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Self Managed Super Fund (SMSF) Article
Self Managed Super Funds and Reserves
By Tony Negline.
This article may be out of date.
23rd September 2009
Reserves have been used by larger superannuation funds and life insurance companies for hundreds of years.
A reserve occurs when a super fund has surplus assets. That is, the net market value of assets in a fund exceeds the value of benefits payable.
Under super laws, trustees are allowed to keep reserves unless a fund's trust deed specifically disallows them.
Over the last 20 years reserves have played a useful role in helping some people manage Reasonable Benefit Limit or super surcharge problems inside their Self Managed Super Funds. Fortunately both these awful policies are no longer with this.
Do reserves still have any useful purposes in small super funds?
a. Investment reserve – these are used a lot by large funds to smooth investment returns. Let's look at a very simple example:
A super fund has two members, M1 & M2. M1 has $50,000 and M2 has $1.5m of the assets in the fund. Respectively they have 3.2% and 96.8% of the assets in the fund.
Suppose that the investment strategy of the fund is to earn an average return of CPI + 2% per annum (this is not an investment strategy – it is actually an objective. The strategy is how you go about achieving this objective but this is a topic for another day).
Now assume that the CPI rate is currently 2.5%. This means that the trustee merely needs to allocate 4.5% to each member’s account.
The fund has had a net investment return of 5% (after all fees, expenses, taxes, etc) for the most recent year end. The trustee decides to allocate 4.5% ($2,232 for M1 and $67,518 for M2) to each member and place 0.5% ($11,250) into an investment reserve.
That investment reserve can then sit there for a period of time and be allocated to members of the fund when the fund fails to perform as expected.
How would money be allocated from this type of reserve? A fund running an investment reserve needs an allocation policy. That is, a policy that discusses how, to whom and over what period of time money would be allocated from the investment reserve. This policy must treat all fund members fairly and equitably.
Many industry funds use this type of approach to smooth investment returns over 3 to 5 year periods. The major issue for using this technique is ensuring equity between different members especially making sure that those who stay don't receive all the good times and those leave don't unfairly get lumbered with lower earnings or even losses. These problems can particularly manifest themselves when a fund invests in assets which are valued infrequently.
About 10 years ago the Tax Office said that this type of reserve should not exceed 15% of the total assets of the fund.
b. Contribution reserve – these have been used to hold a contribution made for a specific member for sometime. These types of reserves have ceased to have much use since July 2004 when the law was changed to force super funds to allocate contributions to the member within 28 days of them being made
c. Expense reserve – which a fund trustee can use to pay general or specific fund expenses
d. Insurance reserve – used to fund the payment certain benefits to members such as temporary disablement benefits
e. Forfeiture reserve – this might occur when a member's benefit is forfeited (that is, given up). Under current super laws it is not possible for a member to forfeit their super benefit
f. Anti-detriment payment reserve – this may be set up to pay an additional benefit upon death equivalent to the tax on contributions paid for a particular member. This reserve could be funded from excess investment returns or allocated from another appropriate reserve account and must be established before death
When allocating from a reserve a super fund trustee has to be very careful about how they allocate money from the reserve to a specific member.
In general an allocation from a reserve account will be deemed to be a Concessional Contribution for a particular member unless the amount is allocated in a fair and reasonable manner to every fund member and the amount allocated is less than 5% of a members account balance before the reserve amount is allocated. If the allocation from the reserve account is a Concessional Contribution then it will be taxed at 15% in the year it's received by the member.
There is also another rule excluding allocations from a reserve when a pension is commuted but we will not look at this rule here.
The super laws demand that a trustee cannot run any reserve account if a super fund's governing rules specifically stop a trustee from operating one. This does not mean that the governing rules can be silent on this issue. In order to operate a reserve account a super trustee should have a specific power including the types of reserve accounts that can be used and rules for how each account will be created and their operation monitored.
From time to time various superannuation experts publish material which suggests that reserves have a big role to play in Self Managed Super Funds.Reserves are reasonably complex, and therefore costly, to administer. Many Self Managed Super Fund administrators and advisers don't seem to understand the finer details of running a reserve. Personally I think most people will not get sufficient benefit from these structures to justify their use.
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