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Self Managed Super Fund (SMSF) Article
Protecting pension income needs a strategy

By Tony Negline.

This article may be out of date.

25th February 2009

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Since financial markets have tanked many people with market linked pensions or annuities have become very concerned about their product's asset position.

We need to discuss how to avoid the problem in future but also how current pensioners and annuitants might be able to deal with their predicament.

Most people with a market linked product, structure their pension so that they invest in a range of asset classes.  For example they might be invested into cash, fixed interest (domestic and international), shares (Australian and overseas), listed property trusts and possibly alternatives such as hedge funds.

Some investors move money between these various asset classes in order to ensure that there is always cash money available to make income payments.

For example pension income might solely be paid from the cash portion.  As the cash portfolio gets depleted, some of the fixed interest portfolios might be sold and moved into cash to meet future income payments.  The more volatile asset classes (shares, LPTs and hedge funds) might then be partially sold and moved into fixed interest before finally being transferred into cash for income payments.  The idea here is to allow the riskier investments sufficient time to generate decent returns whilst also riding out the ups and downs.

Others have simply taken income payments in whatever proportion their funds have been invested.  For example if they put 50 per cent of their money into Australian shares then fifty percent of every income payment is made from that asset class.

Both these systems work very well when markets are producing good positive returns.  They also work very well in theory when assumptions use a constant average return (for example it's common to see a constant 7% used for Australian shares).

However over the last ten years systemic problems have been identified in how some investors have implemented these two income paying strategies.

Many people have used this system whilst investing 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.

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.  Between April 2000 and January 2003 the Australian dollar was below US$0.60 and for many months traded near fifty US cents.

By February 2005 the Australian dollar was worth just under US$0.80.  The impact of these upward currency movements on retirees' portfolios was particularly adverse especially if the international assets had been bought when the Aussie was close to US$0.50.

Perversely the fall in the Australian dollar from almost US$1 to under US$0.70 has cushioned some of the asset price falls in international financial markets for those investors impacted by the dollars previous rise although many of them have still lost considerable sums of money.  (We don't have space to explain how a fall in the dollar improves the value of overseas assets and how a rise does the opposite.)

The most recent event causing similar problems has been the widespread market crash since August 2007.

These asset price issues for pensions are particularly pronounced because pension investors have to value their pension assets at 1 July for the next financial year and thus far asset prices have fallen during 2008/09.

For pension investors watching their capital disappear there are three strategies they could consider employing:

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