At a glance
The marketing pitch for self-managed superannuation funds (SMSFs) sounds compelling: greater financial control and tax breaks along with the business benefits and flexibility equals financial success.
Then why are SMSFs under fire in some quarters? The short answer is that, for now at least, some SMSFs are not matching the returns of default MySuper funds regulated by the Australian Prudential Regulation Authority (APRA). That is a real worry, given that in Australia there are more than 595,000 SMSFs with combined assets of about A$712 billion, representing about one-third of the total superannuation sector.
Aaron Dunn, CEO of Smarter SMSF, concedes there is always likely to be volatility with the performance of self-directed funds.
“[However] not to the extent that it’s become a huge problem, and ASIC [the Australian Securities and Investments Commission] has stepped in where needed.”
How SMSFs stack up
Consider the performance of the average SMSF. From 2011-2016, APRA-regulated funds earned an average return of 7.4 per cent a year and industry funds 8.2 per cent, which falls in line with data released in February by Industry Super Australia. In the same period, SMSFs with assets of more than A$2 million earned on average 5.6 per cent, while those with A$1 million to A$2 million (4.5 per cent) and A$500,000 to A$1 million (3.7 per cent) also underperformed the APRA-regulated and industry funds. Alarmingly, for SMSFs with balances below A$200,000, average returns fell into the negatives.
According to SuperGuard 360, the SMSF sector posted a 12-month return to the end of April 2018 of 6.6 per cent before fees and taxes. In contrast, the SG360 Default Index, which is based on APRA-regulated products, achieved a 7.8 per cent return. SuperGuard estimates that this underperformance of 1.2 percentage points in 12 months has cost the SMSF sector A$8 billion in lost investment income, or A$13,000 per SMSF.
However, Alun Stevens, a senior consultant at financial advisory firm Rice Warner, urges caution with such comparisons because SuperGuard 360 uses a hypothetical top-10 MySuper index – these funds are the biggest and best-performing of the APRA-regulated funds – when weighing up performances against SMSFs.
“What’s happening in super at the small end and the bigger end is really quite different,” Stevens says, adding that a significant proportion of SMSFs are in or near retirement phase and therefore need a higher allocation of stable assets than MySuper funds, which are primarily for much younger people.
Changing market cycles also mean that comparisons can differ substantially depending on timeframes. For example, Rice Warner’s analysis of SMSF versus MySuper returns from 2005-2016 reveals that the former has collectively outperformed the latter, with average compound returns of 8 per cent per annum and 6.2 per cent per annum, respectively. The margin is even greater if fees are deducted from returns.
Size matters in super
Regardless, Stevens agrees that the recent performance of smaller SMSFs has been less than stellar.
ASIC suggests an asset threshold of at least A$200,000 for an SMSF to be viable if trustees are managing it, while the figure jumps to about A$500,000 if management is outsourced to fee-charging accountants and financial advisors.
Stevens says smaller SMSFs typically put most of their money into cash and term deposits, which he notes “haven’t been the greatest earners” in recent years because the cash rate has been at record lows.
“Those funds do have a bit of a problem,” he declares, “but prior to that they were actually very good earners and one of the reasons why SMSFs were doing very well.”
A draft report released in May by the Australian Government’s Productivity Commission supports the belief that the size of SMSFs is crucial to performance. It found that the difference between returns from the smallest SMSFs (less than A$50,000 in assets) and the largest (more than A$2 million in assets) is more than 10 percentage points a year.
Dunn says there is no doubt larger super funds have benefited from a more diversified investment strategy, including investments in listed and unlisted assets. He adds that SMSFs with assets of more than A$2 million have generally performed on par with APRA-regulated funds.
Criticisms notwithstanding, Dunn says there are obvious attractions to SMSFs for business owners, among others. They can, for example, own an office or factory within their SMSF and get tax breaks or protection from creditors in the event of financial difficulties.
“Those tax benefits might somewhat supplement [lower] investment returns,” he says.
It is worth noting, too, that during the global financial crisis, the performance of many APRA-regulated funds fell considerably, encouraging many investors to set up SMSFs and go it alone.
One of the recognised weaknesses with some SMSFs is trustees’ choice of investments.
Australian Taxation Office (ATO) figures in the year to June 2016 indicate that about 60 per cent of SMSFs with balances under A$100,000 had 80 per cent or more invested in a single asset class such as cash, term deposits, managed trusts or domestic listed shares.
David Knox, a senior partner at financial advisory firm Mercer, says this focus on local shares and trusts contrasts with MySuper funds that often have a large overseas equities component.
“That’s an important difference,” he says. “People in SMSFs tend to favour investments they’re familiar with, which is understandable.”
The problem is that this can shut them out of overseas assets such as biotech companies and “glamorous”, blue chip stocks such as Apple and Amazon, many of which are currently outperforming Australian assets. To underscore the impact, Knox cites figures for 12-month returns to the end of February this year. The S&P/ASX 50 Accumulation Index delivered a return of 7.5 per cent for the year, compared with the MSCI World Index, excluding Australia, of 14.7 per cent (hedged) and 16 per cent (unhedged).
“If you are just looking at a one-year return that’s a pretty powerful difference,” Knox says.
Furthermore, during a five-year period to the end of February 2018, the S&P/ASX Accumulation Index delivered a 7.2 per cent return, compared with 13.8 per cent for the MSCI World Index (hedged).
Knox notes that cash and term deposits make up about 22 per cent of SMSF investments, compared with just 11 per cent for APRA-regulated funds. “With cash rates being very low, that’s having a real impact on SMSF returns,” he says.
While Dunn agrees that mum-and-dad SMSF investors’ love of domestic banks and corporations such as Telstra has cost them exposure to overseas assets, he is encouraged that SMSFs are becoming more sophisticated by embracing investment options such as exchange-traded funds (ETFs).
In the past five years, total assets invested by SMSFs in ETFs quadrupled from A$4.2 billion to A$19.6 billion and the percentage of SMSFs using ETFs more than doubled from 7.9 per cent to 18.9 per cent, according to the Class SMSF Benchmark Report for March 2018. Key drivers for investing in ETFs are diversification, cost-effectiveness and access to overseas markets.
“It’s a sign that the sector is maturing,” Dunn says. “Slowly but surely we’re seeing more diversification within SMSFs.”
Fees and expenses are another big issue for SMSFs, which incur many establishment and administration costs. The ATO’s list of common costs includes actuarial, accountancy and auditing fees, compliance imposts associated with government regulations, investment research subscriptions and annual lodgement fees. As funds grow, the expense ratio drops because most costs are fixed, so they become a smaller percentage as asset values increase.
ATO figures reveal that the average total expense ratio for SMSFs with assets less than A$50,000 topped the 10 per cent mark each year from 2012 to 2016, peaking at 14.05 per cent in 2016. In that year, for example, funds of A$500,000 to A$1 million (1.58 per cent), A$1 million to A$2 million (1.06 per cent) and more than A$2 million (0.69 per cent) had dramatically lower total expense ratios.
Stevens says the high costs for smaller funds could perhaps be justified if they are relatively new and trustees intend to quickly inject more money into them. However, if the investment level is stagnant, having an SMSF could be a flawed strategy.
“Unless there is a commitment to put quite a bit more money into the fund, in all likelihood such a SMSF is unlikely to go anywhere,” Stevens says.
Knox believes the impact of fees depends on how the SMSF is run, with trustees paying “almost nothing” if they handle administrative and investment decisions. What is more, if they benefit from a rental property that sits within the fund, or if businesses are paying rent into the SMSF, the fund may be strongly viable.
Nevertheless, despite ATO guidelines that have increased fee transparency, Knox adds that “right through the superannuation industry, comparing fees is incredibly difficult”.
“That’s not necessarily because people are trying to hide them – it’s because fees come in all shapes and sizes.”
Are SMSFs worth the trouble for trustees – and are trustees up to the management challenge? Despite a perception that MySuper funds, benefiting from experienced fund managers, should outperform SMSFs, Knox says that is not always the case.
“Those who are astute and know what’s going on in the market can do very well.”
There is also a view that, with major banks and some wealth management firms feeling the heat in the wake of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, there could be a flight to SMSFs.
“There’s some validation to the argument that there could be some flow-on effects,” Dunn says.
What SMSFs must do, though, is diversify their portfolios, manage fees and try to build up assets as quickly as possible.
So, is your SMSF costing you money? For larger SMSFs with a diversified asset base and a relatively low proportion of fees, the answer is probably no – your SMSF investment probably makes sense financially.
The news, however, is not so good for smaller funds. Stevens says: “If all they [investors] are wanting to do is sit there and hold big blocks of cash and term deposits [in a fund under A$200,000], they do need to think quite carefully as to whether the problem with yields is a reasonable price to pay for control.”