Shadforth Insurance Specialist Kunaal Parbhoo, in the second of a three-part series “Shedding Light on Financial Exposure” for Legalwise News, continues exploring the under-insurance problem in Australia and specifically, the liquidity problems which SMSF trustees face. Kunaal’s previous instalment discussed how Australians are over-reliant on Government, under-insured and financially exposed.
Self-managed super funds (SMSF) are one of the fastest growing sectors in financial services. As at March 2018 there were over 595,000 funds holding $712 billion assets, with more than 1.1 million members.
The growth and popularity of SMSFs has largely been attributed to the offer of greater control, choice and flexibility that other funds are unable to provide. Direct property is a popular asset class for many SMSFs, with a single property often the fund’s main asset. Also we continue to see a rise in the proportion of SMSFs with limited recourse borrowing arrangements (LRBA), which now represents $32 billion in assets, with reported total borrowings of $24 billion representing 3.3% of total SMSF assets. However only about 13% of SMSFs have any form of life insurance cover, confirming once again the underinsurance issues we face in Australia.
Requirements to consider insurance
SMSF trustees have a regulatory requirement to review their investment strategy and address risk and return, diversification, liquidity and the ability of the fund to discharge liabilities. In addition to this, as part of the 2012 Stronger Super reforms SMSF trustees are also required to give consideration to the life insurance needs of fund members.
Liquidity and cash flow
SMSF trustees who hold direct property as part their asset allocation strategy, are obliged to carefully consider their member’s life insurance requirements under superannuation law. But, they also need to consider happens to the property upon the death or disablement of a member. While direct property investment may be attractive, this strategy needs to be carefully managed to ensure the fund is able to discharge its liabilities when required. Trustees should give particular consideration to the fund’s liquidity in the event that the fund is required to make a benefit payment. Liquidity could be particularly challenging if a benefit payment is unexpected such as when a member dies or is permanently incapacitated.
Without appropriate solutions in place, illiquid assets such as property within an SMSF may need to be sold to enable payment of member benefits. This could lead to some unexpected outcomes for the fund, including:
- Needing to sell the property quickly, which may mean a lower price and loss of future growth and rental income.
- If the property is a business premises, it may affect the continued viability of running the business.
- A delay in paying a benefit to beneficiaries due to the time needed to sell illiquid assets.
- Unforeseen CGT implications.
Liquidity problems can be further compounded when a fund has borrowed money to purchase the property through an LRBA, and upon the death or permanent incapacity of a member, it is no longer receiving member contributions to fund the loan repayments.
Managing the liquidity problem
Liquidity risk is essentially the risk that an SMSF will be short of funds to meet its cash flow obligations. It occurs when investing in ill-liquid assets and where an unexpected (typically death or disability) benefit payment for one of the member’s risks not being met because of the lack of cash in the fund.
An appropriate liquidity strategy will depend on the specific circumstances of the fund and its members. Life and TPD insurance can protect the financial future of SMSF members and their families. However, just as importantly, liquidity insurance can protect the fund’s assets by providing liquidity if the unexpected occurs. Liquidity insurance enables benefits to be paid in the event of death or permanent incapacity without the need to sell a property asset, as the insurance proceeds can be used to provide funds to assist with repayment of debt and improving cash flow. Insurance can be the key to providing the requisite liquidity, however if it is structured incorrectly it can be ineffective.
That is, traditional life insurance is taken out for a specific fund member; liquidity insurance is taken out by the fund for all its members, and is treated as an investment of the fund. In this way, the proceeds from any insurance claim will not increase the member’s benefit, but rather will be retained in the SMSF to provide liquidity.
Many SMSFs will hold large illiquid assets often in the form of property. On the death or permanent incapacity of a member, a benefit payment will be required; however surviving members may wish to retain the property in the fund. In the absence of an appropriate liquidity strategy, in some circumstances the trustees may be forced to sell the property. When coupled with the requirement to consider insurance as part of the fund’s investment strategy, trusted advisers are well positioned to guide trustees in fulfilling their obligations to consider insurance as a mechanism to provide liquidity to an SMSF.
Kunaal Parbhoo holds a Bachelor of Business (Banking and Finance) with Honours from Monash University. He has also completed the Advanced Diploma in Financial Services. Kunaal commenced his financial services career in the 2006 Commonwealth Bank Graduate Program (Financial Planning), where he rose to become a financial adviser. He then transitioned to a boutique financial planning practice in Melbourne where he developed his specialist knowledge in risk management solutions. Kunaal joined Shadforth Financial Group in 2016. Kunaal is passionate about ensuring clients understand the risks faced by their financial situation or business and providing advice to help protect them. Away from work Kunaal is actively involved in his community and takes great pleasure in spending time with his family. Contact Kunaal at firstname.lastname@example.org