Here are three often-forgotten risks that every SMSF trustee should consider:
1. Sequencing risk
As an SMSF trustee, you spend a lot of time thinking hard about investment risk and how to reduce it. You also know that your fund will perform better in some years than in others, and that investments can sometimes have negative years - especially growth investments, such as shares. But did you know that the sequence in which gains and losses occur can be just as important as the returns themselves?
It’s called sequencing risk, and it works like this.
Imagine you and your friend Emma both set up SMSFs with a starting balance of $200,000, then contribute $35,000 a year over 20 years. You each experience positive returns of 6% a year (after tax and costs) for 19 of those 20 years, with just one year of negative returns - let’s say minus 10%. The only difference is that your loss happens in the first year, with positive returns in every year after that. For Emma, it’s the other way around.
How different would your final balances be? The answer is that Emma would end up with a super balance more than $198,000 lower than yours.
That’s the difference sequencing risk can make. The closer you are to retirement, the greater the risk typically becomes. That’s because the more you save, the more you have to lose, and the less time to recover those losses.
Sequencing risk was a huge issue during the GFC, when many investors close to retirement experienced heavy losses from falling share portfolios. As a result, many had to work for longer than they intended. In the worst case scenario, a significant loss close to or during retirement could see you run out of money altogether.
So what can you do to help prevent sequencing risk?
While there’s no single solution, a combination of strategies can help keep it under control. Diversifying your fund with the right mix of income and growth-producing investments can help. It’s also important to adjust your asset mix over time, with fewer volatile growth assets as you grow older. It’s also important to make sure you have enough liquid assets to draw on when your fund needs cash, so that you don’t end up having to sell other assets and erode your capital.
Finally, if you’re in retirement, you could withdraw a smaller percentage of your fund during periods of negative returns - giving your capital more time to recover when things turn around. But remember, you’ll need to withdraw the legal minimum amount of pension.
Minimum pension withdrawal requirements
|Age||Minimum % of pension you can withdraw|
Source: Australian Taxation Office
2. Liquidity risk
Liquidity risk is simply the risk that your SMSF will be short of cash when you need it. For many investors, that can happen when their fund is asset rich but cash poor.
For example, consider the strategy of holding property through an SMSF - either a residential property or business premises. While it has many attractions, this strategy needs to be carefully managed to ensure the bulk of the fund’s value isn't locked away in an asset that can take months to sell. Even if you hold easily tradable assets, such as shares and bonds, a lack of liquidity could mean being forced to sell at a time not of your choosing.
That’s important, because SMSFs need to keep cash at the ready for a range of reasons.
First, you’ll need access to cash during the accumulation phase to cover the many costs of running your fund, including auditing, administration, advice, and investment fees and charges. You’ll also need cash during the pension phase to pay members regular pension payments or lump sums for holidays, large purchases and medical bills. Finally, if a member passes away or becomes totally and permanently disabled (TPD), you may need to find cash or sell assets to pay the member or their family a benefit.
If you’re short of cash and you’re forced to sell an asset when the market is down, you could lose out. Even if you have income-generating assets, such as high yield shares or a rental property, you can still find yourself short of cash when you need it - if you’re unexpectedly left without a tenant, for example.
That’s why it can make sense to keep cash on hand in a high interest SMSF cash account. It can also be important to ensure you have the appropriate type and level of insurance - which is where the next risk comes in.
You probably already know that the government’s 2012 Stronger Super reforms made it compulsory for SMSF trustees to consider the life insurance needs of fund members. There can be good reasons to do so.
Life and TPD insurance can help protect the financial future of SMSF members and their families. Just as importantly, it can also help protect the fund’s assets by providing liquidity if the unexpected happens. That’s because, if one of your members passes away or becomes permanently disabled, insurance can help you pay out their benefits without selling assets at an unfavourable time. So insurance is worth considering carefully, especially if your fund has more than one member.
Getting the right advice
As you can see, SMSF risk management involves more than simply choosing the right investments. A financial planner can help you consider all the risks of managing your fund, then put measures in place to protect yourself and your fund, now and in the future.