SMSFs, LBRA strategies and life insurance

The self-managed superannuation fund (SMSF) sector represents over $32 billion in limited recourse borrowing arrangements, underpinning around $116 billion in property assets1.

A typical limited recourse borrowing arrangement (LRBA) involves an SMSF borrowing money to acquire an asset (often property) which is held on trust.

The SMSF has beneficial ownership of the asset until the loan is paid off, after which time it attains legal ownership of the asset. If the SMSF defaults on the loan repayments, the lender may repossess or dispose of the asset (sell the property) to satisfy the loan.

By law, every SMSF trustee must consider the need for insurance as part of its investment strategy.
In many cases, lending institutions make it mandatory for an SMSF to have life insurance in place for members to pay off the loan in the event of a premature death. The death of a member often triggers the repayment of a loan in full or its refinancing.

Historically, many SMSFs took out life insurance for members to protect against a member’s premature death. There used to be three common strategies for life insurance ownership: owned by life insured member’s account; owned by the SMSF via reserve; and cross-owned by another member of the SMSF (not life insured). Two of the three strategies are now prohibited by the ATO.

The only remaining strategy is policy ownership by the life insured member’s account.

Reserving strategy – Prohibited

Under this old strategy, an SMSF owned a life insurance policy or policies on members’ lives with the life insurance proceeds being paid into the SMSF’s reserves upon the death or permanent incapacity (TPD) of the member. This money was then taken from the reserve and applied against any outstanding LRBA to pay off the loan.

According to the ATO, this strategy breached the sole purpose test under section 62 of the Superannuation Industry (Supervision) Act 1993 (SIS Act) because life insurance benefits are not being used for the benefit of the insured member.

Cross member ownership strategy – Prohibited

Under this strategy, the account of one SMSF member owned life insurance policies on another member’s life. Any life insurance proceeds were paid into the account of the surviving member of the SMSF, upon the death or permanent incapacity (TPD) of the life insured member. Any claim entitlements were taken from the surviving member’s account and applied against any outstanding LRBA to pay off the loan.

Again the ATO said this strategy breached the sole purpose test under section 62 of the SIS Act given life insurance benefits are not being used for the benefit of the insured member.

Member-owned strategy – Permitted

This strategy is still permitted. Basically, the account of one SMSF member owns life insurance on the member’s own life. The life insurance proceeds are paid into the SMSF account of the life insured member upon their death or permanent incapacity (TPD). This strategy is permitted as the life insurance benefits are being used for the benefit of the insured member.

Unfortunately, in many cases, the proceeds from the life insurance policy is not available to the trustee to pay off the loan. The life insurance proceeds must be credited to the life insured member’s account balance. This leaves the trustee with funding problems, as the deceased member must have their account balance paid as either a lump sum or a pension upon death, while the trustee may not have adequate liquidity to pay off the loan.

As a result, the trustee of the superannuation fund will normally need to find alternative funding arrangements for the both the loan and the death benefit payment. They may opt to sell assets of the superannuation fund, arrange to have additional concessional or non-concessional contributions made to the fund or refinance the loan (if possible).

In the worst case scenario, the lender would take full beneficial and legal ownership of the acquirable asset (the property) if the SMSF could not repay or refinance the loan.

The superannuation rules are constantly changing so it’s important for SMSF trustees to continuously review their investment and insurance strategies. SMSF trustees with an LRBA in place should ensure any insurances are properly structured so entitlements can be used to repay the loan upon the death or permanent incapacity of a fund member.
Poorly structured insurance arrangements may cause an SMSF to lose the asset they purchased via LRBA.

1. ATO SMSF Statistical Report – March 2018

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