The final nail in the coffin for SMSF lending?

The recommendation by the FSI panel to remove direct leverage from superannuation may have delivered the final blow to limited recourse borrowing arrangements (LRBAs). Concerns about the growing use of leverage inside superannuation raised the attention of the FSI panel, in particular focusing on the increase in risk on Australia’s financial system that direct borrowing provides. With Australia’s retirement system built on a foundation of savings, not leverage, the recommendation by the FSI panel is to remove section 67A of the SIS Act prospectively. This reference aims to reinstate the existing borrowing provisions contained within section 67 to simply short-term liquidity management purposes (eg. settlement of securities and payment of benefits).

The FSI panel has noted the continued interest and growth of LRBAs, with total amounts borrowed increasing from $497 million in June 2009 to $8.7 billion in June 2014. The recommendation seeks to address the issue, as the FSI Panel believes, that whilst leverage is in its infancy within superannuation, further growth of direct borrowing would over time, increase risk in the financial system.

The limited recourse nature of these borrowing arrangements delivered protections for superannuation monies by limiting the exposure of member’s retirement savings to the acquired asset. However, because of these higher risks associated with such lending, lenders had the ability to charge higher interest rates and frequently required personal guarantees from trustees. Even with mechanisms in place to limit a fund’s exposure, the panel highlighted that under financial duress with these arrangements, it is likely that the trustees will sell other assets of the fund to repay the lender, particularly where a personal guarantee is involved. As a result, LRBAs are generally unlikely to be effective in limiting losses on one asset from flowing through to other assets, either inside or outside the fund. The fact that this potential ‘downside’ is effectively being underwritten by taxpayers through the Age Pension system is also of concern.

Stability of Australia’s largely unleveraged superannuation system was important throughout the global financial crisis (GFC). The absence of leverage broadly benefited fund members and enabled the superannuation system to have a stabilising influence on the broader financial system and economy during the GFC. Although the level of direct leverage is relatively small, if left to continue to grow at current rates (18 times growth over last five years) it could pose a risk to the financial system in the future. The Reserve Bank of Australia (RBA) stated that “The Bank endorses the observation that leverage by superannuation funds may increase vulnerabilities in the financial system and supports the consideration of limiting leverage”. In addition, such direct borrowing could also compromise the retirement incomes of individuals. The Australian Prudential Regulation Authority (APRA) was of the view that “… the risks associated with direct leverage are incompatible with the objectives of superannuation and cannot adequately be managed within the superannuation prudential framework.”

Overarching these concerns, the panel also expressed the view that borrowing by some superannuation funds also provided scope for members to circumvent contribution caps and accrue larger assets in the superannuation system in the longer term.

As a result, the FSI panel has concluded that direct borrowing by superannuation funds should cease and be restored to the original prohibition (prior to 24 September 2007). It is inconsistent with the objectives of superannuation to be a savings vehicle for retirement income, and discontinuing direct borrowing would preserve the strengths and benefits of the super system and limit the risks to taxpayers.

Whilst acknowledging proposed alternatives to reduce the risks surrounding borrowing, it was found that such alternatives would impose additional regulation, complexity and compliance costs on the superannuation system.

Should the federal government look to implement this recommendation, funds with existing borrowings should be permitted to maintain those borrowings. Funds disposing of assets purchased via direct borrowings would be required to extinguish the associated debt at the same time.

So, is this the end of the road for LRBAs? The 44 recommendations have now been released by Treasury for public consultation until 31 March 2015. I suspect the white flag by the super industry hasn’t been fully raised yet, but it would appear that a significant amount of work will be required for it to survive.

This originally appeared on Aaron Dunn's blog, The Dunn Thing.