Anyone running a self-managed super fund in pension-paying mode quickly realises they have taken on a challenging investment task. There are no new contributions coming in to bolster any investment losses. Ideally the fund should earn enough to pay the required pension while running a portfolio, which has to focus on preserving the fund’s capital.
An event like the global financial crisis (GFC) and its effect on markets was guaranteed to turn trustees cautious, perhaps to the point where they have been slow to return to the stock market. But now, with interest rates low and bank term deposits no longer solving both questions of income and security of capital, investors are being forced back to dividend-paying shares in search of higher income.
The risk of equities is heightened because SMSFs just into pension mode have probably reached their peak, with maximum life savings at risk. This concentrates the mind and means the risk of buying shares takes on a different complexion in a pension fund.
Risky business?
There are at least two risks for SMSFs in investing in shares: timing the overall stock market and selecting individual stocks. Most portfolio changes should address these two issues.
SMSF trustees obviously have re-embraced the share market this year; the real question is whether they were early or have only recently followed the herd. Ideally, everyone wants to avoid buying just before a dip, blinded by any late-stage optimism, just as they don’t want to be holding cash while shares rise. While most people currently might feel more confident about the stock market, it still is really a five-year-plus proposition, susceptible to dips as new doubts re-emerge regularly.
Stock selection questions are heightened because many portfolios are concentrated in about a dozen blue chips and there can be questions about even apparently safe, high-yielding stocks like the banks and Telstra. Does Telstra, everyone’s favourite, have its NBN future income locked in if the government changes? Might the banks be at risk of a housing meltdown? There may be only minimal concerns about either question – but they at least deserve consideration.
Income options
Some other stocks suitable for a pension fund include infrastructure providers, like toll road operator Transurban, Sydney Airport and pipeline groups like APA and Envestra. They have a natural monopoly and secure income flow, sometimes with some inflation link.
Other income options for a pension fund are REITS (real estate income trusts), which have regained poise after a disastrous market decline in the GFC. Diversified REITs offer yields averaging more than 6% and now have reduced their gearing levels – but can still carry the risk in their share price.
Hybrid issues can offer tempting yields (though these are tied to cash rates). But these securities still lag in after tax returns compared with say, bank shares – and still have equity risk and a more complex structure. Hybrids may slightly enhance yields, but my fund works on keeping its exposure to less than 20% of assets.
What I do
To enable annual pensions to be paid without needing to realise investments, my fund keeps two years of pensions in cash; say 10% of assets (assuming a minimum pension). It was almost 60% in fixed interest and cash until mid-2012 and subsequently has cautiously bought some leaders (CSL, Telstra, CBA and the S&P 500 index ETF) and some new fixed interest offerings, moving to a 50/50 split of equities and fixed interest.
It would take the promise of a really sustained strong stock market to increase its equity exposure any further.
Disclosure: The author’s own SMSF holds major bank shares, Telstra, Transurban, Envestra and APA.
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.
Also in the Switzer Super Report
- Peter Switzer: China meltdown or Chanos’ claptrap [1]
- Penny Pryor: Newcrest – a bargain at these prices? [2]
- Paul Rickard: Product road test – Centuria’s ‘10 Spring Street Fund’ [3]
- Rudi Filapek-Vandyck: Weekly broker report – Boral and Incitec Pivot upgraded [4]
- Penny Pryor: Auction clearance rates – over 75% in Sydney [5]