SMSFs, insurance and implementing a borrowing strategy

Borrowing to invest can provide significant benefits, but it adds quite a bit of risk. Self-managed super fund trustees in particular should consider insurance when implementing an LRBA strategy.

While borrowing via a Limited Recourse Borrowing Arrangement (LRBA) can allow gearing into assets such as a direct property or shares, it can also expose the fund to significant risks in the event of the death or disability of a member.

Trustees and their advisers should therefore consider the need to use insurance to protect the fund when implementing a limited recourse borrowing strategy.

Where a member of a fund that has borrowed dies or becomes permanently incapacitated, the surviving trustees may be forced to sell the asset in order to pay out any lump sum benefits required, or because the fund will not have sufficient cash flow to be able to continue to repay the loan.

This may especially be the case where the loan was approved taking into account the member’s contributions.

This could then have a number of potential negative impacts on the fund, including:

  1. Potential reduced investment returns associated with being a forced seller
  2. Increased transaction costs
  3. The fund being forced to sell the property prior to conversion to pension phase, resulting in the realisation of taxable capital gains
  4. The fund being forced to crystallise capital losses
  5. The fund needing to be wound up as it is no longer required or justified from a strategic or cost perspective.

To manage these risks trustees should consider implementing an insurance strategy that would provide the necessary liquidity to extinguish debt and to pay benefits in the event of the unexpected death or disability of a member.

However, to implement this strategy a trustee would need to consider a range of issues. These include:

  1. The fund’s trust deed must allow the trustees to acquire insurance policies and to pay death benefits as an income stream
  2. The fund’s investment strategy should specify that the fund will hold insurances for liquidity purposes as part of the LRBA arrangement
  3. That the fund could afford the cost of the premiums – note the premiums would be fully deductible based on the fact that the proceeds would be paid as a death benefit.

If you would like some help and professional advice relating to your using your super fund to borrow to invest or to protect its members, please feel free to call Michael on 02 9299 7044 to arrange a time to meet.

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