Self-managed superannuation fund (SMSF) loans are becoming more prominent in Australian RMBS transactions. This follows nonbanks increasingly offering the lending product as they move to diversify their portfolios. SMSF loan performance has been solid to date, with low levels of arrears and losses.

Interest in SMSF loans will likely continue to grow. But SMSF loans are nuanced products and not without risks--some of which are harder to mitigate.

In this article, we take a closer look at these niche loans and their unique features. We also look at the risks inherent in these loans and how we analyze the risks in our RMBS analysis.

SMSFs Are A Sizable Part Of The Superannuation Sector

The SMSF sector accounts for around a quarter of Australia's behemoth A$3.9 trillion superannuation assets. SMSFs are regulated by the Australian Taxation Office (ATO). Other superannuation funds are regulated by the Australian Prudential Regulation Authority (APRA).

Most SMSFs have two members, typically a couple. Around two-thirds of members are older than 55, while around 10% are aged between 35 and 44, according to ATO statistics (chart 2). The average assets per SMSF member are A$780,254 and the average assets per SMSF are A$1,450,642 as of the 2021-2022 financial year, according to ATO statistics.

Chart 1

Chart 2

Chart 3

Chart 4

SMSFs In Australia's Superannuation Sector

Under Australian superannuation laws, employers must set aside a minimum 11% of employees' ordinary earnings for retirement. This will increase to 11.5% in July 2024. Individuals can make additional contributions to their superannuation. Contributions can be concessional (i.e., made from pretaxable income) or nonconcessional (post-tax income).

Superannuation contributions are invested in superannuation funds. The funds are permitted to invest in a wide range of assets, including shares, property, managed funds, and fixed-interest investments. There are five types of superannuation funds in Australia:

• Industry funds: Open to employees in a particular industry or under a particular industrial award and if their employer signs up with the fund.
• Retail funds: Run by financial institutions and open to everyone.
• Public sector funds: Generally open to government employees.
• Corporate funds: Generally open to people working for a particular employer or corporation.
• SMSFs: Super funds that are self-managed, including investment decisions, administration, and legal responsibilities.

With industry, retail, or public super funds, professional trustees are responsible for managing funds under investment and ensuring compliance with relevant regulations. SMSF members, who are also the trustees or directors of the corporate trustees, are responsible for complying with relevant superannuation and tax laws.

The Appeal Of SMSFs

SMSFs are popular due to the flexibility and the autonomy they offer to directly manage personal retirement savings. They also enable couples to combine their superannuation into a single fund, which can have tax advantages. And unlike APRA-regulated super funds, SMSFs can directly invest in residential and commercial property. This enables members, particularly the self-employed, to purchase their own business premises. Superannuation contributions are not mandatory for the self-employed and personal contributions can be tax deductible, heightening their appeal.

SMSF Lending Versus Non-SMSF Lending

An SMSF loan permits members to leverage funds in their SMSF to purchase an investment property. SMSFs can only borrow in limited circumstances. These include limited-recourse borrowing arrangements that meet certain conditions. Different rules apply, depending on when the borrowing arrangement was entered into, as outlined in the Superannuation Industry Superannuation Industry (Supervision) Act 1993.

According to regulations governing SMSFs, rental income or capital gains from a property are to be reinvested and only accessed at retirement. Residential properties can only be purchased for investment purposes and rented out at market rates; fund members cannot live in the property or use it as a holiday home. SMSF members can purchase commercial properties to use as their business premises, but this must be done at market rates.

Typically, an SMSF trustee is the borrower under a loan from a third-party lender to fund the purchase of a single asset or collection of identical assets that have the same market value. The asset is held in a separate trust or bare trust (chart 5). Unlike standard residential mortgage loans, these are not full recourse. This means that in the event of a loan default, the lender's rights are limited to the assets held in the separate trust and not any other assets held in the SMSF.

Chart 5

Guarantors Incentivize Prudent Borrower Behavior

SMSF loans originated by RMBS lenders in trusts rated by S&P Global Ratings have SMSF members/beneficiaries--often the same people--to provide a personal guarantee for SMSF loans. The guarantee helps to align the incentives of the SMSF member to the performance of the loan, given the requirement for SMSF loans to be limited recourse. Lenders look to these guarantees to help cover any shortfalls in the event of a borrower default. This effectively aligns the interest in the limited-recourse arrangement to that of a full-recourse loan.

In our credit analysis, given the presence of the personal guarantee in SMSF lending conducted by RMBS originators, we treat these loans as equivalent to full recourse loans. In their underwriting, lenders typically conduct credit checks on guarantors.

Consequences Of Noncompliance Are Higher For SMSF Loans

Superannuation is a highly regulated sector and super funds must comply with many regulatory and tax obligations. Noncompliance with these regulations attracts penalties. These penalties are there to ensure funds are appropriately managed for the sole purpose of providing retirement income for members. Because SMSFs are self-managed, the members, who are often trustees or directors of corporate trustees, undertake all administrative and regulatory compliance obligations--either personally or with the help of financial or legal advisors.

SMSF members consequently are personally liable for a fund's decisions, even if they engage professional help. The trustee or directors of the trustee, who are often SMSF members, shoulder the risk of noncompliance and can be personally fined if a fund breaches the law. In industry or sector funds, the compliance risk is born by professionally licensed trustees.

More serious or continued breaches can attract penalties, some of which are quite severe, including:

• Enforceable undertakings.
• Rectification of directors.
• Administrative penalties.
• Raising income tax assessments.
• The freezing of the fund's assets.
• Trustee disqualifications.
• The winding up of the fund.
• Civil and criminal penalties.

Underwriting Requirements Have Some Fundamental Commonalities Across RMBS Originators

Given the high level of compliance requirements for SMSF loans, RMBS lenders have some fundamental loan conditions for SMSF loans (table 1).

Table 1

RMBS originators underwriting SMSF loans generally require loan applications to be accompanied by independent legal advice. However, the SMSF member is responsible for the fund's ongoing compliance with relevant superannuation and tax laws. The typical product specifications for SMSF loans are outlined in table 2.

Table 2

The key differences across the small number of RMBS lenders that originate SMSF loans mostly relate to maximum loan-to-value ratio restrictions, loan sizes, and interest rate buffers used in debt serviceability assessments.

Income And Expenses Are More Limited

SMSF loans' debt-serviceability assessments include a narrower range of income and expenses than non-SMSF loans. The main income sources for SMSF loans are:

• Members' mandatory superannuation contributions.
• Members' voluntary superannuation contributions (generally have to demonstrate capacity to contribute).
• Rental income from property (haircut of 10%-20% typically applied to this income stream).
• Interest/dividend income earned by the SMSF (typically subject to a capped rate).

The expenses included in SMSF debt serviceability assessments include the running cost of the fund. Lenders typically take these amounts from the financials of the SMSF. Many lenders will apply their standard debt serviceability assessments to SMSF loan applications, including overarching interest rate buffers and income verification checks. A small number of lenders have bespoke SMSF serviceability assessments that use different interest rate buffers, for example, or interest coverage ratio assessments as opposed to net-service-ratios-style tests.

Age Is An Increasingly Important Consideration

As more SMSF members approach retirement, it is important to understand how lenders factor in funds moving from the accumulation phase of investing money into super, to the retirement phase, when money is drawn down from the fund. Although an SMSF can hold an asset under a limited-recourse borrowing arrangement (i.e., an outstanding SMSF loan) while it pays a pension to members, it may become cashflow constrained when concurrently meeting loan repayments and pension payments.

Lenders increasingly are considering age in their general lending decisions. The specific wording varies in credit policies on how this is done. For example, some lenders will only consider SMSF loan applications if one or more of the SMSF members is in the accumulation phase. Other lenders have more standard wording in their credit policies around how they assess beneficiaries' capacity to make ongoing super contributions.

SMSFs' reliance on rental income versus super contributions will influence funds' exposure to reduced income from super contributions as members enter retirement.

Performance Has Been Solid

The collateral performance of the small universe of SMSF loans in the Australian RMBS sector has been strong to date. This is the case for both commercial and residential SMSF loans. Recorded arrears have tracked below the Standard & Poor's Performance Index (SPIN) for Australian prime mortgage loans for the past five years (chart 6). The strong performance partly reflects many SMSF members' higher net asset position, given their age and stage in life. It also reflects a prolonged period in Australia of relatively benign economic conditions and mostly property price appreciation. Anecdotal evidence from lenders suggests that, to date, one of the key reasons for property sales in the case of SMSF loans has been divorce, requiring property to be sold. As per the wider RMBS sector, loss experience has been limited, given Australia's strong property price appreciation over the past decade.

Mostly benign economic conditions and strong property price appreciation over the more limited performance history of these loans also limits the instances of personal guarantees needing to be enforced in the case of borrower default resulting in loss. This limited performance is one of several reasons for the higher default frequency applied to SMSF loans.

The transition of more SMSF members from the accumulation to retirement phase, given Australia's aging demographics, could affect SMSF loan arrears.

Chart 6

SMSF loans' prepayment rates are generally lower than for the broader RMBS sector. This is partly due to the funds' more limited income streams and less incentive to pay down these loans more quickly compared with owner-occupier home loans. Refinancing activity, which is often a marker of prepayment activity, is also likely to be lower for SMSF loans than for standard residential mortgages. This is due to the smaller number of lenders who are active in this space. As competition grows in this space, prepayment rates are likely to rise, though off a low base.

SMSF Lending Is Gaining Momentum

SMSF loans make up a small portion of the banking landscape. APRA statistics show that outstanding SMSF loans account for less than 0.5% of authorized deposit-taking institutions' outstanding residential property exposures.

Many banks withdrew from SMSF lending in 2018-2019 due to the more intensive underwriting and higher capital requirements. Nonbanks have filled this void.

SMSF loans account for about 5% of total RMBS loans outstanding, up from about 1.5% five years ago. These loans have been originated exclusively by nonbanks. With increased competition from larger lenders for prime borrowers, we have observed increasing competition among nonbank lenders in the SMSF space as they seek to extend their footprint into niche areas. This is flowing through to lower margins on these loans and higher exposures to SMSF loans across nonbank transactions.

Increasing competition in this space, with more nonbank lenders looking to underwrite SMSF loans, is likely to lead to some easing in lending standards. We have observed an increase in maximum loan-to-value ratios permitted in lending policies and, for some lenders, a reduction in interest rate buffers used for SMSF loans in debt serviceability assessments. This is similar to what we have observed in other loan segments where competition has increased.

Higher Default Frequency Adjustments Reflect Risks

SMSF loans attract a higher default frequency than investor loans. This default frequency is applied to both residential and commercial SMSF loans. Loss-severity assumptions applied, including market value decline assumptions, are consistent with the residential and commercial RMBS loss-severity assumptions applied under the relevant RMBS criteria.

The higher default frequency reflects several factors, including the more limited track record, particularly the enforcement of personal guarantees, and performance of this asset class in periods of economic stress, as well as its greater underwriting complexity given the highly regulated nature of superannuation.

SMSF loans are a bespoke subset of investor loans--more complex and driven by different motivations. In periods of heightened economic stress, investor loan performance in various markets worldwide deteriorated more than owner-occupier loans. We believe the more speculative nature of investment loans is likely to alter borrower behavior in more stressful economic periods. Property investors are generally motivated by capital gains. To address this risk, we apply a higher default multiple to investor loans more broadly compared with owner-occupier loans, despite their strong track record of performance in Australia.

SMSF loans also have greater underwriting complexity. Lenders rely on SMSF borrowers (and their professional advisors) to ensure SMSFs remain compliant with superannuation and tax laws over the life of the loan. This creates a different risk profile compared with non-SMSF loans. The potential consequences of noncompliance could cause significant financial pressure for some borrowers, depending on the nature of the breach.

An element of reputational risk is also inherent in these loans. In more stressful economic periods, the potential liquidation of assets that form part of peoples' retirement savings could increase conduct risk for lenders because regulators are increasingly focused on the fair treatment of borrowers.

These multifaceted factors are why we apply a higher default frequency to SMSF loans in our RMBS analysis.

Growing Presence In RMBS

SMSF loans will likely feature more prominently in RMBS transactions as nonbank lenders diversify their loan portfolios and more property investors look to alternate-financing options to invest in Australia's property markets.

The loans' collateral performance should remain solid, provided economic conditions do not deteriorate markedly. But we believe the more significant consequences of noncompliance, as well as the onus placed on SMSF members to ensure compliance in an ever-changing regulatory landscape, elevate the risk profile of SMSF lending, in addition to its more nuanced underwriting complexity. The higher default multiples applied to SMSF loans reflect these risks, many of which are harder to mitigate.