Helping clients manage diving markets

Richard Edwards outlines some of the technical issues financial advisers need to consider when talking to their clients about possible responses to market declines.

The financial headlines have recently been dominated by share market volatility and the impact this has had on investment portfolios.

However, when talking to clients about how they may respond to market downturns, it is also important to consider the technical issues and how they interact with the asset allocation and investment selection decisions.

Volatile times can create some strategic traps and opportunities, especially for retirees and super fund members.

Strategies for pension investors

Pension investors are usually the hardest hit by market downturns. It is therefore essential to assess whether their portfolios are well positioned to meet their income and other liquidity needs while minimising (where possible) the need to redeem growth assets at lower prices.

The amount and frequency of income payments drawn by account based pensioners should also be revisited.

For example, they may want to reduce their income payments if they are currently drawing more than the minimum. Alternatively, if they are already receiving the minimum, they could:

• Spend less than this and ‘save’ the rest (in a managed fund, for example); and/or
• Change the payment frequency from, for example, monthly to annually at the end of the financial year.

Those who have other money to meet their income needs could even switch off the income payments completely by commuting and rolling the money back into the accumulation phase of super. 

Each of these strategies could ensure more of their money is invested in the market so they can benefit from any future upside.

There are some implications to commuting a pension.

Before clients commute a pension, there are a range of factors that need to be considered.

For example, where a pension is commuted back to the accumulation phase:

• Investment earnings will be taxed at up to 15 per cent, not tax-free;
• The commutation will trigger a calculation of the tax-free amount under the current rules for account based pensioners under the age of 60 who commenced their pension prior to 1 July 2007;
• If the pension was commenced or continued due to death, it will lose its death benefit status upon commutation and the recipient will no longer be eligible for a 15 per cent tax offset if they use the money to recommence a pension under age 55;
• Superannuation pensions are generally treated more favourably under the income test when compared to the deeming rates that would apply when money is held in the accumulation phase of super; and 
• A lower social security deduction amount could arise if and when a pension is recommenced, but this will depend on whether the account balance goes up or down, and the amount of time that elapses.

Furthermore, where a pension is fully commuted to cash:

• A recent draft Australian Taxation Office ruling has indicated there may be capital gains tax (CGT) implications;
• Investment earnings will be taxable at marginal rates, not tax-free; and
• It may not be possible to get all the money back into the concessionally taxed super system due to the contribution caps and possibly the work test (when over the age of 65).

Other social security implications

Another issue to consider is, while Centrelink will usually review age pensioners’ investments twice a year, they can approach Centrelink at any time and request a reassessment based on their latest investment values.

By doing this, some age pensioners may find they are now eligible for higher payments due to their reduced account balance.

Retirees who previously were not eligible may now qualify for a part pension due to the reduction in the value of their assets and income.

SMSFs and investment strategy changes

If self-managed super fund (SMSF) trustees want to change the investments in the fund, they will need to:

• Ensure the changes are consistent with the investment strategy;
• Update the investment strategy, if required; and 
• Ensure complete records are retained to correctly calculate any capital gains or losses.

Implications of rolling over superannuation

If super fund members are thinking about rolling over their benefit to another fund, the tax-free and taxable components will be recalculated at that time.

This could be undesirable if the tax-free component declines and:

• The member intends to start a pension investment before the age of 60; and/or 
• The benefit is passed to financially independent adult children in the event of the member’s death.

Other issues to consider are:

• The CGT implications when investments are sold prior to transferring the benefit;
• Whether any insurance cover will be given up;
• If any exit fees are payable;
• If binding death benefit nominations are offered by the new fund; and
• The administrative procedures and potential time lags that could apply while the transaction is being processed.

Implications when cashing out superannuation

There is the risk that super fund members with unrestricted non-preserved benefits in the accumulation phase could decide to pull their money out of the super system if not sufficiently informed of the potentially adverse tax and social security consequences.

For example, if super money is redeemed and invested outside super:

• CGT will potentially be payable in the fund after the disposal of assets;
• Investment earnings will be taxable at marginal rates, not a maximum rate of 15 per cent;
• The money will be assessed under the social security income and assets test (whereas it is exempt if held in the accumulation phase of super and the person is under the age of age pension); and
• As discussed in the pensions section, it may not be possible to get all the money back into the concessionally taxed super system.

The bottom line

When markets take a dive and investors reassess what they are doing with their money, it is important to consider both the technical and investment implications, and how they interact.

Richard Edwards is technical writer at MLC Technical Services.