Open wounds in funds- 14th August 2002

Barry Dunstan - Australian Financial Review

S M A R T I N V E S T O R
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PORTFOLIO
Open wounds in funds
Aug 14
Barrie Dunstan


All is not well in the allocated pension and annuity market - a $34 billion (and growing) sector of funds management which is providing retirement incomes for thousands of Australians.

As with other managed fund portfolios, many allocated pension funds are showing negative returns. But, unlike investors in super and unit trust products, when allocated pension investors lose money, it's gone forever.

A couple of investment industry veterans, Peter Thornhill and Tony Negline, have tackled the controversial topic which doesn't seem to have generated much comment from the investment professionals. But, says Thornhill, the worries are raised at every public seminar he attends.

He and Negline are partners, along with Lester Wills, in a weekly email newsletter, All Things Considered. They believe there are some flaws in the way some people - fund managers, advisers and clients - use allocated pensions.

Indeed, at a time when the funds management industry is lobbying noisily for the Federal Government to give its blessing to growth pensions, the potential problems in allocated pensions might even affect on thinking in Canberra.

It might also provide food for thought for those who believe buying retirement products is no more challenging than buying a car or a house.

With allocated pensions, the investors carry the investment risk, rather than it being carried by an annuity-type issuer such as a life office. This means any short-fall in eventual retirement income will cause a larger demand on the aged pension safety net.

Thornhill sees the problem as smouldering: if managed portfolios which support the allocated pensions produce negative returns, and the product has not accumulated cash reserves, then the pensioner starts to eat into capital.

Allocated pensions are designed to use up the investors' capital - but in a controlled draw-down over the person's average life expectancy, rather than after only a couple of years of operation. The minimum and maximum incomes are set by the Government and in general this mean investors have to draw about 6 per cent a year from the fund, Negline says.

Because of the potential problems from short-term fluctuations in ensuring cash flows, financial advisers usually work on a rule of thumb that an allocated pension should have about two years of income in cash.

But, a potential problem arises if after, say, the last two years, payouts from an allocated pension's cash reserves have not been replenished by a fresh inflow of income from the fund.

The problem is, Thornhill says, that most allocated pension funds are "total return products" - that is, the more traditional managed fund where a large part of the return consists of capital gain rather than assured dividends or fixed interest income.

And, in a product which is based on regular income payments, he says it is impossible to rely on steady capital growth. Instead, as the cash reserves are paid out, they have to be replenished by further income from the portfolio.

He is reluctant to put the blame on any one group of people in the decision chain but clearly one or all may be at fault - managers for using total return rather than income producing portfolios; financial planners for not ensuring income is assured (or not explaining the product) and clients who have unreal expectations of allocated pensions or who are more interested in the tax angles.

Negline says that the tax advantages have been a great selling point in allocated pensions. The nil tax environment, the 15 per cent rebate and the ability of a couple to have a $50,000 a year income tax free "are all issues which have been repeated ad nauseam and, some would argue, too aggressively".

In some cases, he says, the government-provided benefits may have helped paper over some of the design deficiencies in the investment areas. "I wonder if the Government is happy with having performed such a task."

With other investment products, such as a superannuation managed fund, if the investment starts to turn into a dud, the client or the advisers can switch to a better quality product (provided they're not caught with early transfer penalties or exit fees). But this isn't a luxury that most allocated pension investors can afford.

By the time they are well into the life of a product and they run into a couple of lean years, such as the last year or so, they may have run down their cash reserves and the tap which refills the tank might have run dry.

Because, by law, funds have to pay out a minimum income each year, investors have to cash in some units to generate the necessary money. By this time, of course, the price of the units will be down as well. That means, Thornhill says, that investors who have to realise on their capital may find that they are having to sell $1.20 instead of the $1 invested just to meet requirements.

He says some of the problem may have been caused by the fact that a lot of allocated pensioners are people who have become reluctant, first-time investors as a result of the Government's push towards retirement income streams.

These people may not understand (or may not have had it explained to them) that they, rather than the provider of the allocated pension, have to bear the risk of investment markets going down as well as up.

But, he says, there also may have been cases where some investors became greedy in the light of continually rising stockmarkets and took their income and, rather than reserving it in cash, re-invested in local and overseas stockmarkets.

These people would now be suffering from the double whammy of no cash reserves to pay the pension and a reduced capital value from a depressed stockmarket. For these people, it is no consolation that markets might eventually recover if they have to sell some units at a loss to live on.

With about 14 per cent of the retail managed funds market now invested in allocated pensions, according to Assirt figures, there will be a lot of people - including managers and advisers - hoping for a rapid recovery in investment markets to avoid a really nasty future for many allocated pensioners.


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