SMSF pensions are paying out too much

With ever lower interest rates the government must review pensions – they could start with the ‘distribution rate’ which is excessive.

Summary: Super funds in pension mode are required to distribute substantial amounts in pensions which are out of line with low risk returns. If these high payout demands are not reduced, more people will be forced onto the age pension. Meanwhile, there is a serious cloud over important segments of the Sydney and Melbourne property markets. Asian investors buy a high proportion of the inner city apartments, but if government changes make these investors feel unwelcome, that could trigger selling.

Key take-out: If you are buying a dwelling it probably makes sense to steer clear of those areas that are vulnerable to Chinese selling at least for the next two or three months.

Key beneficiaries: General investors Category: Superannuation, property investment.

When the Reserve Bank of Australia cut the official cash rate once again this week (on Tuesday May 5), the share market went from a positive to a negative. And the Australian dollar edged up overnight rather than falling. That share market fall, albeit small, and the oil market driven currency rise were signals to us all that the Australian rate reduction is merely part of a much more complex world. When the budget comes out next week I will explore further aspects of this world but today I want to pick up two vital points. 

The first concerns the really rough treatment retirees are getting in the current environment. We will need to work very hard to restore fairness. (You can see in detail the pinch to part pensions in the contribution from Scott Francis today: Hockey’s pension plan will hurt.)

And secondly I want to urge you to be very careful about being tempted to use the current interest rate reduction as a trigger to hastily buy residential property in parts of Sydney and Melbourne. I will come back to that in a moment. 

Those with superannuation funds in pension mode are required to distribute substantial amounts in pensions which are way out of line with low risk returns. Many funds are in danger of being run down by compulsory excess distribution and therefore will be less able to finance retirement in later years. 

A person who is aged between 65 and 74 and has a fund in pension mode is required to distribute five per cent of their fund in a pension (for those aged between 55 and 64 the pension mode distribution requirement is four per cent and in ages over 74 it goes higher). This distribution rate was set when bank deposits were around or above the distributable levels and at that time it was therefore very easy to earn the distributable amount of money in a fund. Now the bank deposits are between two and three per cent so the required distributable amount is approximately twice the bank deposit level!

A great many superannuation funds have a high cash content and will therefore be distributing more than they earn. Those with strong equity positions have usually performed above five per cent in recent years but I know a lot of people who will find it difficult to earn sufficient money to cover the pension requirements. And if we have a fall in the stock market it will be very serious for many funds as they are hit with lower capital values and higher payouts.

Now of course many retirees require the higher distribution rates to fund living expenses but if their fund is running down they are less able to finance retirement cost rises caused by higher medical bills. More and more people will be forced onto the age pension if these high payout demands are not reduced. There are precedents for reducing the amount of money that must be distributed from a superannuation fund when there are economic difficulties. But of course we have never seen interest rates at this level before. Given that most journalists these days are young getting this onto the politicians’ radar will not be easy but we will have to try hard.

The second aspect concerns investment in dwellings. With interest rates so low it is very tempting to buy bricks and mortar either via a house or an apartment as an investment. With such low interest rates the gap between rental income and the cost of borrowing is narrowing. But there are important segments of the Sydney and Melbourne markets that have a serious cloud over them. This does not apply to all areas of Sydney and Melbourne or to other capital cities and regional areas. 

In Sydney the Chinese and Asian investors buy around 80 per cent of the inner city apartments coming on the market and in Melbourne in the CBD the figure is even higher. In other words they completely dominate the market and their demand sets the price. There seems to be an almost insatiable Chinese/Asian demand for these apartments and they are being sold to ‘mum and dad’ Chinese residents by aggressive sales people. But there are cracks appearing in the market and in Sydney the price of apartments in the last few months has actually fallen. The fall has not been large but it is a long time since we have seen a decline in an important segment of the Sydney property market albeit small. 

In Melbourne there is a considerable difference between what the Chinese and other Asian investors are paying for apartments from off the plan developments and those apartments that you buy from an existing owner. And so both in Sydney and Melbourne if recent Chinese investors want to sell they will incur a loss unless there is a rise in the Australian currency against the Chinese currency. 

Some of the biggest apartment developers in Sydney and Melbourne are telling me the combination of Tony Abbott’s planned attack on Chinese who are buying existing dwellings and the Victorian government’s extra taxes on those buying apartments being built is in danger of making the Chinese mum and dad investors (who are the vast majority of buyers) feel unwelcome. 

And if that triggers even moderate selling then the Chinese will realise that these apartments at least in the short term can incur losses. It would not take much to trigger a volley of selling which will hit the market hard. And any fall in apartment prices will affect many suburban areas. And in suburban areas many overseas resident Chinese have bought existing houses and apartments via Australian Chinese citizens who effectively are a front. The law says this is illegal but the law has never been enforced. The Abbott Government is threatening to enforce the law after a grace period to November. It’s not known how many dwellings may need to be sold or whether the Chinese will gamble that their ‘front’ arrangements will not be exposed.

The Chinese have been enormous supporters of Sydney and Melbourne apartments and there is no tangible sign that they are about to change their approach. 

But both the Victorian and national governments, in their attempt to win local political support, are playing a very dangerous game because apartment developments are the main stay of the Victorian economy and an important factor in New South Wales. 

I am always reluctant to issue warnings about dwelling prices for Sydney and Melbourne because they seem to keep rising irrespective of any other market forces. But there is genuine concern among those in the apartment game because at this stage nobody knows how the Chinese will react to these two simultaneous blows. We have to hope that it does not trigger an avalanche of selling.

What we really want is a period of stability or a mild fall so as to allow Australians to get into the market. Any major fall will of course please those that do not own residences but it will stop development of new apartments and therefore kick out an important linchpin in the Victorian economy and to a lesser extent New South Wales. If you are buying a dwelling it probably makes sense to steer clear of those areas that are vulnerable to Chinese selling at least for the next two or three months until we know which way the Chinese will move. As always when you buy a rental property it makes a lot of sense to know who you can put into it as a tenant. 

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