With record low interest rates showing no sign of lifting, Self-Managed Super Fund (SMSF) trustees are planning to shift their cash allocation into equities, according to the 2021 Vanguard/Investment Trends SMSF Investor report. However, this may not give them the steady income stream they are seeking. 

Almost one in two SMSFs say cash is currently a ‘poor investment’ and 40% believe they will need to invest in other assets to make up the yield shortfall.

In April 2021, SMSF trustees said they expected dividends to average around 4.2% for the next 12 months – making this seem like a sound strategy. Traditional defensive strategies like term deposits and bonds currently offer little in the way of cash flow returns. Australian 10-year government bonds were yielding just 1.7% in May 2021, down from around 5.5% way back in the early 2000s.

Yet, with many public company business models disrupted by COVID, investors cannot depend on franked dividends for reliable income.  

That’s why some SMSF trustees are looking outside the box to an ever-growing number of investment options – including listed and unlisted trusts, managed investments and private real-estate debt.

Diversification under the spotlight

“People choose to set up SMSFs to have more choice and flexibility over their superannuation investments, and the past 12 months has seen the strongest net growth in the number of SMSFs for many years,” says Michael Lorimer, Managing Director of the Self-managed Independent Superannuation Funds Association (SISFA).

Following the ATO’s communication targeting SMSFs it perceives to be poorly diversified, auditors have been paying closer attention to SMSF investment strategies to ensure trustees properly consider their fund’s liquidity and cash flow requirement.

Because of the high ticket price of investing in direct property, the reality for many SMSFs is that if they choose to invest in a property directly, it is very difficult to diversify beyond that.

Beyond bricks and mortar

“For SMSFs, passive property exposure is not complicated. But whether it stacks up financially is another consideration,” says Michael.

If an SMSF needs to borrow under limited recourse borrowing arrangements (LRBA) to fund a property purchase, it will be subject to higher interest rates. There are also compliance challenges if the fund decides to develop or improve that property investment, as well as grey areas around non-arm’s length income (NALI). For example, any income derived from a property purchased from a related party for less than market value would be taxed at the top marginal rate.

There is, however, another way SMSFs can benefit from Australia’s property boom, without buying directly into the asset. And that is to ‘be the bank’ – to fund the private lending deal that underpins a specific asset.

The alternative advantage for SMSFs

SMSFs have more flexibility to diversify than APRA-regulated super funds – and for larger SMSFs with the ability to deploy capital into less liquid or unlisted assets, private debt is one option to consider.

SMSFs can tap into direct deals or invest via managed funds.

“We are working with advisers to simplify access through bespoke funds, and also democratising access for wholesale investors to invest in individual deals they feel comfortable with,” says AltX co-founder and co-CEO Nick Raphaely.

He says first mortgage investments can deliver three important benefits:

• Liquidity – For SMSF members nearing retirement, the relatively short-term position (6 to 12 months) of a private debt deal is comparable to a fixed-term deposit.

• Income – Once you’re in the retirement phase, it can be reassuring to have interest income paid monthly, rather than waiting for company dividends and franking credits.

• Capital preservation – Our SMSF investors say they feel comfortable knowing there is a “bricks and mortar asset” as underlying security – and as a first mortgage holder, they rank ahead of other creditors for repayment of capital.

For SMSF members close to retirement, protecting the wealth they’ve worked so hard for is the number one priority. “One of our investors told us, ‘My only goal for managing my own super is to preserve my capital and establish enough income to enjoy life. I’m not here to get rich quick,’” comments Nick.

That investor derives retirement income from a combination of property, shares and first mortgage investments. Using AltX’s alternative investment platform to invest directly in private debt deals, he receives monthly returns in the form of interest payments.

“Another investor has told us private debt plays a conservative role in his SMSF portfolio – and he sees it as working his capital harder than cash in the bank, without taking undue risk,” notes Nick. “The underlying security is the collateral that directly supports the loan – much the same way as banks operate.”

As with any investment, it’s important to weigh up the relative risk and return. When you can access the details on a private debt deal, you can weigh up the opportunity on its own merits. This includes understanding the valuation, location potential, borrower track record, and the LVR (Loan to Value Ratio). “The higher the LVR, the greater the risk – and the higher the return the opportunity should deliver,” notes Nick.

While cash and bonds are currently struggling to deliver the returns SMSFs expect, it’s still important to have some defensive assets within your portfolio as a buffer against market volatility and inflation. And with the ability to generate income in the low-interest-rate environment still one of the largest retirement concerns for SMSFs, alternative income strategies like private debt could be the answer.