Getting control of SMSF Liquidity Risk

What happens when your SMSF can't pay its bills?

Failing to meet the financial obligations of a self managed super fund (SMSF) can trigger an unintended domino effect of financial problems, that could be impossible to stop.

Read in this article

As an SMSF trustee, there are some things you can never get wrong; managing the liquidity risks of your SMSF is one of them

At its most basic level, liquidity is the ability to access cash when it is needed;  from meeting taxes, paying mortgage repayments and to being able to payout a member's disability claim as well.

Managing liquidity is a core financial skill we all need to learn, and an essential financial skill for a self managed super fund (SMSF) trustee.

Managing the liquidity needs of an SMSF

Super ‘preservation rules’ require that member benefits are retained within the superannuation system until;

• members reach their retirement age,
• members meet a condition of release, like death or total disability or
• upon compassionate grounds or instances of severe financial hardship.

What happens if an SMSF has a liquidity crisis?

If liquidity is not managed well, an SMSF may be forced to sell their investment assets quickly, (potentially for less than expected) or in extreme situations, fail to honour member obligations, including requests for portfolio changes, disability payouts, and even death and terminal illness payouts. In these circumstances, a fund may have no option but to immediately sell the investment assets, even at a net loss.

Managing SMSF liquidity is a legal obligation; not an option

SIS Regs. require SMSF Trustees to consider the insurance needs of their members and so they have a legal obligation to consider whether to hold a contract of insurance that provides life and TPD cover for one or more of their members and renew it annually as part of the investment strategy. In addition, the Trustees are required to review the SMSF investment strategy at least once a year. - Self Managed Superannuation Guide, 2nd edition, Smith, Koken & Davies 2023 CCH

Managing liquidity and lumpy investment assets in an SMSF

Problems with lumpy investment assets can destroy a super fund if not managed. Lack of diversification leaves you open to concentration risk. It’s like putting all of your eggs in one basket — if something happens to that basket, all of your eggs will be affected.

SMSF trustees who invest using a single asset strategy and in direct property need to carefully consider not only their requirements under superannuation law, but also what happens to the property upon the sudden death or disablement of a member. And is there an exit strategy for the surviving fund member(s)?

Liquidity and Limited Recourse Borrowing Arrangements (LRBA)

Where an SMSF has allocated the majority of its funds to acquire a large lumpy asset (such as residential or commercial property), and perhaps using a Limited Recourse Borrowing Arrangement (LRBA) as a part of its investment strategy, it may not have the liquidity necessary to pay out a lump sum death or disability benefit to an SMSF member, if suddenly required.

It’s important to note that while a single asset strategy is not prohibited, the grounds for investing solely in property — or any other asset class — must be justified and documented in your investment strategy to demonstrate your fund is complying with legislation.

Both these aspects require a strategy to manage the risks.

Using Insurance to help reduce liquidity problems

Life Insurance and Total & Permanent Disability Insurance can be useful in helping SMSF trustees who use an LRBA to acquire property and manage liquidity problems if a member dies or becomes incapacitated.

• An injection of cash from insurance proceeds can service LRBA debt, or pay it out completely, and pay a death or TPD benefit.
• A super death benefit pension could then be commenced for the surviving partner where less liquidity is required to fund minimum death benefit pension payments and other ongoing expenses.

Are you the trustees of an SMSF? Has your SMSF purchased an investment property and utalised an LRBA? Make sure your investment strategy continually reviews your funds liquidity needs and download our free SMSF Liquidity Worksheet here.

Pro tip: Insurance premiums paid from an SMSF are usually tax deductible and result in a 15% reduction in insurance costs. There’s a restriction preventing transferring an existing life insurance policy from an individual's member's hands, into an SMSF. Such an existing policy has to be canceled and re-issued with the SMSF being the new policy owner. This creates a problem where a fresh insurance underwriting assessment needs to occur; where any changes in the health or occupation of an SMSF member, will need to be re-assessed. This could increase the costs of premiums, or worst case, may result in the member not being able to be re-insured.

Speak with Sapience Financial for a confidential chat about your circumstances.

Drew Browne is a specialty Financial Risk Advisor working with Small Business Owners & their Families, Dual Income Professional Couples, and diverse families. He's an award-winning writer, speaker, financial adviser and business strategy mentor. His business Sapience Financial Group is committed to using business solutions for good in the community. In 2015 he was certified as a B Corp., and in 2017 was recognised in the inaugural Australian National Businesses of Tomorrow Awards. Today he advises Small Business Owners and their families, on how to protect themselves, from their businesses.  He writes for successful Small Business Owners and Industry publications. You can read his Modern Small Business Leadership Blog here. You can connect with him on LinkedIn.  Any information provided is general advice only and we have not considered your personal circumstances. Before making any decision on the basis of this advice you should consider if the advice is appropriate for you based on your particular circumstance.