course the community as a whole might have yet another view of risk.

The community’s focus is likely to be on the tax concessions provided to superannuation and whether the way in which these are targeted is skewed by allowing borrowing.

In effect, this is the risk the ATO has been trying to address via its Interpretive Decisions on related party lending. For example, if I can lend money to my SMSF with no interest and my SMSF then uses it to make money for me in a 15 per cent/ 0 per cent tax environment, was that intended?

Obviously it’s not the ATO’s role to rewrite laws so that they do what the policymakers intended but it will naturally feed into their decision-making when an interpretive issue could go either way. Unsurprisingly, the ATO has not made a blanket statement that related party borrowing is unacceptable per se (in fact, quite the opposite).

Rather, the commissioner has highlighted examples of situations where income earned on the asset purchased with borrowed funds is likely to give rise to non-arm’s length income, resulting in a very nasty tax outcome.

Does borrowing present unique opportunities to put in place strategies that optimise the tax outcome for SMSFs? Probably to some degree – but is this a good enough reason to terminate LRBAs entirely? Or is that somewhat heavy-handed?

We could and should have a debate about the risks presented by gearing. But we shouldn’t kid ourselves that we can ever completely do away with risk – minimising or removing one risk inevitably means accepting another.

That’s life. When we do discuss gearing in super, we should consider all the risks, weigh them up and then decide.

Meg Heffron, head of customer, Heffron SMSF Solutions