A reserve occurs in a superannuation fund when it has surplus assets. That is, when the net market value of assets in a fund exceeds the net value of benefits payable to its beneficiaries. Reserves have been used by larger superannuation funds and life insurance companies for hundreds of years. Over the past 20 years, reserves have also played a useful role in helping some people manage Reasonable Benefit Limit (RBL) or super surcharge problems within their self-managed super funds (SMSFs).
Fortunately both these awful policies are no longer with us and the potential reserving strategies that were applied to help mitigate their impact are no longer relevant. Under the current superannuation and tax regime, how might a super fund use a reserve? There are at least six purposes: – Investment reserve – these are used a lot by large funds to smooth investment returns. Let’s look at a very simple example: A super fund has two members, M1 & M2. M1 has $50,000 and M2 has $1.5 million of the assets in the fund. Respectively they have 3.2 per cent and 96.8 per cent of the assets in the fund. Suppose that the investment strategy of the fund is to earn an average return of CPI + 2 per cent per annum. (This is not really an investment strategy – it is actually an objective. An investment strategy might involve how you intend to go about achieving this objective – but this is a topic for another day, so we’ll put this issue to one side.)
Now assume that the CPI rate is currently 2.5 per cent. This means that the trustee needs to allocate 4.5 per cent to each member’s account. The fund has had a net investment return of 5 per cent (after all fees, expenses, taxes, et cetera) for the most recent year-end. The trustee decides to allocate 4.5 per cent ($2250 for M1 and $67,500 for M2) to each member and place 0.5 per cent ($7750) into an investment reserve. That investment reserve can then sit there for a period of time and be allocated to members of the fund when the fund fails to perform as expected. For example, suppose in the following year the super fund’s investments delivered a 3 per cent return. The trustee might decide to allocate some or all of the investment return to bolster the poor performance. How would money be allocated from this type of reserve? A fund running an investment reserve needs an allocation policy. That is, a policy that discusses how, to whom and over what period of time money would be allocated from the investment reserve.
This policy must treat all fund members fairly and equitably. Many industry super funds use this type of approach to smooth investment returns over three- to five-year periods. A major issue is ensuring equity between different members – especially making sure that those who stay don’t receive all the good times and those who leave don’t unfairly get lumbered with lower earnings, or even losses. These problems can particularly manifest themselves when a fund invests in assets that are valued infrequently. About 10 years ago the Tax Office said that this type of reserve should not exceed 15 per cent of the total assets of the fund. – Contribution reserve – these have been used for some time to hold a contribution made for a specific member.
These types of reserves have ceased to have much use since July 2004, when the law was changed to force super funds to allocate contributions to the member within 28 days of them being made. In 2009, the ATO released some information about how these reserves could be used to assist with the timing of non-concessional contributions between financial years. In reality, only a small number of people will find this of any benefit. – Expense reserve – which a fund trustee can use to pay general or specific fund expenses. – Insurance reserve – used to fund the payment of certain benefits to members, such as temporary disablement benefits. – Forfeiture reserve – this might occur when a member’s benefit is forfeited (that is, given up). Under current super laws, it is not possible for a member to forfeit their super benefit. Some industry commentators believe that it might be possible for a pension member to forfeit their benefit. If this type of transaction could be completed it would potentially enable pension benefits to be retained in the super system.
The net effect might be to allow super members to find a way around either the contribution caps or to value-shift. It’s difficult to believe that this type of strategy would be allowed by the regulators of all persuasions for long. -Anti detriment payment reserve – this may be set up to pay an additional benefit upon death equivalent to the tax on contributions paid for a particular member. This reserve could be funded from excess investment returns or allocated from another appropriate reserve account and must be established before death. A super fund trustee has to be very careful about how they allocate money from the reserve to a specific member. In general, an allocation from a reserve account will be deemed to be a concessional contribution for a particular member unless the amount is allocated in a fair and reasonable manner to every fund member and the amount allocated is less than 5 per cent of a member’s account balance before the reserve amount is allocated. If the allocation from the reserve account is a concessional contribution then it will be taxed at 15 per cent in the year it’s received by the member.
There is also another rule excluding allocations from a reserve when a pension is commuted, but we will not look at this rule here. The super laws demand that a trustee cannot run any reserve account if a super fund’s governing rules specifically stop a trustee from operating one. This does not mean that the governing rules can be silent on this issue. In order to operate a reserve account a super trustee should have a specific power, including the types of reserve accounts that can be used, and rules for how each account will be created and their operation monitored. Do reserves still have any useful purposes in small super funds? From time to time various superannuation experts publish material that suggests that reserves have a big role to play in SMSFs. Reserves are reasonably complex, and therefore costly, to administer. Many SMSF administrators and advisers don’t seem to understand the finer details of running a reserve. It is certainly very easy to muck up their operation.
The use of reserves often seems designed to extract every last dollar of tax concession out of the super system. Whilst most investors hate paying any additional tax that can be easily and legally avoided, it is also true that the current super system provides a wide range of very generous tax concessions, and it’s often relatively easy to be tax efficient. In other words, desperately trying to eke out the last tax saving is often unnecessary. Personally, I think most people will incur costs that are more than the benefits of using these structures. Therefore it’s difficult to justify their widespread use.