A key risk faced by SMSF retirees is sequencing risk as the order and timing of investment returns can have a significant impact on account balances and the ability to meet future cash flow.
This risk is attributed to the regular cash flow that must be drawn from an SMSF in pension phase, of at least the minimum pension requirement.
This means trustees face a trade-off between a long-term consideration of investing in growth assets to maximise the SMSF balance, and a short-term consideration of meeting regular cash flow requirements.
This article will examine how securing cash flow for a period of time can help reduce an SMSF’s sequencing risk exposure and maximise the upside potential while controlling downside risk.
The strategy
The SMSF cash flow strategy addresses three key goals SMSF retirees are looking to achieve:
- Regular cash flow
- Free up capital for long term growth opportunities; and
- Maximise upside potential while controlling downside risk.
Investing in growth assets, like equities, can provide the potential for greater long-term returns, leading to higher balances and income in retirement. However, it could also mean increased volatility and the risk of significant falls in capital values. Market swings present a particular risk for retirees. Poor returns at the start of retirement, when balances are at their highest, can have a significant impact on retirement savings.
A strategy that secures cash flow for a period of time, using an investment that pays a regular income over the period, provides the Trustee with greater confidence that the SMSF’s future cash flow requirements for the period will be met. In particular, minimum pension payments so the fund can claim tax exempt income. This also helps to protect growth assets from needing to be drawn down on during the period, reducing sequencing risk.
The SMSF cash flow strategy can be considered as a three-bucket approach to separate cash flow from the market-linked investment portfolio.
Figure 1 – SMSF cash flow strategy
- The first bucket is typically the SMSF’s bank account and is used to cover current day-to-day spending requirements;
- The second bucket needs to provide cash flow to cover outflows for a reasonable period of time, to protect against sequencing risk; and
- The SMSF’s remaining assets in the third bucket can be invested for longer-term growth, ideally protected from being drawn upon over the short term, or in a market downturn.
Case study
Consider a two-member SMSF with members Janet and Scott – both aged 65. Janet and Scott each have $500,000 in an account-based pension. The minimum pension requirement in the SMSF is 5% of the fund balance, or $50,000 this year. The SMSF is currently invested in a 50/50 growth and defensive portfolio.
After reviewing their cash flow goals, Janet and Scott decide that over the next seven years they would like to ensure that the SMSF can make pension payments of $50,000 per year, increasing each year with inflation.
To do this they would like to compare their current strategy with that of the SMSF cash flow strategy for a period of seven years. As illustrated in Figure 2, the SMSF cash flow strategy invests in a RCV0 (Residual Capital Value 0) fixed-term annuity, which pays the SMSF $50,000 per year for seven years (Purchase of a guaranteed term annuity for a term of seven years by an SMSF, full CPI indexation, purchase price $332,172 at 14 July 2017), increasing each year with inflation. The total asset allocation at the start is kept similar to their current mix by increasing the growth allocation within the growth portfolio to 85%.
Figure 2: SMSF Strategy cash flow vs current strategy
Guarantee cash flow in the SMSF
The minimum pension standards provide a reference for what the required cash flow from the SMSF needs to be. It is important pension payments are paid each financial year irrespective of how the fund’s investments are performing. If they are not, the fund may not be eligible to claim exempt current pension income, and instead earnings may be entirely taxable.
It is important to recognise that income on market based investments, such as dividends on shares, is not guaranteed. With minimum pension requirements starting at 4% of the fund balance, it is unlikely that such income will be sufficient without spending capital.
By analysing the outcomes based on 3,000 possible market scenarios, we are able to test how often Janet and Scott would be required to draw on capital invested in the market to fund cash flow over the seven-year period. The results of that analysis are summarised in Figure 3, and highlight that there is a high risk that the income from their current strategy would be insufficient to cover cash flow requirements. Janet and Scott would have to draw on capital invested in the market in 88% of the years tested (Stress testing uses 3,000 Willis Towers Watson market scenarios for CPI, growth and defensive asset class total returns and yields, assume growth investment fee of 0.5% and defensive fee of 0.3%). On average, capital was required in 6.2 of the 7 years.
Figure 3: SMSF Strategy cash flow results
Using the SMSF cash flow strategy, Janet and Scott were able to secure their cash flow requirements over the seven-year period. The income from their investments would meet the cash flow requirements in each of the seven years illustrated. They can have confidence that growth assets will not need to be drawn on to fund short-term cash flow needs, even in times of market volatility.
The regular income produced by the strategy can be used to meet the fund’s cash flow requirements, giving the trustees peace of mind. This disciplined approach to funding cash flow allows Janet and Scott to focus on long term investing. Irrespective of day-to-day market fluctuations, investment buy and sell decisions can be made without the risk of short term thinking overriding long-term strategy.
Free up capital for long-term growth opportunities
The freedom for SMSF trustees to invest in a wide range of assets opens up growth opportunities when short-term liquidity and cash flow considerations are removed. Investing over a long time horizon allows the fund to take advantage of illiquid and growth assets that may be expected to achieve higher returns over the long term, compared to investments suited to a shorter time horizon.
In particular, the use of an RCV0 fixed term annuity secures cash flow using the minimum amount of capital compared to other more capital intensive options, such as a series of term deposits. An RCV0 fixed-term annuity has no residual capital value, the focus is entirely on providing a regular cash flow for a fixed period by combining both capital and interest in payments.
Using the cash flow strategy, Jane and Scott will invest 33% of fund assets to secure the cash flow over the 7-year term. They invest the remaining $667,828 in assets in a portfolio with 85% growth assets. Whilst this increases their overall growth/defensive asset mix by 7% (from 50% to 57%), it is still broadly in line with current asset allocation, and they are comfortable with this.
The RCV0 term annuity will decrease in value over the term because both capital and interest are repaid to the fund. Janet and Scott decide to allow for the portfolio asset mix to rebalance over the term back to a balanced strategy at the end of year seven. This can be seen in Figure 4 below, which shows the SMSF balance over the 7-year term based on fixed assumptions (CPI of 2.5%, Defensive: capital growth of 0% p.a., income of 3.4% p.a., Growth: capital growth of 2.1% p.a., income of 4.6% p.a., net of fees).
Figure 4: SMSF Strategy cash flow balance and asset allocation
Maximise upside potential while controlling downside risk
In many cases, SMSF trustees are faced with a trade-off between risk and return in achieving their objectives of maximising the fund balance but also ensuring cash flow requirements will be met.
The SMSF cash flow strategy can help improve the upside potential of the SMSF balance because assets can be held to achieve their full potential capital gains over a period. The downside risk is controlled because even in periods of market volatility capital does not need to be drawn on, losses are not locked in and assets have time to recover.
Making portfolio allocation decisions based on risk measures allows trustees to consider the impact of a strategy under a range of market scenarios. We analysed the outcome of the SMSF balance at the end of year seven across the 3,000 future market scenarios. We found that the SMSF cash flow strategy increased the potential upside of the SMSF balance, while controlling downside risk.
Figure 5 illustrates that looking at the top fifth percentile of outcomes, the SMSF balance under the cash flow strategy was nearly 7% higher than the current strategy. At the median outcome (the middle outcome across all scenarios), the balance was almost 3% higher and even in the bottom 5th percentile outcome the downside risk was controlled, with the SMSF cash flow strategy leading to no material change in the SMSF balance at the end of year seven compared to the current strategy.
Figure 5: SMSF strategy cash flow upside potential and downside risk
This information is provided by Accurium Pty Ltd ABN 13 009 492 219, a wholly-owned company of Challenger Limited ABN 85 106 842 371. Any financial product advice is general advice and is provided by Challenger Retirement and Investment Services Limited ABN 80 115 534 453, AFSL 295642 (CRISL) and Challenger Life Company Limited ABN 44 072 486 938, AFSL 234670 (CLC). It does not take into account the objectives, financial situation or needs of any particular individual. Scenarios, examples and comparisons are shown for illustrative purposes only and should not be relied on by individuals when they make investment decisions. We recommend that individuals seek appropriate professional advice before making any financial decisions.