Thinking about self-managed superannuation?

If you want to own direct investments within superannuation or have a greater say in your wealth creation strategy, you might have considered starting a Self-Managed Super Fund (SMSF).

SMSFs, sometimes known as DIY funds, are the fastest growing superannuation sector in Australia¹. Many people are attracted to them because they offer a level of control and flexibility that many larger retail and industry super funds cannot match.

As well as providing a wider array of investment and asset choices, SMSFs also provide some opportunities to reduce tax on investment income and capital gains.

With the right approach and expert advice, an SMSF can be much more than a set-and-forget retirement savings tool.

But self-managed super is complex, so it's crucial that you understand the pros and cons before investing.

How SMSFs work

An SMSF is a form of trust and can be established as a corporate or individual trust structure.

SMSFs can have up to four members, although they are usually two-member spouse funds. Each member is a trustee.

The sole purpose of an SMSF must be to provide an income upon retirement for its members, or as a death benefit.

An SMSF has its own Tax File Number (TFN) and Australian Business Number (ABN), and is required to have its own bank account. The members of the fund simply direct their superannuation contributions into the SMSF bank account, like you would with a retail super fund.

Quickly buy or sell assets: SMSF members can instantly change their investments or the asset allocation of their portfolio to suit market conditions or personal circumstances. With large funds, there is often a lag between investment changes being requested and those changes being executed.

More buying power: Because you are pooling your super savings with the other members – usually family members – you have greater buying power. This means you might be able to buy assets that normally would be beyond your reach, like direct property. SMSF members may also be able to borrow to invest using instalment warrants of similar securities.

Potentially lower costs: SMSFs with larger balances, usually more than $200,000, may have lower fees than they would with larger super funds. That's because administration costs of an SMSF are more or less fixed regardless of the fund balance. When SMSFs invest directly, they do not pay management or performance fees.

Possible tax savings: The tax advantages of superannuation funds are well known. SMSFs have further advantages that may allow for even greater savings and efficiency, particularly in relation to capital gains tax (CGT), self-insurance and franked dividends. As these can be complex, it's worth talking to a financial adviser to learn more about how this may benefit you.

Flexible estate planning: SMSFs give you more estate planning options than a traditional fund.

The downside of self-managed super

There are also some significant issues you need to consider when setting up an SMSF. This is a complex process with a lot of paperwork, legal and compliance costs, and the prospect of harsh penalties if you get it wrong. Consider these issues:

Cost barriers: The upfront costs to establish an SMSF are usually between $1,000 and $5,000. But there will likely be ongoing costs that can range from $3,000 to $6,000 per annum. Costs will vary depending on the complexity of your investments and the level of financial advice you might need.

Time barriers: Setting up and running an SMSF entails a considerable amount of work to ensure you meet administration and compliance requirements. And that’s not to mention researching and managing your day-to-day investment choices. If you are time poor, an SMSF might not be the best choice for you.

Lack of investment knowledge: In retail or industry funds your fund manager does the hard work of knowing where to invest. But you're on your own in an SMSF. Because SMSF members are directly responsible for what happens with their retirement savings, it's important to understand the basic principles of investing and to seek expert financial advice.

Diversification challenges: Diversification is important in any investment strategy. Your SMSF owns should own more than just one or two large assets. A lack of diversification is probably not in the best interests of the SMSF members.

Non-compliance: The penalties for not complying with the super rules are harsh. The Tax Office, which regulates SMSFs, has the power to remove a fund's complying status, which means you will be taxed at the highest marginal rate. Trustees can also face civil and criminal sanctions for serious breaches.

Restrictions: SMSFs are strictly for the purpose of providing retirement benefits, so you cannot subsidise your current or pre-retirement lifestyle. For instance, you cannot buy a holiday house for your private use. Your SMSF would have to buy that same holiday house and rent it out to an unrelated party.

Exiting is difficult: Leaving an SMSF for whatever reason is difficult. When you start one, you should create an exit plan to minimise the amount you have to pay. The retirement savings of others in the fund are also protected when there's a well-documented exit plan.

Ageing: Consider whether you'll be able to manage your SMSF as you get older. You might become too frail or you may have an illness that prevents you from managing your affairs. Also, consider whether you could manage your SMSF if your spouse passed away.

While SMSFs can provide many benefits, especially for experienced investors with enough time and money to make it worthwhile, the cons will outweigh the pros for many people. If you don’t think an SMSF is for you but still want the flexibility to choose which assets you’d like your super invested in, check whether your super fund offers DIY investment options. Many do, and this will give you some control over your investments without having to manage onerous regulatory and tax issues, among other things.