Drafting your SMSF investment strategy: A Super Guide

Tip: For background information on how investing works, especially super investing, see SuperGuide article Superannuation investing: How does it all work?.

Trustees must consider 4 factors, at least

Your SMSF’s investment strategy, by law, must take into account the whole of your fund’s circumstances, including

• Risk and return: The risk of making any investment and the likely return on that investment, taking into account your fund’s investment objectives and expected cashflow requirements.
• Diversification: The composition of your fund’s investments as a whole and whether you’ve considered the appropriate spread of risk across industry sectors, asset classes and countries. If you choose to invest in a single asset class or a single asset, make sure you document that you considered the risk of taking this action, and check that your trust deed permits such an investment.
• Liquidity and ability to discharge your fund’s liabilities: The ability of your fund to pay taxes, expenses and benefits when they’re due for payment. Investing 100 per cent of your fund’s assets in one investment may mean you don’t have enough cash to cover your SMSF’s expenses, or to pay benefits.
• Insurance needs of fund members: An assessment of whether the SMSF trustees should hold a contract of insurance that provides insurance cover for one or more fund members.

Drafting an SMSF investment strategy in 5 steps

Each SMSF investment strategy will reflect the membership profile and retirement needs of the SMSF. Formulating, implementing and regularly reviewing a SMSF’s investment strategy commonly involves 5 steps (which are explained in more detail later in this article):

1. Identify fund’s investment objectives.
2. Determine fund’s asset allocation.
3. Select and monitor specific assets.
4. Assess whether your SMSF should take out insurance cover for one or more of your fund members.
5. Regularly reviewing fund’s investment strategy, including fund’s asset allocation. 

Warning: If your SMSF fails to draft and implement an investment strategy, the ATO may hit you with an administrative penalty in the thousands of dollars.

1. Identifying your fund’s investment objectives

The first step in formulating your investment strategy is to decide how well you want your fund to perform: Your desired investment outcome or the investment objective for your fund. The objective of your fund is likely to be linked to how much money you believe you need to fund your retirement, the number of years until retirement and the level of contributions you intend to make. According to the ATO, you also need to stipulate the investment methods the SMSF plans to use to achieve the investment objectives.

Any objective(s) you decide on also needs to be measurable. Many funds draft their fund’s investment objectives using industry benchmarks or a desired return in percentage terms. Examples of fund investment objectives include the following:

• To deliver an average annual rate of return exceeding any CPI increase by 4 per cent over 5-year periods. (The CPI, or Consumer Price Index, tracks the rate of inflation.)
• To deliver an annual average ‘real rate of return’ of 5 per cent over 7-year periods. A real rate of return means the fund’s return after taking into account the effects of inflation.

2. Determine your fund’s asset allocation

What asset class combination do you need to meet your fund’s long-term investment goals or objectives?

Asset allocation is an extension of diversification. Diversification is spreading your risk by investing across a broad range of assets, while asset allocation is the process to determine how much you allocate to each asset class — for example, the percentage of your portfolio to be invested in growth assets such as shares and property.

Understanding your risk tolerance (your ability to cope with volatility in investment returns and potential losses), and the risk tolerance of any other members of your SMSF, can ensure that your fund’s asset allocation reflects your long-term objectives and the level of risk you’re willing to take to get there.

SMSF pensions and asset allocation: Prudently,retirees running a SMSF pension, should hold about two years’ worth of income in cash within a SMSF to minimise the risk of forced asset sales to pay for everyday bills, and other living costs, or to meet minimum pension payments requirements (see SMSF pensions). if you have many years until retirement, and you have a high tolerance for risk, then the trustees of your SMSF may choose to hold minimal levels of cash.

3. Select and monitor specific investments

The majority of SMSFs invest mainly in traditional investments such as cash, shares and direct property. If you keep your fund’s investments simple, you require less effort to keep within the special investment rules that apply to super funds. If you do choose to take advantage of the more innovative opportunities available within SMSFs, or plan to invest in unlisted investments, you need to get on top of the super rules, in particular, the special SMSF investment rules.

Your SMSF can invest in any asset, provided that the investment satisfies:

• Sole purpose test. The primary purpose of investing in a particular asset within a super fund, is to maximise the retirement benefits of fund members. This is known as meeting the sole purpose test.
• Trust deed provisions. Any investment needs to be permitted by your SMSF’s trust deed. Your trust deed usually states the types of investments (may be in general terms) permitted by your fund, and the investment you have selected falls within one of these types of investments.
• Super’s investment rules. If your fund invests in non-traditional assets such as collectibles (for example, works of art), or invests in or with related parties, then you need to be across the special SMSF investment rules (see SuperGuide article Special SMSF investment rules: A starting guide [insert article link]).

Note: As trustee of your own super fund, you can invest in anything that you consider fits within your fund’s investment strategy — gold, real estate, artwork, the rights to songs, shares, term deposits, private equity, property trusts. You can also potentially invest in options and warrants, which are derivatives of shares.

Tip: Understanding how the large super funds invest members’ super savings can help you create an SMSF investment portfolio, and provide a performance comparison for your fund (see the special SuperGuide section Latest performance (Superannuation investment returns)).

4. Assessing the insurance needs of your SMSF members

SMSF trustees must consider the insurance needs of fund members when formulating and reviewing a SMSF investment strategy. The requirement to consider whether the trustees of a SMSF should hold a contract of insurance that provides cover for fund members does not, however, require SMSF trustees to actually take out insurance cover for fund members (see SuperGuide article SMSFs must consider life insurance needs).

Note: As a SMSF trustee, you will need to keep documentary evidence that you have considered the issue of insurance for fund members. Trustees can provide this evidence by documenting decisions in the SMSF’s investment strategy or documenting the decisions in the minutes of trustee meetings held during the income year. For information on the types of insurance that SMSF trustees can purchase see SuperGuide article Life insurance and super: 10 facts you should know.

5. Reviewing your fund’s investment strategy and asset allocation

You must regularly review your fund’s investment strategy, which you should typically undertake at least every 12 months, and possibly more frequently. A sensible approach is to review your fund’s investment strategy whenever your fund or a fund member has a significant event, such as a member retiring or divorcing, or when one or more of your fund’s investments is delivering less-than-expected returns. For example, you may choose to review your super fund’s long-term investment objectives if one or more of your SMSF members are close to retirement.

You can review your fund’s asset allocation, and decide whether the proportion of your SMSF’s money invested to each asset class is appropriate. You can also review your fund’s investments, and your fund’s insurance cover for members (if any), to ensure the investments and insurance are still appropriate and consistent with your fund’s strategy.

For more information…

For more information about SMSF investing, see the following SuperGuide links:

• Superannuation investing: How does it all work?
• Special SMSF investment rules: A starting guide
• SMSF investment: What assets do DIY super trustees prefer?
• Superannuation investment strategies
• Types of investments for superannuation