Safe could mean sorry for DIY funds

PORTFOLIO POINT: Feeling spooked about how 2008 will affect your super fund pension? Research shows panic risk reduction is exactly the wrong reaction.

A general levy of concern, if not pity, is held for those who were forced to start a super fund pension ahead of last year’s global investment markets rout.

Could there have been a worse time to start one? Would those that were forced into one be doomed with a fund that would run out way too fast? Would the members have to lower their standards, tighten their belts and prepare the kids and grandkids for Christmases that might have to be a touch … stingey?

And if this happened, is there anything you can do?

If there are super fund trustees out there looking for some sort of reassurance, then investment house MLC has just provided the research. And a strong argument that fund members can certainly make things a lot worse – particularly if they react by scaling back the risk on their investment strategies.

The research heads back through 108 years ofAustralia’s investment markets and starts the equivalent of today’s account-based pensions at the “worst” possible times. These times are just ahead of the crashes that occurred in 1929, 1934, 1946 and 1973 and shows how those income streams would have been affected over the next 30 years.

It should give some consolation that things aren’t nearly as bad as they seem.

The broad-brush findings of what MLC’s researchers (SusanGoslingandAndrewLawless) found are not totally surprising. Predominantly, having more assets in higher risk assets (shares and property) will provide a stronger, but more variable, income stream, that defensive assets do not always live up to their name and that there are some strategies that can be adopted that could improve longer-term prospects.

Most importantly, in my opinion, they found that switching your investments to lower-risk investments now (away from shares and property and towards cash and fixed interest), after a significant market fall, is a losing strategy.

Let’s spell out MLC’s assumptions. Gosling and Lawless have used a 60-year-old who is flicking into pension phase with a $500,000 balance and is going to draw the minimum pension. That is, 4% of the available balance is drawn from age 60. This rises to 5% at age 65, 6% at age 75, 10% at age 85 and 14% at age 95. (Of course, the current rules are assumed to apply into the future. Although that’s as likely as an ice-cream lasting more than a few minutes in the sun in most parts of Australia in the current heatwave.)

Then they compare how different investment risk strategies would impact on the income stream. That is, how does the high-risk income stream, of a fund invested 100% in growth assets (shares and property), compare to other strategies of 70%, 50% or just 30% in growth assets.

The historical average shows that the income stream of the 100% growth strategy will rise from $20,000 a year (4% of $500,000) to a little more than $60,000 over 30 years. (These figures have been adjusted for inflation.) The pension stream from the 70% growth strategy would rise from $20,000 to about $40,000. The 50% growth strategy would have a pension stream of about $31,000 after 30 years and the defensive option of just 30% in growth assets would have an income of about $23,000.

A 70% growth strategy started just prior to four of the worst crashes (1929, 1934, 1946 and 1973) shows some interesting statistics.

The worst crash in Australian history was the fall that occurred in 1973-74. But, MLC shows, an account-based pension there actually would have been higher than the median for all periods, because the strength of the bull runs in the 80s and 90s more than made up for those falls over time. However, there was a long period – approximately 13 years – where the pension was below the $20,000 which had been started initially.

It turns out that 1946 would have been the worst year to have started a pension – for those who live long enough to take their pension for 30 years – because they were also around to take in the poor performance of the 1973-74 crash.

“Another important lesson is that, assuming they were in the right strategy to start with, switching to more conservative investments after a significant fall is unlikely to be in a client’s best interests,’’ MLC says.

Switching from an investment approach that had 70% in growth assets to a 30% growth assets strategy in the year following big falls would have a dramatic impact on the longer-term income.

“While switching to ‘lower risk’ investments resulted, in some instances, in a short-term increase in the income received, it has generally been a losing strategy because it locked in the investment losses,” the researchers said.

“There is a real danger to longer-term pension outcomes if a client switches after significant negative returns. This danger is that the retirement funds run out too soon.”

That is certainly not to say that 2009 – following on from the disastrous 2008 – won’t be different. Last year was the worst calendar year on record. Uncertainty still prevails. We’ve got an economy with a gloomy outlook. Any early sense of optimism about 2009 might be misplaced. Or perhaps it should be misplaced. Just readAlanKohler’s column from Monday.

On the numbers side, the researches go through every year since 1901 and show what the pension income would have been 10 and 20 years after commencement, when comparing a 30% growth strategy with a 100% growth strategy. That is, for a person who started their pension at age 60, how would the different investment strategies compare as a pension when that person turned 70 and 80.

It shows that 86% of all years, the higher-growth strategy will have provided the higher income by the time our pensioner hit the age of 70. This figure rises to 99% when the retiree turned 80. In fact, the only year that a pure growth strategy wouldn’t have provided the higher income stream was 1989.

And what about 1989, our last great crash? Pensions of all investment strategies started then have largely provided incomes that are above the long-term averages for their risk type. Only the full-growth strategy fell below the long-term average in 2008. Interestingly, noted the researchers, the defensive strategy was particularly strong during this period. “When compared to the median outcomes for each investment strategy over the last 108 years, this has still been a highly positive 20-year period.”

What can super pensioners do?

There are a few options. None are quick fixes and some are simply psychological. MLC suggests the following options:

Spend less: If you are currently taking more than the minimum drawdown on your pension, you could reduce the pension payments to preserve cash in your fund and allow you to take more advantage of any market upturn. The fall in fund asset value may also allow for greater Centrelink benefits. The other ‘spend less’ strategy is just to cut your spending and put those savings to work back in the market.

Switch back to accumulation: If you are receiving income from other sources, then you could revert your pension fund back to accumulation to preserve capital. This will, however, mean that income and gains in the fund become taxed again. And there could be some ramifications for your tax-free and taxable components within the fund (for those 59 or under).

Return to work: It might not be a particularly palatable option, but it might not have to be a particularly long-term option either.

Segment your portfolio: While largely psychological, this option would see you segment your investments. This might include two years worth of cash for making pension payments, allowing you to leave the rest in your preferred portfolios, or splitting your funds into short, medium and long-term strategies, taking pension payments only from the short-term option.

But long term, MLC’s statistical study is clear. The higher-risk portfolios will generally provide you with greater growth in your portfolio and greater income from it. However, you need to be able to sleep at night and making sure that you have the right investment allocation is the most important.

Bruce Brammall is a financial adviser and author of Debt Man Walking – A 10-Step Investment and Gearing Guide for Generation X.



Leave a Reply

Your email address will not be published. Required fields are marked *