Financial advisers need to be wise when recommending insurance options within their clients' self-managed super funds. Warrick Hanley explains how small mistakes can lead to big consequences.
There are many reasons to recommend that insurance for a self-managed super fund (SMSF) member is held in their superannuation fund.
However, very careful consideration is required with respect to the purpose and the premium payments if the insurance is to fulfil its function properly. This is most topical when non-related parties are in the same SMSF (such as in the case of business partners) and there is a large disparity in premiums between the parties.
It can also be tricky if you are not in control of the SMSF administration.
Take, for example, two business partners (Bill and Ted) who formed an SMSF and leveraged the purchase of their business premises. Their intention was for the property to stay within the fund and continue as the business premises.
To protect the asset, they are advised to take out insurance. They only want to insure for the value of their member benefits. Bill is 40 years old and Ted is 57 and their premiums are $1200 and $6700 respectively.
Because of the cost differential, they decide that each member will be responsible for meeting their own insurance cost (premiums credited to each member’s account). See Table 1.
What happens if Ted dies? Because the insurance premiums were paid directly, the proceeds must also be allocated to his member account.
The result is that his balance now becomes $800,000 and this has to be paid out as a death benefit. The amount exceeds the cash in the fund by $300,000 and there is a good chance that a lot of planning will need to be unwound at great expense and anguish.
If instead of treating the insurance individually, Bill and Ted had viewed the cost holistically as the cost of protecting their long-term plans, the result would be quite different. See Table 2.
Here the fund paid the premiums, not the member. Assuming (don’t assume, you must check the deed) the trust deed does not require insurance proceeds to be allocated to the member, when Ted dies the money could go to a reserve.
Ted’s member balance remains $400,000 but the fund has $500,000 in cash. Ted’s death benefit can be paid out and the long-term planning remains in place.
The reason it can also be tricky if you are not in control of the fund administration is because your plans may not be reflected in the accounts.
You will need to check the financials of the fund each year to ensure that the fund – rather than the members – paid the premiums. It’s a small mistake from an administrator’s perspective, but it has very big consequences.
Warrick Hanley is the chairman of online training resource SMSF Education.
