Dividends, growth and capital – Your COVID-19 considerations

InvestingNewsSMSF Insights

Dividends, growth and capital – Your COVID-19 considerations

Written by Franco Morelli, Policy Manager, SMSF Association

In August 2019, when the ATO wrote to nearly 18,000 SMSF trustees about portfolio diversification, many in the industry thought the regulator was overstepping the mark. Now the ATO looks like a prophet.

As the SMSF Association conveyed at the time, the ATO was not trying to dictate how SMSFs should invest, but to simply ensure that SMSF trustees were aware of their legal obligations to have understood and documented how their investment strategy suited their retirement goals, and had considered the risks associated with inadequate diversification, liquidity of investments and the risk and return of their portfolios.

Few people could have predicted a global health pandemic, and even fewer could have predicted the resultant economic impacts. Despite the fact the ATO admitted its communication about who the letter was sent to could have been improved (it was originally stated that the letter was sent to all SMSFs with 90% of assets in a single asset class but this was later corrected to state that almost all letters were sent to trustees with limited recourse borrowing arrangements), the conversations that have occurred post receipt are now hopefully paying dividends (but more on that later).

SMSFs and self-funded retirees require income, especially those in pension phase, to fund their living expenses and to pay specific SMSF expenses – this is the purpose of the retirement income system.

Going into the pandemic, SMSF asset allocation had remained steady over time with a significant proportion of assets invested in listed shares and cash investments. The key drivers for this asset allocation include:

  • Tax preferences for domestic equities – fully refundable franking credits increase the after-tax return for domestic equities for SMSFs, especially for those in retirement phase.
  • A desire for liquidity to pay pensions in retirement – this is especially relevant to the SMSF sector where 42% of funds are in retirement phase.
  • Cognitive biases that drive allocation to assets trustees understand, especially blue-chip ASX shares.

A positive for the sector is that many SMSFs should be able to navigate through this pandemic from a better starting point than some of their counterparts who are in a large superannuation fund. It is widely known that SMSFs are attractive retirement savings vehicles for the control and flexibility they provide. At the end of the 2019 calendar year, SMSFs had 20% of their $750 billion of funds under management in cash and term deposits – a handy buffer for what was to come.

This is an outcome of a generally older cohort of investors requiring more liquid assets to fund their retirement living expenses. The benefits of the financial adage about holding two years of income in cash will have borne fruit for many SMSF trustees.

The COVID-19 induced recession means it is now extremely important SMSF trustees consider their asset allocation, diversification and liquidity.

Equities are extremely volatile, interest rates are at record lows and property is likely to be facing a stifled falling market. This is creating a mountain of uncertainty on asset values, dividends and rentals.

So, SMSF trustees should change their thinking in a way they possibly have not done before. What follows is just two of the ways this may happen.

Look beyond a dividend focus

SMSF investors are typically attracted to blue-chip dividend paying stocks. The consistent history of big companies paying significant dividends is ingrained into Australian equity folklore. But in a recession, something Australia has avoided for nearly three decades, this will not continue to be the case. Dividends of many major companies are being slashed or deferred. They may not return to the levels seen in the 2018-19 financial year for many years to come.

Going into the crisis, the most recent CommSec SMSF report highlighted that the top four holdings for SMSFs were CBA, WBC, NAB and ANZ. Most recently, ANZ and WBC have deferred their dividends, NAB has slashed its dividend and the CBA are expected to follow suit.

Therefore, the first change for SMSF trustees to consider when talking about asset allocation is to focus less on dividends and more on growth in the investment equation. The large banks are a perfect example of over-exposed dividend investing without thinking about what could happen when the party is over. Consideration needs to be given to allocations that provide a level of growth assets to cover for the fact that high levels of dividends are no longer a fait accompli.

To accompany this thinking, the second dramatic change is that SMSF trustees should think about their retirement incomes not just for the income they receive from assets but in the exhaustion and utilisation of capital. Yes, that means selling investments.

SMSF trustees should recognise that accumulated superannuation capital is designed to be utilised – to be drawn down to fund retirement incomes. Currently, many individuals risk underutilising their retirement savings because of the uncertainty about their future lifespan and a resultant bias towards capital preservation. A combination of both income and capital is essential to fund retirement incomes.

What about property?

For those exposed to property, in some cases with a limited recourse borrowing arrangement, the same asset concentration risk and liquidity concerns require consideration.

Many SMSF commercial properties (and to a lesser extent residential property) will no longer be receiving the full complement of rent under their lease agreements before COVID-19, and therefore the income of those SMSFs will fall. For those SMSF trustees who house their small business real property in their SMSF, the negative effects of the pandemic on their retirement plans would be amplified.

The unprecedented legal requirements imposed on some landlords to receive less rent to assist their tenants who experience material adverse financial impacts due to the COVID-19 pandemic is something no investor could have foreseen but is another road those SMSF trustees must tread.
Liquidity issues are also amplified because of the indivisibility of property compared with more liquid investments such as cash, shares or bonds.

Going forward, trustees, especially those in retirement phase, should think deeper about the risks posed by large allocations to property when they are used to fund pensions. For SMSFs in this position now, all efforts should be focussed on negotiating with tenants and using the Government support packages to ensure they will be able to withstand the effects of COVID-19 for the rest of the year.

What next?

SMSF trustees need to be having conversations about these issues now. A discussion with an SMSF Specialist is a great starting point.

If SMSF trustees can be agile and flexible about their retirement strategy and their investment strategy, they can navigate this challenging period better than most. By doing so they will demonstrate why they continue to be an essential part of the retirement income system during one of the toughest times Australia and the superannuation sector have faced.