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Over 17,000 SMSFs that are heavily invested in one asset class will soon receive a “please explain” from the ATO to check whether they can justify their diversification risk. Diversification is just one of five key matters that all SMSF trustees must regularly review as part of their legally required investment strategy. Know the essential requirements and ensure your fund’s strategy is airtight.

So, what exactly is required? There’s no prescribed format for what your strategy must look like, but it must be in writing and must be “reviewed regularly”. The ATO recommends reviewing the strategy when a member joins or leaves the fund or when the fund begins paying an income stream to a member.

By law, SMSF trustees must have regard to all relevant circumstances of the fund when setting the investment strategy. However, there are five specific matters that trustees must take into account.

(a) Risk

Trustees must consider the risk involved in making, holding and selling the fund’s investments, and the likely return they’re expected to generate (having regard to the fund’s objectives and expected cash flow requirements).

(b) Diversification

Trustees must consider whether inadequate diversification will expose the fund to unnecessary risk (eg the event of a market downturn or other investment risk). This is particularly important in light of the ATO’s planned SMSF contact.

(c) Liquidity and cash flow requirements

Liquidity means how easy it is to sell an asset and convert it to cash. Trustees must consider their liquidity needs in light of the fund’s cash flow requirements (see more on “liabilities” below.) If your fund has “lumpy” assets like real estate and minimal cash, this could present a cash flow problem.

(d) Liabilities

Trustees must consider their ability to meet both existing and future liabilities, including things like the SMSF’s operating expenses and tax liabilities. Two important liabilities that trustees often need to consider when planning fund investments are annual income stream payments to members and loan repayments on any “limited recourse borrowing arrangement” undertaken by the fund to buy an asset.

(e) Insurance

It’s possible to hold various types of insurance within superannuation. The trustees must consider whether the SMSF should hold cover for its members, which requires the trustees to consider the particular circumstances of the members.

The ATO’s warning about diversification is a timely reminder for SMSF trustees to review their strategies. Contact our office if you have any questions about investment strategy requirements or for assistance documenting your fund’s strategy.

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