Every little rate cut turns the screws on savers just that little bit more. While returns on high cash balances in the self-managed super fund sector are dwindling, a lack of diversification also poses a growing risk in the event of an economic downturn.
Australian SMSFs control some $568 billion of assets, nearly one-third of the nation’s superannuation pool. With about 28 per cent of total assets held in cash, analysis by Credit Suisse estimates that every 25 basis point reduction in the official interest rate slashes cash interest payments to SMSFs by $500 million.
That is lost income, unless it is made up elsewhere. Self-managed funds have a much higher allocation to cash than the 18 per cent average across the spectrum of superannuation assets, and the 8 per cent in a managed fund.
“With cash rates falling, it is becoming painfully clear that Selfies will have to contend with a future income deficit,” the Credit Suisse analysts say in a recent note to clients.
Given that $157bn is held by SMSFs in cash on deposit, last year’s annualised return would have been $5.1bn. After just one rate cut, this year’s income would come down to $4.6bn.
And financial markets are pricing in one more, possibly two more, cuts by the Reserve Bank as Australia’s rates remain well above the near-zero global levels.
To make up the emerging income deficit, Australia’s one million SMSF members have a few choices: work longer; spend less in retirement; or take on more risk in their asset allocations.
Of course, this has been one of the intended consequences of a seven-year global easing cycle -- to push cash out of bank deposits and into riskier assets. Asset prices have been inflating even as consumer price inflation stays soft. The local sharemarket has advanced 43 per cent from the start of 2012.
To maintain their current level of income after one rate cut, SMSFs would need to switch about $11 billion out of cash and into equities, an investment of almost one per cent of the market’s total capitalisation. Double that figure if rates are cut again, as markets and economists expect.
If self-managed super investors do increase their allocations to stocks, it would provide a powerful support to the equity market over the coming year. The inflows would be larger than many market watchers, including at Credit Suisse and other investment banks, had previously counted on and implies there will be further impetus to support a run past 6,000.
But there are increased risks associated with this strategy as well. Not only do equities in general ratchet up the risk/reward scale. If you look at where SMSFs like to put their equity allocation, you find a disproportionate devotion to dividend plays such as the big four banks, which some say is distorting the market.
For the banks in particular, where valuations are stretched on many metrics, lending is exposed to a downturn in the economy. The banks have a combined market cap of over $456 billion, or around 30 per cent of the entire sharemarket.
Banks are highly exposed to a deteriorating economy as well as any cooling in the overheated property sector as well. And so are SMSFs, where the allocation to domestic property has hit a record 16 per cent of assets (residential and non-residential combined), according to Australian Taxation Office figures.
It’s as though self-managed funds have doubled down on their risk exposure to both a softening economy and a weaker stockmarket. They are increasingly vulnerable to a downturn.
As Paul Resnik of FinaMetrica said recently, most SMSFs still largely don’t understand just how debilitating a downturn in Australian markets would be to achieving their retirement goals.
The high level of investment in property and shares is probably much more risk than is consistent with SMSF investors’ risk tolerance, Resnik says.
It’s certainly a much higher level of risk than an investor would hold with a growth-oriented super fund, where the asset allocation would typically be about 9 per cent for property, 26 per cent domestic equities and 25 per cent international equities.
The other unhealthy bias of SMSF and Australian investors in general is an over-fondness for the local market and an unwillingness to diversify offshore, where returns have been augmented by the falling Aussie dollar over the past year.
Selfies have put a mere 1.5 per cent of assets into international equities, compared with 25 per cent for a diversified super fund. Given the outperformance of the US stockmarket over the past seven years and the recent lift in European equities as the ECB launches quantitative easing, it is a missed opportunity.
In the domestic market, the price/earnings ratio is above 16 times, a little above the long-term average of 14.5 times, with prices rallying despite a mediocre interim reporting season. Industrials are trading at 19 times forward earnings; the banks’ historical average is closer to 12 times.
The ASX200’s steady gains suggest that some modest correction lies ahead, particularly with the sudden rise in volatility in global markets as the Federal Reserve flags its first tightening around mid-year.
If a softening in stocks presages further weakness in the economy, as equities so often do, self-managed funds may come to regret their love affair with the big four banks and the property market.