SMSF Cashflow Strategy Managing sequencing risk in an SMSF The inf - - PowerPoint PPT Presentation

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SMSF Cashflow Strategy

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Managing sequencing risk in an SMSF

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• Market & sequencing risk
• Sequencing risk faced by SMSFs
• How to protect against downside risk
• Case study of SMSF Cashflow Strategy
• Q & A about the SMSF Cashflow Strategy in practice

Agenda

General advice warning: This presentation may contain some general advice. This means that individual objectives and needs have NOT been considered in providing this advice. It is not appropriate for us to provide personal advice in this forum.

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Market and sequencing risk

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It’s more than market risk

Risks in retirement

Inflation risk

Outliving savings in retirement Possibility of negative returns at or near retirement affecting the market value of investments which cannot be fully recovered in the future Erosion of purchasing power over time

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Equity return range narrows over time but losses can persist for up to 6 years

Market risk

Source: Challenger calculations on data from Morningstar and S&P?ASX200 The shaded area represents the range of outcomes for average annual returns based on consecutive periods betw een 1900 and 2017 for the period noted in the chart

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It’s in the timing

Sequencing risk

Possibility of negative returns at or near retirement affecting the market value of investments which cannot be fully recovered in the future

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Doesn’t exist without cashflows

Sequencing risk

Assumptions: $100,000 initial investment, no further investments or w ithdrawals, investments earn 6% p.a. (net of fees and taxes) in all years except first or last three years w hen investments earn -6% p.a. (net of fees and taxes), figures are nominal and are not adjusted for inflation.

100000 200000 300000 400000 500000 600000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

No cashflow

Neg at start Neg at end

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Can work for you in accumulation

Sequencing risk

Assumptions: $100,000 initial investment, annual contribution of $5,000 p.a. at start of each year, investments earn 6% p.a. (net of fees and taxes) in all years except first or last three years w hen investments earn -6% p.a. (net of fees and taxes), figures are nominal and are not adjusted for inflation.

100000 200000 300000 400000 500000 600000 700000 800000 900000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Cashflow in

Neg at start Neg at end

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Works against you in drawdown

Sequencing risk

Assumptions: $100,000 initial investment, annual w ithdrawal of $5,000 p.a. at start of each year, investments earn 6% p.a. (net of fees and taxes) in all years except first or last three years w hen investments earn -6% p.a. (net of fees and taxes), figures are nominal and are not adjusted for inflation.

20000 40000 60000 80000 100000 120000 140000 160000 180000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Cashflow out

Neg at start Neg at end

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Actual and reversed returns

Sequencing risk

Source: Challenger estimates using ABS, S&P/ASX accumulation and Bloomberg AusBond indices . Assumes retiree draws ASFA comfortable standard of living for December 2016 $43,358 p.a. indexed to CPI each year.

$0 $100,000 $200,000 $300,000 $400,000 $500,000 $600,000 $700,000 $800,000 $900,000 $1,000,000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Account balance

Years into retirement

Retiree A (actual returns and inflation from 1992 to 2017) Retiree B (same returns and inflation, except in reverse chronological order)

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Impact of a downturn at different times in pension phase

Market risk

A 60% equities and 40% fixed income portfolio – draw downs based on average over 140 years of US data aiming to exhaust balance after 20 years. Assumes fees of 1.5% per annum. Source: Challenger, Shiller

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Sequencing risk faced by SMSFs

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• Meet minimum pension standards so can claim earnings as tax exempt
• Maximise balances over retirement so you can

– Afford a comfortable lifestyle ensuring assets last for life – Maximise estate benefit

• Requires

– Regular cashflow drawn from SMSF to meet desired spending & min pension – Investing for long term growth

SMSF objectives in retirement

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• Scott and Sandra Smith
• SMSF balance of $1,600,000
• Currently invested in a balanced asset mix1
• Require cashflow of $85,000 p.a. increasing annually with inflation
• Looking to invest over the long term

Scotty Family SMSF

Case study

1.Assumed asset mix of 25% Aus Shares, 25% Aus Listed Property, 25% Aus Bonds, 25% Cash.

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• Historic balanced asset mix real returns over different timeframes1
• Need to secure cashflow for at least 6 years in order for growth opportunities to be

realised, even in unlikely event of a downturn

Scotty Family SMSF

Market Risk

1.Vanguard 2016 Index Chart, RBA G2 Consumer Price Index, data betw een 1984 and 2016.

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• Traditional forecasts might use fixed assumptions
• Average real return on balanced asset mix over 20 year period 1997 to 2016 was

6.1% p.a.

Does not illustrate risk

Fixed assumptions

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• SMSF balance over retirement if Scotty Family SMSF experienced actual historic

returns1 between 1997 and 2016

Order and value of actual returns has a big impact

Illustrating sequence risk

1.Vanguard 2016 Index Chart, RBA G2 Consumer Price Index, data betw een 1997 and 2016

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• SMSF balance over retirement if Scotty Family SMSF experienced actual historic

returns1 between 1997 and 2016

Order and timing of actual returns has a big impact

Allowing for sequence risk

1.Vanguard 2016 Index Chart, RBA G2 Consumer Price Index, data betw een 1997 and 2016

Using average return showed just under $2m

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• A stochastic model involves the statistical analysis of the range of possible outcomes

– Allows for returns to vary over time like in the real world – Thousands of simulations of likely scenarios to stress test the SMSF over retirement – Actuarial techniques to analyse the resulting distribution of SMSF outcomes

• Challenger’s Cashflow Illustrator

– Considers 3,000 future market scenarios for yields and capital growth on growth and defensive asset classes provided by Willis Towers Watson

Allow for risk

Stochastic models

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• Market and sequencing risk measures:

– How often did the SMSF have to draw on capital invested in the market to fund

$85,000 p.a.?

– What was the SMSF balance after 10 years in a ‘worst case’, bottom 5% of

• utcomes?

– What was the SMSF balance after 10 years in the ‘median’ outcome, the middle

• utcome?
• Instead of having one guess at an outcome using fixed assumptions look at the range
• f outcomes to understand risk!

Measuring risk

Stochastic models

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• Scotty Family SMSF exposure to sequencing risk over a 10 year period
• Chance of needing to spend market based capital to fund cashflow1
• In 95% of all the years tested the trustee must dip into capital to fund cashflow
• On average across all scenarios, capital was required in 9.5 of the 10 years
• A high exposure to sequencing risk!

Using SMSF Cashflow Illustrator

Sequence risk measure

1.Based on investment strategy of 50% in grow th assets, 50% in defensive assets, 0.8% investment management fee on grow th assets, 0.6% on defensive assets, based on 3,000 market scenarios provided by Willis Tow ers Watson. Cashflow of $85,000 p.a. increasing annually w ith inflation.

95% HIGH

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How to protect against downside risk

SMSF Cashflow Strategy

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• SMSF competing objectives of long term growth + regular cashflow = exposure to

sequencing risk

• A cashflow strategy alleviates sequencing risk by

– Using assets that provided a guaranteed income to lock in cashflow – Protecting growth assets from being drawn on

• Capital is segmented for the purpose of growth and cashflow

Security against market and sequencing risk

SMSF Cashflow Strategy

+

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1. Guaranteed cashflow ensure minimum pension payments are paid so the fund can claim tax exempt income 2. Free up capital for growth invest in growth assets to maximise balances available during retirement 3. Maximise SMSF balance while controlling risk invest in growth opportunities while controlling downside risk

Tying strategy to SMSF objectives

SMSF Cashflow Strategy

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• Protect against market risk: growth assets invested for 6+ years
• Protect against sequence risk: secure cashflow for term that growth assets are

invested

• RCV0 fixed term annuity provides capital efficient method to guarantee cashflow

– Peace of mind required cashflow is secured – Growth assets protected from being drawn on

• Fixed term annuity

– Pays a regular cash flow, regardless of how investment markets perform – Re-payment of capital plus interest over the selected term – Flexibility to withdraw at any time

Secure cashflow over a desired term

Cashflow bucket

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Case Study

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• Invest in CPI indexed Challenger Guaranteed Annuity for a term of 10 years

Securing the cashflow bucket

Scotty Family SMSF

New Current

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• Current strategy had high exposure to sequencing risk
• 10 years worth of cashflow requirements fully secured through cashflow bucket
• The SMSF Cashflow Strategy removed the exposure to sequencing risk:
• In no years tested did the SMSF need to draw on growth assets to fund cashflow

Using SMSF Cashflow Illustrator

Measuring sequencing risk

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• Theory: protecting growth assets from being drawn on will reduce downside risk

– Allows assets to time to recover from downturns and realise growth potential – Trustees will not need to lock in losses on growth assets to meet cashflow

• Stochastic modelling risk measures:

– Median outcome (50th percentile) = middle outcome of the distribution. The trustees might expect their SMSF balance to be at least this in 50% of future scenarios – Worst case outcome (5th percentile) = SMSF balance that might occur with a 5% chance. A downside risk measure that can be maximised to provide comfort the fund has minimised risk

• Can compare current strategy vs cashflow strategy to identify investment mix that

provides greatest protection for downside risk

Measuring downside risk

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• We assume the SMSF market portfolio has been re-balanced over the 10 year term

from 95% in growth assets back to 50% in growth

Understanding the SMSF investment mix over time

Scotty Family SMSF

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Measuring downside risk using SMSF Cashflow Illustrator

Scotty Family SMSF

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• We saw how the SMSF Cashflow Strategy greatly improved the SMSF balance at the

end of 10 years in the worst case, and also improved the median outcome

• We assumed that the asset mix was rebalanced back to 50 growth/50 defensive

linearly over the 10 year term. – In practice this re-balancing would occur in light of your knowledge of the fund investments and market conditions.

Case study outcomes

Scotty Family SMSF

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Implementing the SMSF Cashflow Strategy

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1. Under SMSF’s current investment mix and future cashflow requirements 2. Pick a desired term to employ the strategy – 6+ years minimum to protect against market risk 3. Analyse the SMSF Cashflow Strategy for the client – Compare SMSF balance under range of risk measures using stochastic analysis 4. Implement strategy with client – Secure cashflow over the term – Invest remaining assets to grow SMSF balance over the term

Focus on reducing downside risk

Implementing the Cashflow Strategy

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• SMSF Cashflow Strategy landing page

– Strategy guide and case study – Product guide – Short video

• Guaranteed Annuity PDS
• Adviser Online
• SMSF Cashflow Illustrator
• Data template

– Client financial information – Goals of client

SMSF Cashflow Strategy

Support Material

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