Matching your lifestyle to your investment strategy

The lifestyle investing approach aims to lower the risk profile of an SMSF by reducing its exposure to growth assets as the investor approaches retirement.

Self-managed superannuation funds (SMSFs), as their name suggests, are managed by trustees who are generally members. The freedom to take control over one’s own retirement savings and the flexibility over what is allowed to be done are the main advantages of this retirement investment vehicle.

An SMSF may invest in a wide range of assets. These can be commercial properties for the small business owners, gold and silver bullion for those with the commodity bug, or a portfolio of securities. Because an SMSF reflects the trustees’ investment philosophy, it is arguably a “lifestyle fund”.

A lifestyle fund, in terms of investment management, would be expected to have an investment strategy that caters to individual circumstances - particularly the fund’s investment time horizon. The lifestyle investing approach aims to lower the risk profile of the fund by reducing exposure to growth assets as the investor approaches retirement.

As SMSF trustees, you will naturally take an active interest in your fund’s activities and ensure your fund meets its investment objectives. This differs to a large superannuation fund, where the investment range of a lifestyle fund is broadly determined by the member’s age.

An accumulator’s lifestyle investment approach usually involves tax optimisation through active income streaming from personal assets into superannuation assets. The objective is to maximise the use of both concessional and nonconcessional contributions for tax concessions.

For small business owners, there are further contribution opportunities with the 15-year asset exemption and the small business retirement exemption.

With capital injected into the fund over the working life, it makes sense to actively allocate assets to maximise returns. A long time horizon allows for a high tolerance to risk and volatility.

A retiree lifestyle investment approach, on the other hand, is designed to minimise the impact of adverse market movements,
knowing that the fund is less likely to recover from losses given the shorter time horizon.

The timing of when this loss happens also affects investment outcome. This is known as sequencing risk. For example, if a member experiences a 20% loss five years before retirement and another member 15 years after retirement, the former member will run out of money several years earlier, even though they experience the same 7% annual return over the period.

While retirement is a turning point for most people, given they have spent decades working and saving for retirement, retirement is only a milestone on an investment journey. This journey is prolonged when multigenerational members are within the fund.

As members retire, many expect to live on earnings and preserve their capital. To illustrate this, the minimum annual drawdown rate for a 65-year-old is 5%. If the member achieves average net returns of 7%, the member will have increased earnings by $70,000 for a $1 million pension account. This will cover the $50,000 minimum pension.

To achieve the expected rate of return, it is important to maintain growth asset allocation during retirement.

Reducing growth asset allocation can significantly impact the earning capacity of accumulated wealth during retirement, and can expose the SMSF to running out of money and reduced investment value (investment risk).

To manage these investment objectives, review the investment strategy and consider the following:

  1. How much will the pension member require in retirement?
  2. Will there be accumulating members to contribute cash to maintain the income stream of the pension member?
  3. Are there any foreseen capital drawdowns such as medical care or aged care accommodation that will require funding from the SMSF?
  4. How much personal savings are outside the SMSF that the pension member can access for daily living?
  5. Does the pension member have outstanding debts that they expect the SMSF to pay off?
  6. Does the SMSF generate sufficient earnings to cover pension payments?
  7. What are the member’s individual risk profiles and that of the SMSF as a whole?
  8. How does the SMSF deal with inflation?
  9. How long until each member reaches retirement?
  10. Does the pension member have access to welfare such as the Age Pension?

It is important that the investment strategy of an SMSF caters for each member’s risk profile and adheres to a set of long-term
targets (also known as strategic asset allocation), and is managed within an investment range that is flexible enough to allow for asset price movements.

The dynamic asset allocation approach involves rebalancing a portfolio to bring the asset allocation back to its long-term
target. In practice, this involves taking profits in the best-performing assets, while increasing investments in underperforming assets.

The objective is to reduce fluctuation risks and achieve returns that exceed the expected rate of return. For this approach to be effective, trustees must regularly align their portfolio to their investment strategy.

The flexible nature of an SMSF means that rebalancing can come in the form of moving in and out of cash or non-cash assets via contributions and rollovers to inject capital, or conversely, via lump sums and income streams to extract capital. These capital movements will alter asset allocation and has a rebalancing effect.

As you can see, there are several considerations when it comes to matching your lifestyle to your investment strategy. Speak with your investment manager or financial adviser to formulate your asset allocation strategies.

By Victoria Kuok - SMSF specialist advisor at the SMSF Association.
This article has previously appeared on Morningstar.com.au
This article has been prepared by Morningstar Australasia Pty Limited for general use only without reference to your objectives, financial situation or needs. You should seek your own advice and consider whether the advice is appropriate in light of your objectives, financial situation and needs.