In the Australian SMSF marketplace, the proportion of segregated funds is very small when compared to pooled funds. David Barrett, Principal Consultant at Bravura Solutions asks why is this the case? Is it because trustees see little value in segregation, find it too complex or costly, or are there other factors at play?
These questions came to mind when I recently attended a thought provoking session on fund segregation at the 2015 SMSF Association National Conference. Presented by Brenda Hutchinson, TAG Financial Services, the session started me thinking about the reasons behind the low uptake of segregated SMSFs.
Currently in Australia, anecdotal evidence suggests that only a very small percentage of SMSFs – less than 10 per cent – are segregated. This figure is in stark contrast to retail and industry based superannuation funds where each member’s assets are kept segregated from all the other members of the fund.
Let’s take a closer look at segregation and try to understand why so few SMSFs take advantage of it.
What is segregation?
Segregation refers to the practice whereby specific assets in an SMSF are assigned to a specific member, or to the phase that member is in (i.e. accumulation or pension phase). Investment returns on segregated assets flow only to the designated member or phase.
By contrast, as the name suggests, assets in a pooled fund are treated collectively. Investment returns on pooled assets are shared across all members in proportion to their member balances.
In addition, there is a third option, known as a hybrid fund, which combines segregated and pooled assets within the one SMSF.
Pros of segregation
Despite its low uptake, there appear to be numerous advantages to opting for a segregated SMSF, under the right circumstances.
Perhaps segregation’s greatest appeal is that it provides trustees far greater flexibility and choice, by allowing specific assets and income to be tailored according to a member’s age/life stage, risk profile and preferred investment strategy. For example, where an SMSF is made up of a Mum and Dad who are in retirement and their two children who are in their thirties, these trustees are likely to have different needs. Whereas the parents might favour low risk, high income producing assets to support their pension accounts, the children might prefer higher risk, low income capital growth assets to bolster their accumulation accounts. In a pooled fund, this ability to differentiate investment strategies is simply not possible. In a segregated fund, each member is able to ‘do their own thing’, with the provision that each trustee signs off on the investment strategy.
The segregation of pension assets from accumulation assets within an SMSF also offers trustees some tax advantages. This is because earnings from assets that support a pension account are tax free – whereas earnings from assets that support an accumulation account are taxable. Therefore, by segregating the high income producing assets to the pension account and the low income, high capital gain assets to the accumulation account, the trustees can ensure that the vast majority of the fund’s income is received tax free, rather than being taxed according to the proportions of each account. In addition, should an asset allocated to a pension account within a segregated fund need to be liquidated – such as real estate – there is no capital gains tax to be paid on the sale.
Further, because segregated funds separate the income streams of pension assets from accumulations assets, they don’t need to obtain an Actuarial Certificate, which saves time and reduces costs. Conversely, pooled funds must engage an actuary to determine what proportion of the earnings from the assets for the given income year are eligible to be exempted from income tax.
Another key advantage of segregation is the ability to deliver absolute clarity about ‘what’s mine and what’s yours’ within an SMSF. Segregated funds make it possible for trustees to keep their finances separate, by clearly defining separate investment portfolios, separate assets pools and even separate bank accounts. This approach provides a level of protection for trustees and can make life a lot easier in the event of marriage breakdown and divorce, as well as second marriages. It also provides a safety net for business associates who set up an SMSF together. Should personal or business relationships ultimately turn sour, it is much easier to dismantle or depart from a segregated fund and determine respective entitlements. Similarly on the death of a trustee, segregated assets makes the distribution of the deceased’s estate much simpler, by avoiding unnecessary disposals.
Segregated SMSFs can also open the door to different types of trustees. To date, SMSFs have traditionally been the bastion of families and businesses, primarily due to the level of trust required to enter into such an important financial arrangement. However, the ability of segregated SMSFs to formally separate and inherently protect the finances of individual trustees, is likely to encourage entirely new cohorts, such as friends or even like-minded groups, to join together to form a fund.
Cons of segregation
When canvassing the cons of segregation, I was surprised to discover there were comparatively few.
When separating assets, you do need to be careful not to assign low income generating assets to a pensions account that requires an income stream. You also need to be aware that capital losses are forgone in the case of segregated pension assets.
However, it would appear that the greatest detractors to segregated funds are trustee concerns about administration complexity and cost. Segregated funds are viewed as complicated and expensive, whereas pooled funds are seen as simple and inexpensive.
Making an informed choice
It’s true that pooled funds are more straightforward than segregated funds and where the trustees share the same life phase, risk profile and preferred investment strategy, they make a lot of sense.
However, for those funds with a diverse mix of trustees, misconceptions about complexity and cost may be leading them to forgo the considerable benefits of segregation.
When I dug a bit deeper, I found some possible reasons why trustees were being discouraged from establishing a segregated fund. It would appear that some SMSF administrators lack the experience and knowledge to administer segregated funds and prefer to stick to familiar territory. Further, some continue to rely on traditional software administration programs that cannot adequately cater for the segregation of assets within a fund. Many administrators continue to use general ledger packages that are suited to straightforward pooled funds and cannot readily service the needs of segregated funds. To accommodate segregated assets, additional work has to be done outside of the accounting package, usually via a spreadsheet, in order to record income, changes in market values and asset values . Invariably, this additional administration leads to increased costs.
Yet there exists within the marketplace, leading private wealth administration software packages that are designed to support the segregation of assets within SMSFs. Simple to use, this software can effectively keep the complexity and costs of segregated funds down, while delivering the trustees significant benefits.
As more financial advisors get involved in the SMSF space, we may see the demand for segregated and hybrid funds increase. These advisors are comfortable with the concept of segregated assets and are familiar with the many advantages they offer.
So, while a segregated or hybrid fund may not be for everyone, the trustee’s choice should be based on the relative merits of these approaches, not constrained by the software limitations of their fund administrator.
Bravura Solutions’ Garradin platform provides a comprehensive portfolio management and SMSF solution that includes specific support for segregation strategies.