The Federal Government has let the gearing genie out of the superannuation bottle. Restrictions on borrowing by super funds have come to an end following changes to the law. Super has been subject to some big changes over the years - and this one is right up there.

An amendment to the Superannuation Industry Supervision Act last year was designed to clarify the law covering internally geared derivatives such as instalment warrants.

Yet it went much further than expected and established the right of funds to borrow to invest in any asset they would otherwise be allowed to buy outright.

The main beneficiaries of this change will be the trustees of the country's 370,000 self-managed super funds, who can now gear into property.

This change was a surprise to almost everyone in the industry and has led to a flurry of product development aimed at providing funds with gearing options.

At this stage no one knows whether it is a good genie or a bad one.

The Australian Taxation Office has cautioned trustees of self-managed super funds to be careful about the types of loan arrangements they get into.

In a taxpayer alert issued last week, the Tax Office said trustees had to ensure that in entering into a loan contract they did not breach provisions of the Act that prohibit the acquisition of in-house assets. It emphasised the sole purpose of superannuation investment is to accumulate benefits for use in retirement.

Before the change, super fund trustees were able to borrow in a limited way through structured vehicles that were internally geared, such as instalment warrants and other equity derivatives, and geared managed funds.

Several boutique fund managers had devised geared property investment products that used a similar structure to instalment warrants. One of those was Calliva Group, which launched a product called SuperAccess in June.

Under the terms of the scheme, Calliva would purchase 70 per cent of the value of a commercial property.

The super fund subscribed for a property note, which represented the balance of the purchase. The note included a right to buy the property outright at any time.

On settlement of the transaction, the property was held by a trust company. The super fund entered into a lease with the trust company and the super fund, then sublet the property to a tenant. Any excess of gross rent received over interest outgoing was applied to reduce the funding.

Calliva launched the product after getting a favourable product ruling from the Tax Office and a letter from the taxman stating that the funding arrangement did not breach the Act's prohibition on borrowing.

Calliva was not the only group with such a scheme. A Babcock & Brown offshoot, SPI Plan, produced a property warrant that allowed super funds to gear into its property developments and a group called Quantum Warrants, a subsidiary of daVinci Funds Management, had a similar product.

These have been overtaken by events.

Last year's amendment removed the focus on instalment warrants that had been in the legislation. It established the broader principal referred to above, that funds could borrow to invest in assets they otherwise could buy outright.

Now lenders are free to offer arrangements that resemble conventional lending products.

Westpac, which entered the market in March, simply modified the terms of a couple of existing commercial loans.

Lending to a super fund is not exactly the same as lending to an individual. The money borrowed must be used for the purchase of an asset.

As the loan is being repaid, the asset must be held in trust with a security trustee and the super fund has a beneficial interest in any income, interest or capital gains from the asset. When the loan is paid out, ownership can be transferred to the super fund.

If the asset is residential property, the fund members cannot live in it. If it is commercial property, they could lease it as long as rent was struck on a commercial basis.

The existing assets of the fund have to be protected from loss if the loan goes bad.

Loans must be non-recourse, which means that if the borrower defaults, the lender can take possession of the property being offered as security but no other assets of the fund. In this way the rights of the lender against the fund for default are limited to the security.

Lenders can ask the members of the fund to give personal guarantees, which means the lender could recover assets held outside super if the loan goes bad.

Some lenders, such as Macquarie, include a security trustee in the loan package. Others, such as Westpac and Seiza Capital, do not. Some law firms, including Gadens, have started businesses that set up a security trustee for borrowers.

Lenders and self-managed super fund trustees are happy with these changes but many people within the super industry are not. The Government has heard from a number of sources that opening the door to super fund borrowing in this way is a mistake.

Speaking at an industry conference last month, the Minister for Superannuation and Corporate Law, Senator Nick Sherry, said: "Sophisticated financial investment instruments are increasingly being marketed to SMSFs. I also note that SMSFs had a high exposure to Westpoint [a failed finance company], which raises risk and diversification issues. It is the responsibility of the Government to monitor this area and we will continue to keep a close watch on the marketing of any sophisticated products to SMSFs."

The Tax Office says it would be concerned about loans advanced by related parties at rates higher or lower than commercial rates.

It says: "Money advanced by a member or related party at greater than a commercial interest rate may result in a breach of the sole purpose test, on the basis that the excessive interest rate may mean that the SMSF is not being maintained for the sole purpose of providing super benefits." The Tax Office also says it would be concerned if interest on a super loan was capitalised.

One issue that will worry lenders relates to personal guarantees. Several lenders with products in the market, including Westpac and Seiza Capital, require the members of the fund to give personal guarantees. The Tax Office says a regulatory issue would arise if the personal guarantee resulted in recourse being made to any assets of the super fund.

Gadens Lawyers partner Jon Denovan says personal guarantees are legitimate. "Superannuation legislation does not regulate the members, only the fund."

Denovan says a problem would arise if the fund member giving the personal guarantee then sued the fund to recover lost assets. He says loan contracts would have to be written to exclude this possibility.

One critic of the change to gearing rules is Pauline Vamos, the chief executive of the Association of Superannuation Funds of Australia.

"We recognise that the flexibility offered by SMSFs is a good thing for lots of people," she says. "But we want to make sure that when SMSF trustees go into these products they balance the risk of taking on debt against their retirement needs."

Macquarie Adviser Services executive director David Shirlow says the anti-borrowing argument is illogical. "If you are going to control gearing, you have to do so on a look-through basis. It does not make any sense to impose controls on one form of geared investment and not on another."

Yet Vamos argues that an important difference between a geared fund and a loan is that the geared fund is an investment product that must be sold by way of the product disclosure statement that has been vetted by the Australian Securities and Investments Commission and sold by a licensed financial planner. "It is a very different regulatory structure to a commercial loan," she says.

Loan brokers have started signing up to sell self-managed super fund loans. They see the new loan packages as a way of supplementing their dwindling mortgage businesses.

Seiza Capital managing director Simon Robinson says his group has signed up a number of brokers to sell the product it launched in February, the Self Managed Super Fund Loan.

One of those brokers is Queensland's Allstate Home Loans. Allstate managing director Tony Shield is expecting a slowdown in mortgage sales and is looking for a change to Allstate's product mix.

Mortgage broker Firstfolio has signed up with Calliva Group and will sell its SuperAccess property investment loan to SMSF clients.

The prospect of loan brokers setting up gearing arrangements for SMSF trustees worries some people.

Denovan says he supports the right of self-managed super fund trustees to borrow to acquire an asset of their choice for their fund and also choose the level of gearing that is appropriate for their risk tolerance.

He says the alternative, geared funds, often have high fees.

But Denovan can see the potential for mis-selling.

"This market could get hyped up because it is allowing super funds to do something they have not been able to do before. Australians are hardwired to gear into residential real estate."

Asgard, the wealth management division of St George Bank, is working on a modification of its margin loan that will be marketed to SMSF trustees. The executive heading the project, Dean Thomas, says he cannot understand all the panic about super funds borrowing.

"There is no question that borrowing is a long-term wealth creation strategy and has been used successfully by investors for many years to accelerate their wealth accumulation," he says.

"What we need to keep in mind is that we have a retirement savings gap. There are still very few people in this country who retire with enough in their super funds to generate a comfortable retirement income. One way to get your investments working harder is through gearing."

He, too, argues that one of the strengths of a regime that allows funds to borrow and not just invest through geared funds is that they can choose the appropriate gearing for their risk tolerance.

What the products look like and what they cost

Self-managed super fund loans tend to have lower loan-to-value ratios than standard mortgages and higher interest rates. And costs are higher because the asset being acquired must be held by a security trustee during the term of the loan.

Some lenders include a trustee service in the package, while others do not. A number of law firms have trustee packages. Some lenders do have product rulings but Gadens Lawyers partner Jon Denovan recommends that self-managed super fund trustees get some independent tax advice before borrowing for their fund.

Macquarie Bank Macquarie Relationship Banking is offering a 9 1/2 -year interest-only loan at 10.95 per cent with a maximum loan-to-value ratio of 55 per cent. The property will be held by a trustee until final payment is made. The trustee is appointed by Macquarie. The loan is limited recourse. Borrowers must enter into a property management agreement with a manager appointed by Macquarie. The minimum loan is $165,000, borrowers pay a $3000 application fee and a administration fee of 0.25 per cent a year. The lender does not require a personal guarantee.

Westpac Unlike other offerings, which are highly structured, Westpac's offering is a modification of an existing loan. The bank has written new lending policies for a couple of commercial loans that will allow them to be sold to super funds investing in property. The loan is non-recourse. The maximum loan-to-value ratio is 72 per cent for residential and 63 per cent for commercial property. The members are required to give personal guarantees. Westpac is offering the loan under its own name and also the BT Financial Group brand. Its rate for a residential investment loan is about 10.55 per cent.

Seiza Capital Seiza's Self-Managed Super Fund Loan has the highest loan-to-value ratios in the market - 85 per cent for residential and 75 per cent for commercial properties. Borrowers must give a personal guarantee and are expected to arrange their own security trustee. Loans are available for terms up to 25 years. The rate is negotiable.

Calliva Group Calliva's SuperAccess loan is a 20-year principal-and-interest mortgage. The lender has recourse only to the property and no personal guarantees are required. The variable rate is 10.8 per cent. The maximum loan-to-valuation ratio is 70 per cent. It can be used only to buy commercial property. An establishment fee of 1.5 per cent of the value of the loan is credited to the borrower's account once it is settled. To establish a security trustee, Calliva provides a trust deed for a $2750 fee and the borrower nominates the trustee.