FSI Interim Report – super gearing gets the thumbs down

If the Financial System Inquiry (FSI) interim report raises some difficult questions for collective super funds, it also does the same for the SMSF segment, particularly in respect of gearing.

The FSI interim raises the idea of restoring the general prohibition of gearing within super, other than for liquidity purposes. It notes the SMSF gearing data from the 2012 financial year, which we discussed here back in January. This data is now well out of date, and although SMSF gearing at 2012 levels are not worrying, the potential for it to rise rapidly could create vulnerabilities in the system.

The is compared to collective funds, where the data indicates very low levels of gearing – although to be fair, there is some additional gearing embedded within underlying vehicles used to hold certain assets, such as real estate (though the same could be said for SMSFs).

The FSI lines up a series of objections to gearing within super:

• Undermines the role of super in stabilizing the financial system in times of stress.
• Creates moral hazard via an ultimate transfer of risk to the Government.
• Correlated with bad advice.
• ?Extends super tax concessions from saved funds to borrowed funds.

Those are some pretty interesting objections.

The first objection pushes back on the traditional view that SMSFs are too fragmented to have any systemic effects. It points to a future where the SMSF segment is larger again than it is today as a proportion of the system, and where gearing is prevalent. The report suggests such a scenario could restrict a reprise of the financial crisis situation, where the super system was successfully able to recapitalise the banking system.

It also raises the issue of moral hazard, and by implication, what are acceptable levels of risk within super given the provision of tax concessions. This is about time. The report points out that negative outcomes from leverage, if they eventuate, compromise the super system’s ability to deliver on its objective of retirement income provision. It also notes that this transfers risk to the tax payer – ie if a super fund blows up because of gearing, the members fall back on the age pension. This safety net may encourage excessive risk taking.

The link with bad advice was something of a surprise, with the Report quoting ASIC data that what the regulator considers poor SMSF related advice is often part of a gearing strategy.

Perhaps the most interesting objection to gearing relates to the interaction with tax concessions. This report argues for the concept that tax concessions for super should apply only to monies which have been saved rather than borrowed; and that gearing in super creates an unintended extension of super tax concessions. It points out there are already plenty of opportunities and tax benefits to borrow outside of super. We illustrated at last week’s ASFA SMSF debate that the use of gearing, particularly in combination with franking credits, makes it relatively easy to construct an SMSF which never pays any tax at all, including on contributions.

The Interim report makes it clear it considers the relaxation of the prohibition on gearing in super to have been a mistake. It does not mince words on this one – its view is that leverage should not be a core focus of any super fund and is inconsistent with retirement income policy.

The next step in the review process is an invitation for views on a restoration of the gearing ban. Keep in mind this is only an interim report, the final report could land anywhere, and whether any recommendations are applied by government is another matter again. But so far, it’s hard to see this as anything other than a stinging rebuke to the unfolding of the gearing in super story to date.