WHAT YOU NEED TO KNOW

In late September 2022, the Council of Financial Regulators, in conjunction with the ATO provided its second report to the Government on leverage and risk in the superannuation system.

The report focuses on limited recourse borrowing arrangements (LRBAs), which allow a superannuation fund to borrow to purchase an asset, with the lender’s rights limited to that asset if the loan defaults.

BACKGROUND

The first report to Government on leverage and risk in the superannuation system was published in February 2019. The report was commissioned by the previous Government in response to the 2014 Financial System Inquiry (FSI) which recommended prohibiting the use of LRBAs by superannuation funds. At the time, the then Government did not consider the data sufficient to warrant prohibiting LRBAs and instead asked the Council of Financial Regulators (CFR) and the ATO to monitor leverage and risk in the superannuation system and report back to it after three years.

The 2019 report found that LRBAs were used almost exclusively by SMSFs and that while the level of SMSF borrowing was not significant enough to pose a material systemic risk to the superannuation system or broader financial system; some individuals were putting their retirement savings at significant risk by using LRBAs in inappropriate ways. Absent reforms to prohibit the use of LRBAs to reduce the risks identified, the report recommended continued monitoring of LRBAs and a further report to the Government by the CFR and the ATO in another three years, including to allow an assessment of recent regulatory changes and of several more years of improved data. The then Government agreed to this recommendation and commissioned a further report by the CFR and the ATO in three years. As such, the second report has been prepared, and as in 2019, contains analysis by the CFR agencies and ATO.

KEY ASPECTS

Consistent with the first report prepared in 2019, the second report finds that LRBAs are unlikely to pose a material risk to the superannuation system or broader financial system and recommends continued monitoring and reporting on an ‘as needed’ basis to ensure appropriate oversight of these risks. However, the report finds that LRBAs continue to be a significant risk to some individuals’ retirement savings. Given this, the report concludes that the Government may wish to further consider current policy settings, particularly in light of the 2014 Financial System Inquiry’s recommendation that LRBAs be prohibited.

The key findings of the second report are set out below.

FINANCIAL SYSTEM

The use of LRBAs remains almost entirely restricted to SMSFs. The number of funds with LRBAs has increased since the FSI and the 2019 report. Assets held under LRBAs form a relatively low but not insignificant proportion of SMSF assets overall. These arrangements are most common in lower balance funds, which as a result, tend to have lower levels of asset diversification.
APRA data shows lending to SMSFs comprised less than 1% of overall residential mortgage lending by authorised deposit-taking institutions (ADIs) as at the March quarter 2022.

The current levels of borrowing by SMSFs are unlikely to pose a material systemic risk to the superannuation or broader financial system at this time.

SUPERANNUATION MEMBERS

LRBAs can represent a significant risk to some individuals’ retirement savings, particularly where they have low-balance SMSFs with high asset concentration and/or personal guarantees.

Less diversified SMSFs with LRBAs are exposed to asset concentration risk, which in the event of a fall in the asset’s price, could lead to a significant loss in value of the SMSF, which could be magnified by borrowing. Further, this high degree of asset concentration could exacerbate risks to SMSF members if personal guarantees are involved, leading to a loss of personal wealth beyond superannuation.

There continues to be evidence of conflicted and poor-quality advice being provided to individuals regarding the use of LRBAs, which could potentially put their retirement savings at risk, including inappropriate advice provided through property one-stop shops.

REGULATORY AND MARKET DEVELOPMENTS

There have been a number of changes in market conditions since the previous report that may influence the demand and supply of LRBAs going forward.

Since the withdrawal of the major banks from new lending to SMSFs in mid-2018 (with the exception of National Australia Bank, which currently offers loans to SMSFs for margin lending purposes but not for property investment), non-ADI lending to SMSFs has seen significant growth, representing around 36% of total lending to SMSFs in mid-2022, compared to around 24% of total lending to SMSFs in late 2020. While non-ADI lending to SMSFs has grown significantly in recent years, the sector is not considered to pose a systemic risk as it represents only a small share (less than 5%) of total house lending, and the exposure of banks to non-ADIs is limited.

The initial shock of the COVID-19 pandemic in the first half of 2020 is likely to have softened growth in borrowing and asset values between June 2019 to June 2020. From mid-2020, accommodative monetary and fiscal policy settings in response to the pandemic and rising house prices have supported increases in borrowing and asset values. However, since May 2022, the Reserve Bank of Australia has begun normalising monetary policy conditions to cool inflationary pressures in the economy.

Since the previous report, there have been several reforms to improve the quality of financial advice. These reforms include strengthening professional standards for financial advisers, requirements by financial services licensees to disclose a lack of independence and a new disciplinary system for financial advisers. Consistent with recommendations by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, an independent review into how the regulatory framework can better enable the provision of high quality, accessible and affordable financial advice is currently underway. The final report will be provided to the Government by 16 December 2022.

Since 1 July 2018, the outstanding value of an LRBA has been included in the total superannuation balance for some SMSF members. This improved the integrity of the system by reducing the ability for SMSFs to use related party loans to circumvent contribution caps. The extension of non-arm’s length income rules to expenditure on 1 July 2018 also disincentivises third party lending to a fund through an LRBA at below market and zero interest rates.
Since the reforms commenced, no new LRBAs have been established by SMSFs with very large balances ($50 million or more), suggesting the integrity measures have worked effectively in reducing the ability of SMSFs to circumvent contribution caps.
We encourage you to contact the team at ROSATI WANG Super with any queries or comments you may have regarding this or any other SMSF audit issue.