November 26, 2012 by stirling

What does the law say about the requirements for an investment strategy and what do the regulators appear to want. What does the law say?

–       The relevant legislation for this is the Superannuation Industry Supervision Act (or SIS Act). Section 52(2)(f) of the SIS Act requires the trustees to formulate and give effect to an investment strategy.

The strategy needs to consider the whole of the circumstances of the fund, across four main areas

  1. The first is the risk of the investments that will be held by the super fund. The risks should be considered in terms of the return they are expected to have (in total) and the way these returns are likely to be achieved. So for example, will the return be mostly in the form of capital growth or income, or a mixture of both. Having regard to this, you would then consider how well that type of investment relates to the objectives of the fund and expected cash flow requirements. You would also consider how much loss you are exposed to, and whether there is a way to control that risk of loss.
  2. The second is the degree to which the fund investments are to be diversified. This is the old ‘don’t put all your eggs in the one basket’ argument. Diversification can take many forms, from simply holding multiple domestic rental properties spread across a broad geographic area, to holding multiple investments across multiple asset classes. An example of this would be a strategy that allows no more than 25% of fund assets to be held in any one asset class (this being property, shares, cash, or fixed interest etc) and no more than 5% in any one investment (for example BHP, Telstra etc). This is not to say that the fund must be diversified. But if it isn’t going to be, this is a risk that needs to be considered and allowed for within the strategy.
  3. The third consideration is liquidity and expected cash flow requirements of the fund. It is important that in considering what investments the super fund may enter into, the trustees consider what the liquidity requirements of the fund are, not only right now, but in the future years of the fund operation. For example, if a large illiquid investment is being considered, how will this impact on the fund’s capacity to pay pensions, or if a member of the fund were to want to leave the fund, how could this be accommodated. These issues can become quite a problem where the asset generates most of its return through capital growth and makes up the majority of the fund assets.
  4. Finally, the strategy must ensure that the fund has the ability to discharge its liabilities when they fall due. You must ensure that the fund does not become insolvent. This was particularly relevant where the SMSF was running a defined benefit pension. If fund assets fell below the level required to fund the pension, it was at risk of no longer having the ability to meet its obligations. But this issue can be as simple as making sure that bank accounts do not get overdrawn, and bills can be paid. It is a problem closely related to ensuring you have considered the liquidity needs of the fund in making your investment decisions.

It is interesting to note that that there is no mention of an investment strategy needing to be in writing. It simply says that the strategy must be formulated and the trustees must give effect to that strategy. However, if push came to shove, it may be hard to show an effective strategy if it is not written down. If you consider the strategy as part of a goal setting exercise, not writing the strategy down also breaks one of the primary rules for effective goal setting.

The regulations also do not state how frequently the ‘strategy’ must be reviewed, they just say ‘regularly’. It is this requirement of ‘review’ where the desire of the regulator and the practical use of investment strategies deviates quite dramatically.

The regulators say that the investment strategy needs to reflect the purpose and circumstances of your fund and consider the following:

–       Maximising member returns while taking risk into account.

–       Diversification and its benefits in a long-term investment strategy,

–       The ability of your fund to pay benefits as members retire and pay other costs incurred by your fund; and

–       The needs of members.

The investment strategy should set out your investment objectives and detail the investment methods you will adopt to achieve these objectives.

How does your investment strategy stack up?????????????????????????