Feeling the pension pinch

PORTFOLIO POINT: Many Australian pensioners are being forced to sell their shares at rock bottom prices to maintain their cash flow … and that needs to change.

When we talk about the ‘structural issues’ in the financial services industry, we tend to think about things such as commissions influencing the judgements of those advising on investments, the conflict of interest that sees institutions providing both investment products and advice, and the low educational thresholds for financial planners.

But another structural problem that has received far too little attention is when retail pension products force retirees to sell their shares when prices are low. This caused significant destruction of wealth during the global financial crisis and has the potential to do the same if sharemarkets fall again.

Let’s consider an example of how this happens in practice.  Consider an investor in a Q-Super balanced pension fund – a good, low-cost fund with comparatively good investment performance (compared to managed fund style peers of 2.35% a year over the past five years while the Australian sharemarket has fallen in value by about 35% over the same period).  Let’s assume an investor put $1 million into this fund at retirement in October 2007, and wanted to draw a pension of $48,000 a year, or $4,000 a month. 

In mid October of 2007, the unit price of the fund was $2.25.  At this time investing $1 million into the fund would buy 444,444 units. 

Assuming they take their first $4,000 pension payment in October 2007, 1,778 of their units would be sold ($4,000/$2.25 unit price) to make the $4,000 pension payment.

Fast forward 18 months into retirement, and the sharemarket low of early 2009.  The Q Super balanced pension fund had a unit price at this time of $1.65.  To make the $4,000 pension payment the fund had to sell 2,424 units – or an extra 646 units.

This situation represents a double problem for investors here. Firstly the unit price of the fund has fallen because of the fall in sharemarket values, so they are effectively selling shares at low prices.  Secondly, because people tend to take regular pension amounts, they are now having to sell more units at these low prices – not a good combination of factors for investors.

The basis of this problem is this. Many people in industry, government and retail pension products use ‘unitised’ pension products to fund their retirement.  They will own units in a managed fund style pension funds – often a ‘balanced’ fund.  On a regular basis – often monthly – they sell units to pay their pension.  These units, and their unit prices, will represent a mix of assets that will commonly include Australian and international shares, listed property investments, fixed interest and cash investments.  So, when investment markets fall sharply in value, as they did during the GFC, the unit price also drops sharply.  When the next pension payment is taken, more units have to be sold to generate the amount of the pension payment. 

Ken Henry talked recently about the over-exposure that many superannuation funds have to shares.  It stands to reason that his comments would be even more significant for people in retirement, who will be impacted more by a fall in sharemarket values.  This analysis, however, goes beyond just the problem of volatility in equities. It demonstrates the way that a fall in sharemarket values has a potential threefold negative impact on the financial position of a retiree who relies on owning units in a pension fund:

1. The value of their overall pension investment falls, because the unit price of their holding has fallen.
2. When they take pension payments by selling units, they are selling those units at lower prices – effectively selling shares at low prices.
3. They have to sell units at lower prices – meaning they have to sell more units to make their pension payment. (Admittedly there is likely to be the option to take lower pension payments, but if a pension investor did this they face a negative impact on their lifestyle).

This is a significant problem in the provision of pension income streams.  The amount of exposure that many funds have to shares is a structural problem that sees a long-term investment (shares) used to fund short-term cash needs (the selling of units to make regular pension payments). 

If Ken Henry is correct, not only might many pension investors have too much exposure to shares but their shares are being used incorrectly as a short-term investment.

The Solution

There is a simple and profound quote around investment strategy.  “Cash lets you sleep, shares let you eat”.

Translated, it means that cash is a great short-term investment that provides liquidity and certainty.  Shares (and I would say growth assets generally, including property) are important to provide long-term income to counter the significant effects of inflation over time.

And the solution to this problem: use cash for your short-term needs, including pension payments, and let the growth assets provide returns over time.

Pension funds with cash accounts – including self-managed super funds, wrap accounts and many pension funds – that allow investors to choose individual asset class investments and have the pension withdrawn from just one option (the cash option) are the solution.

The pension investor can ensure that they have enough assets in their cash accounts to cover whatever period of time makes them comfortable. Using the case study above, the person drawing $48,000 a year with $1 million of assets might want six years’ of pension payments, or around $300,000, in this cash account.  The rest can be invested in a mix of fixed interest, property, shares and other assets that they deem appropriate – all of which will hopefully be paying interest, dividends, distributions and income to top the cash account up. 

This solution means that a pension investor with a cash account will not be forced to sell growth assets to make pension payments.

Conclusion

For investors in unitised pension investments, the forced sale of growth assets to make pension payments magnifies significant market downturns.  Taking enough control of a pension account to include and manage a cash account means that pensions can be taken from short-term cash holdings – avoiding the forced sale of growth assets during a market downturn.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor. He has investments in Q Super accumulation accounts.