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Where did SMSFs come from, and where are they going?

When we laid the foundations for the current superannuation system in the 1991 Budget, I never expected Self Managed Super Funds (SMSFs) to become the largest segment of super. They were almost an afterthought added to the legislation as a replacement for defined benefit schemes.

This is the second article which draws on my talk to ASFA in November 2012, and it examines why SMSFs have become so popular.

In 1992, my Government introduced the Superannuation Guarantee Charge (SGC), with major extensions in coverage for working Australians who previously had no easy access to super. It came from the sea change in the economy and society produced by the co-operative political model adopted in 1983, with a productivity basis for improvements in living standards, and superannuation as a form of distribution of those improved living standards. The co-operative model induced and produced a massive increment to real wealth.

Employer contributions to superannuation rose from 4% of salaries in 1992-93 to 9% by 2002-2003. I wanted to reduce the future reliance on the age pension, and over time, give ordinary people a better retirement. Back in the 1980s, only wealthy people were in the stock market, but I felt mums and dads should be able to share in the bounty of the wealth of the nation. Owning a home was fine but they needed more. And through superannuation funds, everyone is now in it, and it’s been good for both investors and the nation. We have created a $1.5 trillion pool of capital, and many super members have accumulated significant balances which they want to manage themselves.

It was not generally so initially. In 1992, employers mainly made the decision about which fund an employee’s super contributions would be invested in, usually a so-called default fund. This approach was intended to keep the system simple, affordable and understandable. Each year, the employee would see the contributions and the gradually-building balance, without the employee having to take any action. It also kept the accumulations out of the hands of government bureaucracy.

The wealth would address the growing economic problem of an ageing workforce, and realign the mix between capital and labour through labour contribution to real capital growth. Very few countries have developed an adequate retirement income system with no ‘false promise’ in such a universal way, leaving the age pension – an income and asset tested pension – as an anti-destitution payment, which ceases when the recipient dies.

So the SGC was not introduced as a welfare measure to supplement the incomes of the low paid. It was principally designed for Middle Australia, those earning $65,000 to $130,000 a year, or one to two times average weekly ordinary time earnings (AWOTE). This is not to say that those on 50% or 75% of AWOTE should not benefit equitably from the superannuation provisions. They should. But for Middle Australia, the SGC and salary sacrifice was and is the way forward.

At an SGC of 12% and tax arrangements as now, someone on one to two times AWOTE plus adequate salary sacrifice limits should be able to secure a replacement rate in retirement income of around 70% over a 35 year working life.

That was the basic design, and achieving those targets did not require a lot of risk-taking in the investments. If compound annual returns reflected nominal GDP plus say 1%, the system would be doing well. Indeed, the Treasury forecast of system assets growing from $1.4 trillion today to $8.6 trillion in 2040 represents a compound annual growth rate of around 6.7%.

I mention this to provide context commentary on the rapid growth of SMSFs. As a general statement, I believe people’s expectations as to rates of fund returns are too high. The Australian superannuation system is both large in world terms and large in absolute terms. Not only is it forecast to grow to $8.6 trillion by 2040, but currently, the system stands at over 100% of GDP and will mature nearer to 200% of GDP. It is simply too large in aggregate to consistently return high single or double digit returns.

I am certain expectations as to returns and the search for yield have done two things:

  • managers have adopted a higher risk profile in portfolios, and
  • lower returns than expected have soured expectations, encouraging more people to take the initiative and manage their own assets, including taking on the trustee role when setting up an SMSF.

Returns on APRA-regulated funds averaged 3.8% over the 10 years to 2011, notwithstanding volatility from the unprecedented growth in equities and investment markets between 2002 and 2008, juxtaposed against the impact of the GFC. Over the same period the average cash rate was 5.2% and the average GDP growth 3.1%.

These results indicate that significant risk was taken by superannuation managers to secure returns in line with the relatively risk-free government cash rate. Importantly, these risks were taken on by managers who had limited direct exposure to losses – losses ultimately borne by superannuation beneficiaries. However, if the funds did return a significant amount, those same fund managers are often entitled to performance fees! And these fees are generally calibrated to annual returns rather than long term returns required to fund a retirement income.

I believe returns expectations are inflated and those expectations lead to incentives to drive higher fees for managers, but at much higher risks, as was the case between 2002 and 2011. We only have to look at asset allocations. At December 2011, total Australian super assets were weighted:

  • 50% to equities
  • 18% to fixed income
  • 24% to cash and term deposits
  • and the rest across other asset classes including property.

By contrast, the average weighting of OECD country pension assets was:

  • 18% to equities
  • 55% to fixed income
  • 11% to cash and term deposits
  • and the rest to other asset classes including property.

So, Australia is 2.5 times more heavily weighted into equities and relatively underweight in other asset classes. We are disproportionately weighted into the most volatile and unstable asset class.

The question is – how does this weighting work to deliver the key objective of the system? 60% of total superannuation assets are held by investors over the age of 50. A large proportion of these assets should be moving towards less risky, more stable asset classes, protecting capital ahead of the retirement phase. When we reach the point where outflows are increasingly matching inflows, the weighting to equities needs to be rectified. As the system matures, a real capital adequacy risk may start to develop, which will need to be seriously monitored by the government.

SMSFs currently represent almost 32% of system assets, a pool of $475 billion, and growing strongly. As I said earlier, generally this group has unrealistic expectations as to how much is a good return. Single digit returns sour their enthusiasm for managed funds. They think they can do better themselves. Some sophisticated investors probably can, but how many self managers have the required level of investment expertise? And by investment expertise, I do not mean falling prey to financial advisers. Notwithstanding the costs of setting up a SMSF, you need something like $600,000 of assets to make the decision to self manage a better relative fee proposition to management by larger managed funds.

But the main issue gets back to investment skills. How many SMSF investors are competent in matters of asset allocation and general investment savvy? This becomes a real problem for the SMSF system and its deliverability as it occupies an increasingly higher proportion of overall system assets.

For systemic prudential reasons, investment in stable asset classes, such as government bonds or higher rated corporate bonds, could be desirable for SMSFs. That is, perhaps some form of minimum investment will be required which is mandated to mitigate downside risks. As the system reaches the tipping point, where inflows are increasingly being matched by outflows, it will need to be monitored for capital adequacy risk.

Next week, the third article by Paul Keating examines tax and imputation.


October 07, 2019

I couldn't think of anything more stupid than investing in Government bonds. Particularly now days when it is a massive game of pass the parcel before it blows up in your face, but also at the time that Keating wrote this article. The average 60 year old retiree still has 25 to 30 years to live. This is a very long time. More than enough time to ride out several cycles in the equity market. Not investing significantly in equities, the highest returning equity class, is what is actually the highest risk. Investing in equities is the lowest risk on a multi decade view.

Warren Bird
October 07, 2019

Greg, the point you make about equities suiting 25-30 year time horizons is spot on. However, your argument against ever owning government bonds is based upon some typical fallacies that I keep seeing.

Government bonds won't 'blow up in your face'. They'll continue to pay the coupon promised and return $100 per $100 face value at maturity. Buy them today at a yield of 0.87% for a ten year security and that is what you'll earn over the next 10 years. If you have a portfolio of them, then if yields increase you'll be able to reinvest maturing ones at that higher yield and you'll end up earning a better total return than 0.87%.

It's how they work!

Using language like "blowing up in your face" is unhelpful.

The question an investor needs to ask is whether 0.87% is a satisfactory yield at which to purchase them or not. I can't answer that question for other individuals and am not an adviser so I won't try. What I will say as a general comment is that Government bonds are probably not suitable for most people's portfolios. Once a retiree reaches the point of requiring capital to be guaranteed to be returned to you from a liquid investment there may be a role for CGS for some people, but there are other fixed income investments that pay a higher yield that I think do a better job for that part of a portfolio.

EG you want to cover your grandchildren's school fees next year, you've got the money there and you want it to be available and don't want to risk losing 30% of its value or you won't have enough. A one year government bond delivers for the investment needs of this person. (A one year Term deposit, guaranteed by the government, makes more sense, but a bond delivers at a bit lower yield.)

I don't personally own any government bonds and can't envisage that I ever would. But not because they might 'blow up in my face'.

I hope like crazy that yields do rise from where they are now. For that to happen will need the world economy to get back on track so that central banks and financial markets can shift the interest rate spectrum back up again. That might happen, but right now looks like an unlikely outcome and we're stuck with low yields that may go lower still.

Which is yet another reason that they won't blow up in anyone's face. Except perhaps traders who don't look at them as long term securities, but short term price-trading opportunities.

October 05, 2019

The recent APRA research shows that for the past 12 months, all SMSFs, including the good & not so good ones combined, outperformed all Industry Funds for the same period. It is easy to pontificate about the wonders of Industry Funds, when you enjoy the protection of your FWA flows which ensure billions in lazy cash will continue to stream each year, in your direction. Without the Industry Fund's Intra Fund "Advice", it would be interesting to see how long they would survive, however.

John Flynne
October 02, 2019

It was a good review but carefully omitted any reference to those who received Super from their employers predominately the public service.
There we very limited means for other people to create a super fund then and there were limits on the amount that could be contributed (1200), 50% tax on earnings above 5 %, 30/20 rule of prescribed investments. The world has moved on but it has become unnecessarily complicated which does not make clear and simple.

I trust the review will simplify everything and make it understandable for all.

My own concept is to allow the franking credits to be refunded but when in pension phase a tax be payable on the pension above a certain figure

January 14, 2019

I have to laugh at Warren Birds comment. We have done well doing other things. We invested our super into two commercial buildings we ran our business from. We started by opening our DIY fund with $6000 and a pre 1999 unit trust in 1994. I originally got the idea of directly investing in commercial property when I first joined the taxpayers association. An offshoot of the tax payers association was a section run by a lady by the name of Philipa Smith called DIY super which sent out a loose ring binder with hundreds of pages about the ins and outs of DIY super. One section on REIT's (real estate investment trusts) the share markets version of investing in property caught my eye. I went to our solicitor and asked him why couldn't I use the unit trust totally controlled by my super fund as a vehicle. This started our learning journey. I eventually jointed the national tax accountants association as trustee of our SMSF and did about 300 hours over 20 years learning the ins and outs of SMSF's and pre 1999 unit trusts. I was a high school drop out and over 22 years we built a super fund that was in the top 5% of assets. The nonsense that is served up about smsfs for 20 ++ years I could write a book on

Warren Bird
January 15, 2019

Hello Tom, there'll always be individuals like yourself who can point to a successful, high return strategy that worked in the past. Good for you, I'm really pleased it worked out for you.

But that doesn't contradict or challenge what I said about diversification. For a few reasons:

1) It sounds like you continually actively managed your portfolio. You imply that you closely and carefully managed the risks you were taking and, using listed vehicles, had the liquidity to move around. In fact, it sounds like you became at least semi-professional in the management of your fund and your strategy. That greatly improves the chances of a more concentrated portfolio ending up OK. Neither Mr Keating nor I were talking about that degree of attention to detail. Most people, even those with an SMSF, don't do that.

2) Nonetheless, if your strategy delivered high returns then it simply had to be a high risk approach. It sounds to me like it was - one asset class, fairly concentrated security selection etc. Which means it could also have not worked out and you'd be in a poor state. There are lots of people who've done what you did who are now in the lower income brackets. I think of those who lost their life savings in Estate Mortgage or Pyramid Building Society back in the 1980's, as just one example. I could also write a book - about the disasters that undiversified portfolio strategies have produced for investors over the years.

The only free lunch in investing is diversification. No amount of one-off examples of where undiversified investments did well will change the reality that, across all investors and all investment funds, the only way to be very sure you don't lose your shirt is to have a properly managed, diversified portfolio. This could be in one asset class, like Australian shares, but you can get similar or better returns by having a more diversified growth pool that includes property and global shares as well.

3) Finally, how do you know that your portfolio wouldn't have done better if you'd taken a more diversified approach than it sounds like you have. If you'd had some domestic and global shares, and some global high yield, it's quite possible your portfolio would be in even better shape. The fact that you got an outcome you're happy with doesn't prove anything against what I've said.

So, I hear your laughter and raise you a dose of investment reality.

Warren Bird
January 07, 2019

It's been interesting that my inclusion of Paul Keating's article on SMSFs has probably been the most commented on of all those that I included in my guest editorial.

So it's time for a brief comment from me that's more specific.

I think Keating nailed it when he warned about the risk that SMSFs would take excessive risks. He got the risks wrong, though. His concern about equity holdings at a high level was misplaced - which is one of the reasons I also linked to Peter Thornhill's article in my guest column.

No, the activity within many SMSFs that justifies the thinking behind Mr Keating's concern is the taking of excessive concentration risk. It's OK to have 100% in shares, but in my view that needs to be in a well spread portfolio that preferably includes global as well as domestic. How many have been totally focused on banks and Telstra in the last couple of years, for instance?

But even more concerning for me is those SMSFs that have borrowed to buy into a property or two. That sort of tail risk is horrendous. Yes, lots of people can point to the great returns they got in the last 5 years or so from it, but as they say in the classics "past performance is no guarantee of future performance". And if a concentrated property portfolio doesn't work out, the consequences are dire.

What, for example, would be the case if your SMSF had funded that tower that's cracking up in western Sydney right now? If that was only say 0.5% of your portfolio, then it's bad, but not going to bring your portfolio down with it. I see and hear of far too many portfolios that take this kind of risk and take it in bucket loads.

Why does this matter? Well, super is a tax-advantaged structure that's not meant for concentrated speculative investing. It's meant to provide a reliable long term income stream, as immune from one or two assets going under as can possibly be put in place.

That's the key point that Mr Keating was getting at. He was right and in my view the one thing that should change is that a diversification requirement should be introduced. If we did that then whole debate about whether SMSFs could borrow would die. If no one asset could represent more than, say, 1-2% of a total portfolio, then the incentive to borrow because a property spruiker sells you an apartment deal, would simply not exist. You couldn't do it. And in my view you shouldn't.

If you want to do that sort of thing, then do it outside the super system.

So I'd only change Mr Keating's final paragraph to say:

"For systemic prudential reasons, investment in DIVERSIFIED ASSET POOLS could be desirable for SMSFs. That is, perhaps some form of minimum investment will be required which is mandated to mitigate downside risks. As the system reaches the tipping point, where inflows are increasingly being matched by outflows, it will need to be monitored for capital adequacy risk."

Angus Robertson
January 06, 2019

The funds in SMSFs have been earnt and/or saved by the members of each of those SMSFs.

The last thing SMSFs need is centralised control by Government of how SMSFs invest their funds just as Australian Governments of all political colours have not sought to control how each of us invests our other funds outside our Superannuation.

Further, forcing SMSFs to invest in Government and Corporate debt would cause huge distortions in the market and encourage the build up of debt by both Governments and Corporates as there would be a huge pool of funds forced to invest in their debt offerings whether they wanted to or not.

And it would destroy peoples’ already battered faith in the Superannuation system.

What IS needed is freedom, stability and surety in our Superannuation system so that SMSFs can make the decisions that best suit them in their particular circumstances and given their particular investment skills. The current system enables that.

December 27, 2018

if you have millions in Super, no skills in investment and you have difficulty choosing a manager, then go for broad index diversified ETF eg Vanguard Diversified High Growth Index Fund.
This assumes you can live off the dividends only because you have millions.
Good investment managers die,retire or become senile. You need more stability.
If you need to consume capital, this above does not apply. You will have to balance your SMSF with bonds,cash etc

Johnny Up
December 26, 2018

Well PJK has got one thing right - I started my SMSF in the late 90's because just 4% return was ridiculous. And I didn't do too well initially - just 4 or 5 percent - but doing better and better as I developed my skills and experience to the point that it has delivered well in excess of 10%. The more risk I take the higher the return so I have to temper my enthusiasm as I go past 70 yo - and yes, the last 4 months of 2018 has killed my returns unless things spark up in the final 6 months of FY2019. PJK's criticism falls flat because he and his cohorts are on defined benefits of hundred of thousands of tax-free dollars each year courtesy of the taxpayers. And to add insult, Bill Shorten is going to make SMSFs pay tax when he gets into the Lodge.

December 27, 2018

Well said Johnny Up.

Politicians and public servants with very generous Defined Benefit Pensions making rules that will destroy the SMSFs of thousands....madness !

Labor wants all SMSF to be closed and rolled into Union run Industry Funds thus receiving commissions.

Every trustee of a SMSF should talk with their families and encourage them to not vote Labor.

I used to be a Labor voter; no more !

March 08, 2018

Brilliant Peter!
I pray to allah (PJ Keating) in gratitude for delivering tax reform in the 80s but select another god when it comes to asset allocations.

Hema Rajan
March 05, 2017

I am in total agreement with this article.

I have been managing my super assets by outsourcing mechanisms rather than self managing regardless of any investment commentary in favor of SMSF coming out all the time.

I exclude SMSF from my super portfolio as I become fully dependent on advisory services as I am not from an investment background but self taught investor for the past 25 years ever since Keating's budget time of 1992 - The best visionary budget so far

I started collecting and recording my asset returns every year since 1997 and I find that other than GFC period my returns are in double digits mostly.

I realized my self managed non super assets were bringing my returns down and steadily switched to all to LICs and ETFS. Now my overall all asset allocation is the only thing I look at and manipulate to bring it down as I am past 60 to mitigate my capital adequacy risk.

As i am not from a investment management background I Know I lack the skills needed to self manage my assets super and non super in spite of my effort and time over these years

Even if I am brave enough to start SMSF the risk and reward is staked for the risk rather than too much for the reward.

Of course if I am an ex investment manager I could have had the skills....

Thank you very much Cuff links for bringing back this seminal article from Paul Keating.

H Rajan

Peter Thornhill
February 26, 2017

Oh dear another person who thinks shares are risky.
I can tell you why people run a SMSF; we are not constrained by the out-dated mythology associated with investing. 'Modern portfolio' theory was promulgated in the 1940's. The return for the 10 years to 2011 Keating informs us was 3.8% p.a. compound for APRA regulated funds. I run our not insubstantial multi million dollar SMSF which is virtually 100 equities and has been for 16 years. Our compound return over the same period quoted by Keating was 16.4% p.a. compound.
Why the hell would I ever consider using a fund constrained by Neanderthals?

Steve Blizard
December 27, 2018

exactly right. And some of our clients earned 100% on a commercial property syndicate in Parramatta from 2015-2018 (33% pa for 3 yrs), plus 8% pa rental yield on top. It thrashed all Industry Funds hands down. Only possible via a SMSF.


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