What is a lumpy asset and how do you begin to manage the issues and risks around having a large, dominating asset in your SMSF portfolio? A “lumpy asset” is an asset that cannot be acquired in small increments, but must be obtained in large, discrete units.
In prior years, rules and regulations have allowed investors to acquire lumpy assets in their SMSF, especially property. Increases to contribution caps and availability of borrowing were some of the provisions that enabled investors to fund the purchase or transfer their medical suite or industrial shed to an SMSF. There are obvious benefits of doing this, such as control, removing tenancy risks, managing cash flows better and the benefits of future growth. As at March 2019, real assets and residential property account for around 16% of all investible assets and this figure is growing (ATO, SMSF Association).
One of the first obligations as a trustee is to ensure is that your lumpy asset is making a positive return after expenses and calculate its net yield or cash flow (also after expenses). This will ensure you meet the first compliance requirement, the Sole Purpose Test. That is, that the investment will be maintained for the sole purpose of providing retirement benefits to their members. This test will exert pressure on your Super Fund if it is not. A lumpy asset must stand on its own two feet, to provide a meaningful return for retirement purposes.
If your asset has been purchased using borrowings, and subject to Limited Recourse Borrowing Arrangement (LRBA) rules, the asset and strategy must be positively geared for credit and SISR purposes. The risks in this structure are omnipresent and material, and extra diligence is recommended. If credit is approved to purchase a lumpy asset, it is assumed there will be limited recourse to the remaining assets in the Fund, if there is a loan default, and the structure is sound, should there be a problem.
There are several strategies to manage risks of having a lumpy asset, including:
- Have a cash reserve plan. Ensure you have a sensible cash buffer from the receipt of steady income and regularly made contributions. The amount would depend on the overall fund strategy, however, as a guide, at least one year of costs as a minimum reserve is ideal.
- Have a contribution plan. If you are in accumulation phase, contributions such as your mandatory superannuation guarantee, plus some assessment of salary sacrifice should be made. This will help to give the Fund greater flexibility due to available liquidity and reduce concentration risk.
- Have a contingency plan. Problems with lumpy assets can destroy a super fund, if not managed.
Be aware and ready for changes in valuation or income which may affect returns, pension drawings, and loan repayments under a LRBA. It is worth considering potential risks that have not yet eventuated and determining how a worst-case event may affect the Fund, its assets and ultimately you.
For example, the events may include council approval of a development that will take away water view of the property. It could be a revaluation of a unit where the effects of supply or local infrastructure reduces the valuation. It could be the required change of an outsourced manager and new cost effect on yield and total return. Or, an unrented shed, due to low demand. These are issues we have seen keep trustees awake at night, but it may not have to be this way.
- Have an expense schedule. Knowing your (tax deductible) maintenance and operating costs is helpful to know what will be required to ensure the asset is able to continually produce handsome income, over the long term, and achieve its objectives. Avoid unnecessary capital expenses that are not deductible to the Super Fund.
- Having an investment strategy. One of the obligations of a trustee is to develop and put into effect an investment strategy. It is essentially a trustee declaration that they are capable and understand the risks, among other items. It is a compliance document, but a bit simplistic. We suggest you go further than this, and look to build other liquid (i.e. easily converted to cash) assets that produce income and capital growth, in the event you need to access capital cash for an unforeseen event, and reduce the dependency of income from a single asset. High quality shares and managed funds, other income producing assets, and cash itself should be sought as a diversifying strategy to reduce the risk of the lumpy asset.
After all, the performance and efficiency of your portfolio is largely driven from asset allocation.
- Meet your trustee obligations such as giving consideration towards insurance. Some insurance, such as life insurance, can help manage the continuity of a lumpy asset, should something serious and unforeseen occur, without having to sell it. This would be of benefit to the surviving members or family. Life insurance can be tax effective, where a deduction is available when the Fund is in accumulation phase, making it cheaper than other alternatives. It can also protect your family’s future interests.
- Review your strategy and financial statements annually. We recommend monitoring and tracking your goals properly to ensure progress is being made. A proper review will track your progress towards a capital goal and check that any gaps can be managed, and risks reduced.
- If you are in retirement phase and drawing down super fund monies, be aware the minimum percent drawdown increases as you age, and any projection should include this. It will most certainly affect the Fund and result in a sale of that lumpy asset. If that is the case, consider the timing and consequences of that sale, such as taxes and agency fees. Best to make sure.
- Finally, please be aware the ATO have levied costs on your SMSF to fund more supervision of your management and outsourced service providers. Risks are generally borne by the trustee (and member), not your accountant, adviser or auditor. It is up to you to do a self-assessment in your capacity as trustee and assess if you need assistance towards dealing with a lumpy asset.
There are many risks, not limited to the above. SMSFs are the appropriate structure for holding lumpy assets, such as real property, but is always worth checking the unique potential issues or risks that comes with this strategy.If you would like a review of your situation or know someone that might benefit from an advice relationship, please contact us.
The information contained in this article is of a general nature and does not take into account personal circumstances. Before making any decisions based on the factual information contained in this document please consult with your financial adviser.