The extra risk your SMSF can manage

There are many benefits to holding an SMSF, and there’s one extra risk in retirement planning that you may not have realised is better managed in the SMSF environment says Bryan Ashenden, Head of Financial Literacy & Advocacy, BT.

When it comes to your self-managed super fund (SMSF), there is often a lot of talk about the risks and obligations that, as a trustee of the fund, you need to manage. Do you have an investment strategy in place and is it reviewed regularly? Have you considered the insurance needs of all the members of the fund? Is you deed current? Have you met all your trustees reporting obligations on time?

Until recently however, there is another risk that is perhaps even more important for you to consider when it comes to your SMSF. This is a risk that actually applies to everyone and their retirement planning, but one that can perhaps be better managed in the SMSF environment. This is known as sequencing risk.

What is sequencing risk?

At its simplest, sequencing risk is a subset of market risk, and refers to the order, timing and investment returns that can prematurely exhaust retirement savings. Negative returns experienced immediately prior to retirement or in the beginning of the post-retirement phase, can be difficult to recoup. In the superannuation environment, this is further compounded by the timing of contributions (pre-retirement) and withdrawals (post-retirement).

One of the principles of investing is that a focus on the long term will assist in overcoming any short term volatility. Generally this works, and history shows that over an extended period of time a lump sum invested today will be worth more over the longer term if you stay invested – even if you lost some value of the investment in the short term. This theory certainly holds true for the initial lump sum. But when you start making regular contributions along the way, sequencing risk can have an impact. Ideally, you don’t want to make a contribution just before the market falls – you would rather do it just before the market goes up. But of course, without a crystal ball we can’t time the market, which is why another financial planning concept of dollar cost averaging and regular contributions / investments is an important consideration, which can help to take advantage of buying opportunities when markets are low.

So how can your SMSF help you deal to this?

Unless you placed all your investments in cash, sequencing risk can’t be avoided. Any exposure to growth assets, opens up the real possibility of sequencing risk that needs to be carefully managed. And whilst placing everything in cash means your capital is protected, you miss out on the opportunity for capital growth and it’s more likely your savings will run out sooner. As sequencing risk can’t be avoided, the key is to determine how you best manage it.

Managing sequencing risk

In retirement, the biggest impact of sequencing risk can be felt because you are already drawing on your savings and any negative market impacts could have the potential to more dramatically impact your savings. In fact, that is the ultimate double whammy in retirement. One of the best ways to manage this risk is to consider changing the way you think about investing.

In general, the most common way people think of investing is risk based – how much risk are you willing to take on for the potential reward? And whilst accumulating towards retirement, this is probably the right way to think. But as you near or move into the retirement phase, a different consideration could be around “objective based investing”. As the name implies, it’s about considering what objectives you are trying to achieve.

Switch the way you think

A simple way to think about this is to split your objectives between needs and wants. In terms of your retirement income, how much do you actually need for things like food, clothing, shelter etc. If you’re not sure, ASFA’s Retirement Standard can provide a good guide. Your wants refer to the extra things, your discretionary spending. If you think this way, you might start thinking about how you invest your money differently.

For your needs, you may need more security, more of a guarantee, more certainty. This doesn’t necessarily mean investing it all in cash. It could mean you purchase an annuity income stream that will give you a guaranteed payment for the term of that annuity. Today, there is a lot of flexibility in annuity streams that means they can better help you manage this risk.

For your wants, your previous risk based approach may still be relevant as you could potentially take a little more risk as you are considering your discretionary expenses. In fact if your needs are already covered with a secure income, you are liberated to take on a more aggressive approach to achieve any wants above that level of required income. You could use a normal account based pension in your SMSF towards this.

Objective based investing with an SMSF

So why is it any different in an SMSF? The reason is you still get to maintain oversight and control. You can purchase an annuity product in your SMSF. It’s really just like making an investment off the SMSF monies. In a retail fund, you can still achieve your objective based approach, but your annuity stream is generally going to be purchased from someone other than within your super fund, so you end up with multiple sources. In your SMSF you can combine the output from your needs and wants investing to give you a single income stream.

This approach to retirement planning and investing is likely to gain more popularity as a result of the Government’s review of income streams, which was also announced on Budget night this year. Whilst the Government has indicated that it will amend the law to make this approach easier, there is no reason to wait. It might be worth taking the time know to talk with your SMSF’s professional advisers to get ahead of the game. After all, the risks exists now, so why not start managing them sooner?

Next: Managing cash in your client's SMSF

There are three steps to consider when you choose a cash account for your client's SMSF.

This information is current as at 12/09/2016.

This document provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such. This information does not constitute financial advice. It has been prepared without taking account of your client’s objectives, financial situation or needs. Because of this, before acting on this information, you should consider its appropriateness having regard to your client’s objectives, financial situation and needs. Information in this blog that has been provided by third parties has not been independently verified and BT is not in any way responsible for such information.

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