Recent months have shown stock markets to be as predictable as the weather in Hobart. Market swings present a risk for self-managed superannuation fund (SMSF) retirees in pension phase who are required to draw a minimum pension each year.
Australian Taxation Office (ATO) statistics show SMSFs in pension phase hold on average 70% of their wealth in growth assets. Investing in growth assets like equities can provide the potential for greater long-term returns leading to a higher standard of living in retirement. However, many would accept that equity investing generally comes at a cost to security, including exposure to increased volatility and potentially significant falls in capital values.
Poor returns at the start of retirement when balances are at there highest can have a significant negative impact on your savings. In addition, where income is insufficient to meet minimum pension requirements, SMSFs may be forced to sell assets with a reducing value. This means those assets may be realised at a loss to meet the pension standards, and locks in poor returns.
What if you could implement a strategy to maximise returns without taking on additional risk?
The chart below shows Australian equity returns over every 10-year period since 1883.
It shows that, historically, even after the worst downturns, equity markets typically recovered their nominal value after 7 years. An SMSF can take advantage of this.
Where cashflow requirements can be secured so the SMSF does not need to draw down on growth assets during periods of volatility, Accurium’s research shows this can increase SMSF balances across a wide range of scenarios.
The SMSF income buckets strategy
Consider a strategy where your SMSF is divided into three buckets. The first bucket, typically the SMSF’s bank account, is used to cover day-to-day cashflow requirements for the next 6 months.
The second bucket provides secure income to cover your cashflow requirements, so that the SMSF’s remaining assets in the third bucket can be invested for long-term growth.
The key to this strategy is securing cashflow in the income bucket for long enough that, should there be a downturn, there is sufficient time for growth assets to recover without being drawn on.
The bucket strategy is useful for aligning cash flow security and long-term growth potential to maximise SMSF returns.
Case study: Adam and Jess drawing minimums from their SMSF
Each household will differ around spending patterns and needs. Adam and Jess have decided over the next ten years they will be drawing the 5% pa minimum from their account-based pensions.
They would like to examine how the bucket strategy could maximise their SMSF returns. Using Accurium’s retirement adequacy model, which considers 2,000 scenarios of market and inflation outcomes as well as the range of lifespans, we consider whether the income bucket strategy could improve the balance of Adam and Jess’ SMSF after 10 years.
The chart below considers Adam and Jess’ SMSF over the next ten years under one possible market scenario.
The blue line shows the projection of Adam and Jess’ SMSF balance under the traditional strategy with their assets invested in the balanced asset mix. After drawing the minimums each year the value of the SMSF at the end of year 10 has reduced to $886,753 in today’s dollars.
Consider instead that Adam and Jess decided to implement the bucket strategy by securing $55,000 in income for ten years. They decide to purchase a 10-year term annuity, which has zero residual capital value (RCV0) to secure this income with $468,000 of their SMSF balance.
Based on this income bucket Adam and Jess will receive a monthly payment in their SMSF, which includes a return of capital, plus interest totalling $55,000 each year for ten years.
The remaining SMSF balance is invested in growth and cash buckets. The growth bucket is invested in the same mix of growth assets as the traditional strategy, with 5% in cash.
The projection of the SMSF over the ten-year period using the income bucket strategy, can be seen by the orange line.
The RCV0 term annuity provides Adam and Jess with an annual income stream of $55,000. This allows their remaining assets time to grow, protected from being drawn on.
The result in this scenario is that by the end of year 10 when the secure income has been exhausted, the SMSF balance has reached $983,840, an increase of 11%.
This illustrates just one possible outcome. It will be useful for Adam and Jess to understand how likely this strategy is to work across all sorts of investment scenarios.
Looking at the outcomes across all 2,000 scenarios tested by Accurium’s retirement adequacy model we analyse the SMSF balance at the end of the ten years for each strategy.
This is shown in the following chart.
Adam and Jess can see that the bucket strategy outperforms the traditional balanced strategy under a range of market scenarios. The box and whisker chart has moved up. The median balance is 5% higher when using the bucket strategy at $944,000. The strategy also generates a higher SMSF balance under both poor and good market conditions.
As a self-managed trustee you will determine which strategies work best with your risk appetite, goals and expected lifestyle in retirement. However, our modelling shows that an income bucket strategy can outperform a traditionally balanced portfolio when looking to grow your SMSF balance.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
