When to start a pension in a crisis

It happens about every 10 years, but we still react the same. When investment markets are up we buy more and forget they have a downside. But when they are down we drop them like hot cakes and forget there’s an upside. So if you’re in the retirement zone and have superannuation plus a small amount to live on, when’s a preferred time to make decisions about pensions?

Financial planners will tell you that the right time to start a pension just depends on your situation including your age, family situation, what you have outside super and so on. The forgotten golden rule is the necessity to plan adequately for retirement and the strength gained by having a diversified portfolio. We now see the stress placed on SMSFs with high concentrations of assets in one property or listed shares centred on one industry hit by the downturn.

So what effect does the huge drop in financial markets this year have on superannuation for someone entering retirement or currently receiving a pension?

Thinking of retiring or just retired?

If you are thinking of retiring or have just retired, the first thing to consider in the current environment is the cash flow of your SMSF to ensure you can draw down your pension and pay the fund’s expenses.

Although, continued drops in interest rates over the past year probably got you thinking, less cash and more shares, as the stock market continued to climb to pre-GFC levels. But if you had moved cash into shares the volatility in the market that has overtaken things may have taken a big chunk out of your fund, drying up some of that cash flow. If you went too far you may now be forced to sell some of those shares to give you income to live on.

What’s considered to be a better strategy? The first thing to do is to work out how much you think you will need to live on over the next two to three years. The Association of Superannuation Funds of Australia (ASFA) have developed retirement standards that estimates how much you require to live on if you wished to have a comfortable retirement or an adequate retirement. The latest report published in December 2019 says that for a couple a comfortable standard of living in retirement is about $62,269 and for a single person is in the vicinity of $44,146.

If you were to prepare for any shocks over the next three years, a couple would need at least three times the estimated amount, $187,000 and a single person would need at least $132,438. This is the amount that should be invested in cash and cash equivalents such as term deposits and short-term bonds. In view of current difference between interest rates and inflation, we may need to add another one or two per cent to maintain our spending power. This is not just a once-off decision, because you will need to review the available cash each year to ensure there is enough available on a three year rolling basis. If other investments in your fund are doing well, you may need to rebalance your portfolio to add to the cash pool you have available.

The next thing is to work out whether you should keep your money in an accumulation account or commence a pension or a bit of both. If you kept all your super in accumulation phase you can draw as much or as little as you wish in retirement which gives you flexibility. But from a tax point of view any income earned on investments supporting your accumulation balance are taxed at 15%. Taxable capital gains on investments held for more than 12 months receive a 1/3rd discount. If you are over 60 any amounts you withdraw from the fund will always be tax free to you.

In pension phase things are a little different, as income and taxable capital gains from investments supporting your pension are tax free. But each year you are required to drawdown a minimum pension depending on your age. Providing you are intending to draw at least the minimum each year, then starting a pension may not be a bad idea after all.

However, there is a maximum amount that you can use to start pensions in your fund. This is called your Transfer Balance Cap and is limited to a total of $1.6 million. So for a couple who each start pensions with $1.6 million it is possible to have a combined amount of $3.2 million. Once you have commenced a pension any income earned by the fund on your pension assets or pensions you draw out do not increase or decrease your Transfer Balance Cap.

Case study: Sue

Sue is in her early 60s and has been tossing up whether she should retire to drawdown from her SMSF. The current economic situation has tipped the scales for her and she retires. She will require about $60,000 p.a. to live on for at least the next 5 to 10 years and after that expects her expenditure to decrease.

The question for Sue is, does the SMSF have enough cash to provide her with living expenses for the next two to three years? If it doesn’t, does she have personal assets to can provide the cash flow she needs.

If Sue was to commence a pension from her SMSF with her accumulation balance of $1 million she would be required to draw four per cent of the opening balance each year until she turned 65. This would provide Sue with $40,000 each year as a minimum pension and this would be the absolute minimum cash flow requirement plus any fund expenses. The additional $20,000 could come from Sue’s SMSF if it has the cash flow or she may have some private investments to provide her living expenses.

Already receiving a pension?

If you are already drawing a pension from your SMSF, economic shocks like the current one can be very concerning. The recent reduction in the minimum pension percentages for the 2019/20 and 2020/21 financial years can be helpful to ride over the volatility, but what if you require a greater amount to live is the real issue. This is where diversification and cash flow are important.

An SMSF where the members have planned cash flows will usually be able to ride over the ups and downs in the market for a reasonable time. However, those SMSFs which have high concentrations of investments in lumpy assets such as real estate may have tenants who have had to cease business for a short time or permanently. This may require the trustees to take strategic action to protect the property from being sold in a soft market.

Possible options to take if the fund has a cash flow issue is for the members to stop their pensions and transfer their balance to accumulation phase. That may leave them with little to live on but at least that will retain the property and other assets within the fund. The fund will have a reduced cash outflow but there are still some fund expenses such as maintenance of the property, utilities, as well as rates and taxes.

By stopping a pension and transferring the balance to accumulation phase it will reduce the amount that is counted against your Transfer Balance Cap. If you decide to restart the pension at a later date it will give you some cap space to fill and the fund will receive tax exemption on any income earned on those pension assets.

Planning ahead

Planning is essential in the current crisis as the amount you need to live on is the most important thing now and on an ongoing basis. The size of your pension account at the beginning of each year dictates the minimum you are required to withdraw and having the cash flow will determine whether it is possible. So, having a two or three year cash pool to ride out the current storm may save a fire sale of other fund assets.