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Sequencing risk – what is it, and how can its effects be minimised?

“How will I support my lifestyle when I am no longer able to work for an income?”

“Will I have enough money in retirement?”

These questions (or variations thereof) are generally the first questions that come to mind for investors approaching retirement age.

In response, my mind jumps to the old adage “those who haven’t learnt to make their money work for them will always have to work for their money”.

Knowing what level of capital is enough to retire on, or how much income you will need in retirement, are tricky questions to answer. But they’re not necessarily the most important questions to ask. A better question?

“What are the biggest risks threatening the longevity of my retirement nest egg?”

Given recent volatility in national and international markets, this question is perhaps the most pertinent. And in my experience, one of these threats is something called “sequencing risk”.

What is sequencing risk?

Sequencing risk (also known as sequencing of returns risk) is a process whereby the order of market returns has a huge overall effect on your retirement balance. It is a process that is exacerbated by selling equities in your retirement portfolio, to fund expense, after a drop in the equity market.

The order or the sequence of annual investment returns is a primary concern for retirees who are living off the income and capital of their investments, as an unfavourable sequence can lead to less money to live off in retirement.

How does sequencing risk come into play?

Many retirees will have investments in one of, or a combination of, the following asset classes:

  • Equities (personal name or via a superannuation/pension)
  • Bonds (generally via superannuation/pension)
  • Property
  • Fixed interest
  • Cash

The correct mix of these assets proves to be very individualised, but as a general rule you need to keep adequate funds in low risk asset classes so that when we face a “global financial crisis event” you are not a forced seller. For most people this means around four to five years of expenditure, but again it all varies on the individual. Generally those with greater retirement savings and more investment experience tend to have a lower proportion of savings in low risk assets.

As we can see in the above graph, the Australian equity market has delivered a higher yield or income for retirees than term deposits. Most investors understand this, and as a result a reasonable proportion of investor savings are tied up in equity markets, both Australian and international.

It’s widely known that equities tend to deliver higher returns when compared with other asset classes over the long term. However, in the short term, they can be highly volatile; from 26 January 2018 to 8 February 2018, the Dow Jones industrial index dropped over 10%.

This volatility has less impact on an accumulating investor than one who is drawing on their capital – like a retiree. The reason for this phenomenon is that if you lose ten per cent of your capital it requires an 11 per cent return in the following period to restore the capital to its original amount. If you are then drawing down on that capital, like you would do in retirement, you are then crystallizing those losses so you will need an even greater return than 11 per cent to return to your original amount.

How does this play out in real life?

simple example from Challenger Life Limited takes a hypothetical investor and looks at historical Australian market performance data for the period 1979 to 2011. It illustrates how sequencing risk can impact retirement outcomes.

Source: Challenger Life Company Limited estimates based on data from Bloomberg.

Looking at the above graph, the investor illustrated in Path 1 retired at the end of 1979 with an investment balance of $148,000. His portfolio was 50 per cent invested in Australian equities and 50 per cent in Australian bonds. Following his retirement, he lived off his retirement savings, drawing $10,000, indexed to inflation each year. By 2011, the drawdown is equivalent to $40,000 a year.

The retirement capital remaining at the end of each year is shown by the dashed blue line in the chart. The light blue line (Path 2) shows what would have happened if exactly the same returns were achieved, but in reverse order – i.e. 2011 returns first. This change in the sequence of returns would mean that the investor’s money would have run out ten years earlier. As can be seen in the chart, after 22 years in retirement, the other sequence of returns had doubled the retiree’s capital.

How can sequencing risk be avoided?

The short answer is nothing can be done to avoid this risk completely, however it can be reduced by diligent investment management. Some of these strategies may include:

  • Investing in guaranteed income products like annuities, as this means a component of expenses are accounted for.
  • Ensuring wide diversification of investment portfolios i.e. global and Australian shares across all sectors, bonds, property listed and unlisted, as well cash and fixed interest investments.
  • Investment in lower risk asset classes and then strategic drawdown of this lower risk asset class in the event of a downturn.

Ultimately, knowing what level of capital is enough to retire on or how much income you will need in retirement, are both very difficult questions without understanding your unique situation in more detail. However when trying to obtain the answer to these questions and establish an appropriate asset allocation, it is imperative that sequencing risk is considered and minimised.

For more information, and to look at your own financial situation in more detail, please do not hesitate to contact The Hopkins Group for a confidential chat with a financial adviser.

General Advice Warning: This blog may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. It is important that you consider your own situation before acting on any information contained in this blog. Please seek personal financial advice prior to acting on this information.

Disclaimer: James Weir is an Authorised Representative and John Hopkins Financial Services Pty Ltd is a Corporate Representative of WealthSure Financial Services Pty Ltd Level 1 190 Stirling Street PERTH WA 6000 ACN:130 288 578 AFSL: 326450.

Changes to GST on property transactions

If you’ve been around in the tax and accounting game for a while, like I have, you might have noticed that ATO activity in the property arena has been steadily increasing over time. Whether it’s targeting big developers or property ‘flippers’, a quick search on the ATO website shows it is active in making sure taxpayers are correctly recording their income tax and GST liabilities relating to property.

In recent times, the ATO’s activity has been focused on taxpayers correctly remitting their GST liability on new residential premises. If you’re new to the property development game you might be thinking, “There is no GST on residential premises?” Well, that’s not entirely true. If the premises in question are ‘new residential premises’ then the developer must remit GST to the ATO if they are carrying on an enterprise. In my experience, this comes as a surprise to many first time developers.

On the other end of the spectrum, there’s regular developers who register for GST. They claim GST credits along the way, sell the property, but then wind up their structures before remitting the GST on the sales to the ATO. This failure to remit GST has become so common that they’ve made a term for it – phoenixing.

Enter the May 2017 budget, the government announces that they’re introducing legislation that will strengthen compliance with GST law in the property development sector. On 7 February 2018, that legislation was introduced in parliament and it received assent on 29 March 2018. This means from 1 July 2018 purchasers will be required to withhold the GST on the purchase price of new residential premises and remit the GST directly to the ATO as part of the settlement.

What will the new rules apply to?

The new rules will apply to supplies of new residential premises and supplies of potential residential land. New residential premises that have been created as a result of substantial renovations will not be subject to the withholding requirement.

When will they apply?

They will apply to all contracts of sale entered into on or after 1 July 2018. Contracts signed before 1 July 2018 will not be subject to the withholding requirement, provided the consideration for the supply (other than a deposit) is first provided before 1 July 2020.

Accordingly, the new rules will apply to existing contracts and those entered into before 1 July 2018 where the consideration for the supply (other than a deposit) is first provided on or after 1 July 2020.

How will the rules work?

Where a vendor makes a taxable supply of new residential premises or potential residential land, the purchaser will be required to withhold 1/11th of the price and pay that amount to the ATO on or before the day on which any part of the consideration for the supply (other than a deposit) is first provided. This will usually be at settlement and will be done during the settlement process by the conveyancers or property lawyers.

Where the purchaser pays the withheld amount to the ATO, the vendor will be entitled to a credit in its BAS equal to the amount paid by the purchaser. This credit will then be offset against the GST liability on the sale of the property, which the vendor is still required to report in its BAS.

The purchaser must pay the withheld amount directly to the ATO. Alternatively, they can provide the vendor with a bank cheque made out to the ATO. Provided they retain a record of the payment, no penalties will apply to the purchaser for a delay in the ATO receiving payment from the vendor.

Note, where the margin scheme is to be applied to the sale, the GST payable on the supply will be less than 1/11th of the sale price. Instead the purchaser will withhold 7% of the price.

Notification Obligations of the Vendor

To assist purchasers with their obligation to withhold, a vendor is required to give to the purchaser a written notice before the date the supply is made.

The notice must state whether the purchaser is required to withhold and make a payment to the ATO. If so, it must state the vendor’s legal name and ABN, the amount required to be paid, and when the amount is required to be paid.

Importantly, the notification must be provided in respect of all sales of residential premises not just sales of new residential premises.

Failure to provide the notice gives rise to a strict liability offence with a maximum liability of 100 penalty units, which is equal to $21,000 per infringement for an individual. If a company is the vendor, it will be liable for a penalty 5 times that amount.

With the threat of these penalties hanging over them, developers will need to be confident about their GST obligations at the time of sale and not a moment later. For big time developers, this won’t be an issue. My concern is for the mums and dads who are sub-dividing off the backyard and building a property on it, or buying an old knock down and building a couple of townhouses on it. Both scenarios are likely to attract a GST obligation.

Next Steps

If you are thinking about doing any sort of property development, it is important to consider the income tax and GST obligations of doing so from the outset. The team at The Hopkins Group are here to help you understand these obligations and assist you in achieving your financial goals.

Get started today.


General advice warning: The information contained herein is of a general nature only and does not constitute personal advice. You should not act on any recommendation without considering your personal needs, circumstances and objectives. We recommend you obtain professional financial advice specific to your circumstances.

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