Doing business with SMSFs

This week’s Trialogue summarises some of the key themes from the recent Tria Strategy Series breakfasts – doing business with SMSFs.

Tria has not always been wildly enthusiastic about some developments in the SMSF segment. Investors – at least enough to matter – are indeed becoming more engaged with their super. SMSFs are a good fit with this macro theme, which can be seen in many other industries.

But there are clearly problems with SMSFs understanding their obligations as trustees, and getting caught in investment disasters, from Trio Capital to the Rare Coin Company (it’s notable how often disasters involve an investment originating in a regional area). We’ve earned a reputation as SMSF party-poopers for pointing these out. But ASIC now seems to be coming around to this view, if CP216 is anything to go by.

Five SMSF themes to reflect on:

– The numbers. SMSFs represent $500bn which would otherwise be inside collective funds, which is a big deal in itself. SMSFs also drain flows from the collective system, the annual net inflow of which is ~$40bn. The net inflow of SMSFs is ~$20bn, but most of that – ~$16bn comes from collective funds. SMSFs drain about one third of the net inflows of the collective system, and take 50,000 of their most valuable members, every year. Ouch.

– The most compelling SMSF argument. Super should be about building a growing retirement income stream. That idea gets lost in collective funds. Too often funds talk about returns relative to benchmarks or medians, which are meaningless for many members. In an SMSF it’s much easier to build an income stream. By progressively buying a portfolio of income producing assets, you can see the income stream grow rapidly, regardless of whether markets go up or down. That can be pretty satisfying and give you a real sense of controlling your destiny.

– Will new generation platforms be enough? New wrap style products being rolled out, such as AustralianSuper’s Member Direct, offer an SMSF-like experience. This may help reduce outflows to SMSFs, at least in respect of those who mostly intend to use shares, deposits, ETFs and public market instruments. But it won’t be a complete solution. There is a segment which will only be satisfied with a true SMSF. But even here, a fund could potentially retain another chunk of members with an in-house SMSF offer.

– Wealth disasters as a series of small policy mis-steps. Wealth disasters are rarely the result of one big mistake. More often they arise from little mistakes which compound over time. Geared real estate in SMSFs feels like one of those in the making. The lack of effective controls on SMSF formation and investment strategy allows pretty much a free-for-all. The introduction of gearing brings real estate within reach of the average SMSF. Then you keep real estate exempt from FoFA, and property developers can offer huge commissions to distributors. The scene is set.

– Risk. Low cost group insurance is one of the great benefits of collective funds – even after recent premium increases. When members shift to a SMSF, insurance costs typically rise substantially, but often insurance this is something that simply falls through the cracks.

There should be a major role for the wealth industry in the SMSF segment. SMSFs need quality products and services (including advice). The trick is that many SMSF members have rejected the wealth industry’s traditional value proposition. To do business with them, the industry needs to deliver on what SMSFs actually like.

When you boil it down, and exclude investments which are really financing personal or business goals, SMSFs are adopting four main strategies:

– Deposits, to de-risk and generate yield
– Blue chip shares, for franked income and long term growth
– Property (and property funds), for tax preferred income, and long term growth
– A bit of global investing, which gives exposure to a falling AUD

So apart from the dodgy stuff, doing business with SMSFs comes down to offering a relatively small number of propositions, with a strong theme of yield, particularly tax effective yield, supported by longer term capital growth.