The case against LRBAs (Limited Recourse Borrowing Arrangements) is unclear, but there could be bad news for SMSF trustees who want control over their investment strategy, regardless of whether they intend to use an LRBA or not. Treasurer Josh Frydenberg has confirmed the retention of LRBAs for SMSFs, while it is Labor Party policy to ban them.
An LRBA is a borrowing whereby an SMSF can purchase a specific asset with debt. The debt is limited in recourse to the asset purchased and not the other assets of the fund. From a financial risk-return perspective, the ‘economic’ asset of the fund is the equity component (the purchased asset value less the limited recourse debt). LRBAs can work well for property assets because they are often large value, steady annuity-like investments that are beyond the reach of the average SMSF without the borrowed amount.
What the regulators say
On 22 March 2019, the Treasurer publicly released a report prepared by the Council of Financial Regulators (CFR) and Australian Taxation Office on Leverage and Risk in the Superannuation System.
The report showed that 8.9% of all SMSFs have an LRBA representing 5.2% (or $3.8 billion) of total SMSF assets. The CFR said: “Given this magnitude, LRBAs are unlikely to pose systemic risk to the financial system at this time.”
However, the report expressed concern with the “prevalence” of property as the main asset purchased under an LRBA, which was most common with “low balance” SMSFs with balances under $500,000. As a consequence of “significant implications for the security of individuals’ retirement saving” (supposedly those with low balance funds), the CFR concluded that their “preferred” option was to remove the exemption allowing SMSFs to access LRBAs.
So, while LRBAs pose no systemic risk to the financial system, a portion of self-funded retirees could be subjected to high levels of risk through a concentrated exposure primarily to residential property, particularly in the event of a general property market downturn. They argue this risk could revert back to the government via greater dependency on the government-funded pension system. However, there is no attempt to evaluate the systemic risk or why SMSFs are particularly vulnerable. Indeed, it could be the case that SMSFs are better positioned to deal with a generalised downturn due to lower leverage, less incentive to negatively gear and the protection afforded by mandatory superannuation contributions.
Borrowing by SMSFs
There is some great data on LRBAs in the report compiled by the ATO from audited annual accounts prepared by SMSFs.
While the number of funds with LRBAs has steadily increased to 8.9%, the value of LRBA assets as a portion of total fund assets has plateaued and even declined from 5.3% in June 2017 to an extrapolated 5.2% in June 2018 (although with current lending practices and declining property prices, the actual percentage could be lower). The portion of SMSFs in the “low balance” bracket invested in residential property has declined from 39% in 2016 to 36% in 2017.
Concentration has also been increasing amongst SMSFs with LRBAs. The report found that “over 90% of the SMSF LRBA population within the $200,001 to $1 million fund size ranges had an LRBA concentration of greater than 50%.” What is not clear is the portion of net LRBA assets (the equity) as a portion of net fund assets. This is a reasonable measure given the limited recourse structure and would undoubtedly show much lower levels of concentration across the board.
The report also paints a concerning picture with respect to leverage ratios of LRBAs invested in residential property. For example, funds with leverage ratios greater than 50% increased from 68% in 2016 to 73% in 2017. However, funds with leverage ratios greater than 70% declined from 29% in 2016 to 26% in 2017, implying overall leverage is falling (and is probably much lower today).
What is also missing from the analysis is a lenders’ perspective of LRBAs. How do LRBAs compare to other investment loan products by key measures of risk? Loan to value ratio (LVR) is a key indicator of risk: lower the LVR, the lower the risk. The data provided in the report does not provide much granularity around LVR. However, crudely dividing the average LRBA borrowing by the average LRBA asset provides a system-wide LVR of 49% as at June 2017. By comparison, Westpac’s dynamic LVR across its mortgage book at the same time was 52%, implying it is riskier than LRBA loans.
Another concern expressed by the CFR is that LRBA lending has gravitated to the non-bank sector where they have less control. This problem is not insurmountable with targeted regulation.
The report does not support the Labor case to ban LRBAs. Banning LRBAs for residential property investment is a small piece of Labor’s housing affordability policy on the premise that LRBAs make housing less affordable. This premise is speculated in the report but not supported by its conclusions (or even the earlier Productivity Commission Report on superannuation). Unlike negative gearing and CGT policy announcements by Labor, LRBAs have virtually no revenue impact on the budget, so the incentive to change is not for fiscal reasons.
The current government on the other hand is taking a more pragmatic approach. It is adopting the CFR’s second preferred option of targeted regulation, most of which it says it is adopting anyway as a response to the Financial Services Royal Commission. It wants to see more data, which makes sense given the tectonic changes that have occurred over the last year.
Implication for SMSF trustees
The options put forward by the CFR do nothing less than limit the investment options available to SMSFs. We have written on the subject of SMSFs investing in residential property in the past. We don’t sugarcoat the risks, but we do think it is a suitable strategy for some investors at certain stages of their retirement savings journey. The CFR acknowledges that SMSFs acquire residential property “early in their lifecycle”, which is a sensible strategy for an anticipated 30+ years of accumulation.
The debate needs to shift back to the quality of advice and selling techniques that influence SMSF trustees to make investment decisions. This would be the same advice a trustee should presumably receive if they thought it was sensible to invest over 50% of their retirement saving in venture capital, or a single small cap listed company or many other investments that are riskier than leveraged residential property and much more easily available and executable than an LRBA. When will the CFR contemplate a ban on those investments as well just to prevent them from happening?
Overall, the suggestion of a ban on LRBAs looks like a solution in search of a problem. The implications of a property downturn on small investors are potentially adverse regardless of the structure through which they invest, and whether through their super or not. No evidence has been presented that the implications are necessarily more adverse for SMSF investors. There is no consumer outcry for more regulation in this segment, unlike so many other aspects of the financial services industry, and SMSF trustees want greater flexibility and an end to capricious regulatory changes. The CFR found no systemic risks, and the data seems to support the proposition that the majority of SMSF property investments are soundly based.
What is missing in the proposal to ban LRBAs is a clear benefit to consumers, or to the economy, or to the housing market, or to the financial system. Absent this, we are left wondering as to who really benefits from this proposed change to limit the investment opportunities open to SMSF trustees.
John Chauvel is a former senior debt capital markets executive with a major bank, and a current fintech entrepreneur. Adam Smith is a Director of The Super Group, an SMSF advice and administration provider. This article is for general information purposes and it does not consider the circumstances of any individual.