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Self Managed Super Fund (SMSF) Article
Cashflow is king in retirement funds

By Tony Negline.

This article may be out of date.

28th July 2010

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As is widely known most allocated pensions, market linked pensions, term allocated pensions and account based pensions received a reprieve from the normal minimum income requirements for the 2008/09 and 2009/10 financial years.

The reprieve cut the required minimum income in half.  It was introduced to ease the impact of falling asset values on the amount of income that has to be paid from these investments.

On 30 June 2010 the Treasurer, Assistant Treasurer and Minister for Superannuation announced that this rule will also apply for the 2010/11 financial year.

As in previous years this change will not apply to defined benefit pensions.

Like most super laws, the minimum income reduction is allowed but not specifically permitted.  The go ahead to allow these changes should therefore be expressly provided for in a super fund's trust deed.

In order to put this change into action, super fund trustees will have to carefully examine under what rules the pension is paid under.  Are the rules that define the pension solely found in the super fund's trust deed?  Alternatively were a pension's rules presented to member in a Product Disclosure Statement or a written Pension Agreement or perhaps both?

Whatever documentation has been used, it is likely that a trustee will have to prepare a minute to show that it has been agreed to abide by this new government rule and that necessary documentation explaining the change will be given to the client and that necessary deed amendments will be put in place.

Pension structures which have income amounts determined by the underlying asset values have been popular for almost twenty years.

The factors which determine the minimum income which has to be paid are specifically designed to ensure that income payments increase as a pensioner gets older.  As the income paid gets higher the lower the account balance becomes.  In time the account balance will run out.

For example for people aged under 65, the minimum income paid is normally 4% of the account balance at 1 July.  For those aged at least 80 but under age 85 the minimum is normally 7% of the account balance.  For the 2009, 2010 and 2011 financial years the minimums will be 2% and 3.5% respectively.

The Ministers said that, "Extending the drawdown relief for a further year will help retirees to recoup capital losses on their pension portfolios as equity markets recover over time."

Is this actually necessary?  At present the Cannex website is showing $100,000 12 month term deposits paying around 6%.

What about Australian equities?  For the 2009 calendar year, the ASX 200 All Ordinaries index paid 4.3% in income before any franking credits.  If we assume this income was 70% franked then the rate of return increased to 5.7% for 0% taxed pension assets.

So what is the real problem here?  Many pension investors have not structured their pension assets to pay income.  Given that a pension, by definition, involves paying an income, this is fairly strange.

As anyone in small business can tell you, cashflow is king.  Without cashflow a business will quickly go broke.

A pension is very similar.  To pay the income, a pension needs to have sufficient cashflow.  Without that cashflow, assets have to be sold to make the income payments.

This cashflow drought in pensions has arisen for two distinct reasons.

The first reason is asset allocation.  It's difficult to know what many pension paying Self Managed Super Fund trustees are up to however Tax Office data does not show much difference in asset allocation between funds with no pensions and those only paying pensions.  The pensions do not seem to be structured to generate income.

The second reason is that many pensions have invested in what are known as total return managed funds.  A total return fund is one that combines all income, capital gains, expenses and capital losses into one unit price.  A managed fund's accounting and administration departments work out what the unit price should be based on all monetary flows into and out of a managed fund and the changes in every asset's market value.

Suppose an investor puts $100,000 into a managed fund that has a $1.00 unit price which means they 'own' 100,000 units.  Suppose that after several years the unit price has increased to $2.  Their 100,000 units were worth $200,000.

If the investor wanted to pay themselves $10,000 income from this fund they would need to sell 5,000 units whilst the unit price was $2.

Now suppose that the price of the units has crashed to 75 cents but they still wish to pay themselves $10,000 income.  They now need to sell 13,333.33 units.

Under this scenario units are literally walking out the door as income.  This problem is exacerbated because fund managers must value all their assets at the prevailing market price.

Many retirees have been convinced that investing in non-Australian based assets is worthwhile. The logic is that Australia is a very small fish on the world economy league table or ladder and exposure to bigger economies provides protection and diversification.  But, without going into specifics these people have been very adversely impacted by currency movements.

What is most strange about these issues is that, although these two design flaws have been around for 20 years, and were identified in 1994, neither the Henry Tax Review or the Cooper Review recommended changes that would alleviate these problems.

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