Chapter 11 – Case Study: Client with a substantial super balance

This case study is based on an actual client presentation in August 2017. Names have been changed for obvious reasons, and figures have been rounded to allow for easy computation. However, all other details are as they were experienced.

Rachel is a divorced lady in her early 60s. She lives in country New South Wales and was referred to a financial advisor by her accountant. She has recently sold various assets related to her business and has decided to establish a self-managed superannuation fund. Her current superannuation benefits are as follows:

  • approximately $1.1 million being held as cash within the new SMSF; and
  • approximately $280,000 being held in a retail super fund. Rachel has plans to roll this money into her new SMSF, such that the total benefits within the new fund will be approximately $1.4 million.

Rachel is in good health and owns further assets outside of superannuation totalling $1.7 million. Most of this is made up of her family home and some agricultural land. Rachel is seeking advice as to how best to invest the substantial amount of cash within her superannuation fund.

Rachel is not eligible for any Centrelink benefit. She will commence paying a pension from her superannuation fund. This will make the fund a tax-free investment vehicle. Rachel does draw some small amounts of cash from her other investment assets.

The first thing to establish is Rachel’s investment profile. She and her adviser agree that a balanced investment profile will be appropriate to the needs of her superannuation fund. In some ways strangely, a balanced investment profile is one in which approximately 25% of investment assets are held in defensive asset classes such as cash or term deposits, with the remainder being held in growth assets such as shares or property. So, ultimately Rachel’s superannuation fund will hold 75% of its benefits in share market based investments.

The Share Investments

Whenever investing into the share market, there are two particular types of risk that need to be managed. The first is specific risk, which is the risk that shares in a specific company will fall in value as a result of poor business performance on the part of that company. Specific risk is best managed by diversification. So, Rachel’s adviser is looking for a simple way to achieve diversification for Rachel’s superannuation investments.

The other substantial risk is timing risk. Timing risk is the risk that prices in a market generally will fall after an investment has been made. Prices in share markets are inherently volatile. This means that there is always a strong chance that an investment will be made at a price point higher than would be available at some other time.

Timing risk is best managed by separating the amount to be invested into smaller portions and investing these portions at different points over an extended period of time. If the same amount of money is invested at each point in time, then an investor will automatically purchase more units of the chosen investment when prices are lower. This technique is known as dollar cost averaging.

Rachel’s adviser is convinced that index tracking ETF’s are the best way to hold share based investments. Further, given the franking credit system, and as adviser also prefers to invest in Australian-based securities. Therefore, Rachel’s adviser suggests she make use of three index tracking ETF’s. As index trackers, these ETF’s all deliver adequate diversification to effectively manage specific risk.

Rachel has $1.4 million to be invested. 25% of this will remain in defensive asset classes such as cash or term deposits. The remaining 75% will be spread across three index tracking ETF’s. Therefore, $350,000 will be invested into each of these ETF’s.

Of the $1.4 million, around $270,000 is to be rolled into the new superannuation fund from the existing retail fund. As it happens, the existing fund is holding around $250,000 in share based investments. When the order to roll over the benefits is received by the fund, this money will be withdrawn from the sharemarket. For this reason, the adviser is happy for the same amount to be immediately invested into the sharemarket. Because the divestment and the investment will occur within the same market, timing risk is not an issue.

That is, at the same time that the existing retail super fund withdraws $250,000 from the sharemarket, the new self-managed super fund can invest $250,000 into the market. This new investment will of course occur in exactly the same market conditions.

Given that the new fund is holding cash, the purchase of the new investment can occur at the very same time as the rollover is being effected.

So, the advice is to immediately invest $81,667 into each of the three index tracking ETF’s. This equates to $250,000. Ultimately, the fund will invest 75% of its $1.4 million into share based investments. This equates to $1,050,000. So, a further $800,000 is to be invested into the sharemarket. From this, each of the three ETF’s will receive $266,667.

This money has never been invested into the sharemarket before. It effectively derived from the sale of business assets over the last two years. Therefore, timing risk is very relevant to this money.

Rachel is only 60 years old and is in good health. She can expect to live at least another 25 years. Therefore, 25 years is an appropriate timeframe to be considering for her share based investments. Given this, her adviser is happy to take a little over 10% of these years to move her cash into the sharemarket. Over the next 27 months, Rachel is advised to make an investment of $30,000 into one of the index tracking ETF’s. Each month, the target ETF is rotated so that ultimately, she will have made nine purchases at nine different points in time for each ETF. The purchasing looks like this:

Month ETF Amt to purchase Accumulated Investment
1 ETF 1 $30,000 $30,000
2 ETF 2 $30,000 $60,000
3 ETF 3 $30,000 $90,000
4 ETF 1 $30,000 $120,000
5 ETF 2 $30,000 $150,000
6 ETF 3 $30,000 $180,000
7 ETF 1 $30,000 $210,000
8 ETF 2 $30,000 $240,000
9 ETF 3 $30,000 $270,000
10 ETF 1 30,000 $300,000
11 ETF 2

$30,000

$330,000
12 ETF 3 $30,000 $360,000
13 ETF 1 $30,000 $390,000
14 ETF 2 $30,000 $420,000
15 ETF 3 $30,000 $450,000
16 ETF 1 $30,000 $480,000
17 ETF 2 $30,000 $510,000
18 ETF 3 $30,000 $540,000
19 ETF 1 $30,000 $570,000
20 ETF 2 $30,000 $600,000
21 ETF 3 $30,000 $630,000
22 ETF 1 $30,000 $660,000
23 ETF 2 $30,000 $690,000
24 ETF 3 $30,000 $720,000
25 ETF 1 $30,000 $750,000
26 ETF 2 $30,000 $780,000
27 ETF 3 $30,000 $810,000

 

Rachel is a competent woman who is comfortable with Internet banking. Once her Internet trading account is established, she is confident that she will be able to action the above transactions.

Many people would argue that taking 27 months to commit money to the market is too long. Certainly, the drawn-out nature of the investment strategy did create a conversation between the advisor and Dover’s compliance team, because it meant that the target asset allocation (approximately 75% growth assets for a balanced investor) would not be met for at least two years. However, the adviser was right to be mindful of timing risk and to point out that the long time frame over which Rachel was planning to hold these investment assets meant that a 27 month investment period was not inappropriate.

Ultimately, the decision belongs to Rachel as to whether she accepts this level of prudential management or whether she prefers to accelerate the rate at which she makes investments. What can be said is the adviser will never be sued for implementing an established strategy of dollar cost averaging when recommending that large amounts of money is committed to the sharemarket.

The Cash Investments

While investments into things such as bonds would meet Rachel’s investment needs, the adviser is aware that she likes the perceived security of Australia’s banking system. Therefore, the recommendation is for Rachel’s cash investments to be held in products available at her preferred bank. This means that a combination of high interest savings accounts and term deposits is suitable.

Rachel will need to maintain liquidity in her cash investments for two purposes. The first is to be able to undertake the above investments. As the table makes clear, the liquidity needs are known well in advance and so Rachel will be able to manage her term deposits accordingly.

The second is the ongoing income requirement for her income stream. Given her age, the minimum withdrawal is only 4% of the total balance within the fund. In a full year, this is $56,000 and so Rachel will need to maintain at these this much as an easily withdrawable cash asset.

In the first 12 months of the strategy, Rachel will need no more than $450,000 to be available as cash. This money will facilitate the first 12 monthly purchases of ETF’s, pay her income stream payments and generally be available to meet any expenses of the fund. Money that is not going to be used within the first 12 months is recommended to a term deposit where slightly greater interest will be earned. This should amount to a figure of approximately $700,000.

At present, interest rates are at historical lows. Rachel’s adviser is aware of the 12 month term deposit paying 2.7%. He recommends this but also recommends the Rachel not enter into a term deposit for a period of longer than 12 months, given the current state of play regarding interest rates. Rachel’s adviser is also aware that, given the large balance, she is receiving 2.3% on the savings account in which her money is currently being held.

Rachel and her adviser agree that there will be an annual review of her portfolio, with a particular emphasis on how best to manage the defensive elements of that portfolio.

Taken Together

Taken together, once the rollover has been affected, Rachel’s self-managed superannuation monies will be invested as follows:

ETF 1 $81,667
ETF 2 $81,666
ETF 3 $81,667
Term Deposit $724,000
High interest savings account $450,000
TOTAL $1,400,000

 

The Income Stream

Finally, Rachel’s advice included a recommendation to establish an income stream from the self managed superannuation fund. Doing so renders the fund tax-free for both income and capital gains. This is a simple thing to do and her accountant is able to handle all of the administration involved.

The Dover Group