Superannuation, Family Law and the Global Financial Crisis - How to Protect Your Client

1. Superannuation, Family Law and the Global Financial Crisis - How to Protect Your Client Peter Skinner PGS Superannuation Consulting Pty Ltd petergskinner@optusnet.com.au 07 3901 7210

2. About this Talk • In volatile markets, selecting a base amount or a percentage split is not straight forward. • This talk addresses what practitioners need to consider to protect their client’s interest. • Generally, if one side is advantaged, the other side is disadvantaged. • However, superannuation provides for a neutral solution and this is also addressed. • Outline PGS Superannuation

3. The Global Financial Crisis • The cause of the Global Financial Crisis (GFC) is not controversial. The extent of the credit crisis and its lack of predictability are. • The term, toxic debt, has entered our vocabulary and is associated with the cause of the GFC. We have all seen the TV images of home foreclosures in the USA, the level of prices in some areas such as Detroit falling to 20 year lows, and of stories of loans being sold to people who could never afford them. • These loans were securitised, given a triple A rating, and sold throughout the world. The demand was insatiable, the prices of the securities rose, more loans were sold and everyone loved them, - until the bubble burst. • The GFC is the worst financial crisis since the great depression. PGS Superannuation

4. Cause of the GFC • No-one saw it coming, especially Reserve Banks • Macro economic imbalance • China excessive savings/undervalued currency • US excessive consumption/budget deficit • Flow of funds into financial assets • Fueled By • Excessive lending to high risk borrowings • Predatory lending (NINJA loans) • Securitised loans backed by credit default swaps (leverage on leverage) • Regulatory failure - capital adequacy ratio, • Moral hazard of govt guarantees - Freddie Mac and Fannie May - reckless lending • Outcome • Highly leveraged households, banks and companies pumped up by paper wealth PGS Superannuation

5. Asset Price Bubble Burst • Process thrown in reverse • De-leverage through asset sales • Sand castles collapse faster than they take to build • Credit squeeze • Solutions • Fiscal priming $1t to buy toxic assets • Catastrophic if happens again in the next 3 decades • Long term - capital adequacy requirements (take away punch bowl as party starts) • Australia not as exposed • Banks better regulated, govt debt, immigration & housing demand • Room to cut interest rates PGS Superannuation

6. The financial crisis explained in simple terms! • Heidi is the proprietor of a bar in Berlin. In order to increase sales, she decides to allow her loyal customers to drink now but pay later. She keeps track of the drinks consumed on a ledger – the ledger is her loan book. • Word gets around and as a result, increasing number of customers flood into Heidi’s bar. Taking advantage of her customers’ freedom from immediate payment constraints, Heidi increases her prices for wine and beer. Her sales volume increases massively. • A young dynamic customer service consultant at the local bank recognises these customer debts as valuable future assets and increases Heidi’s borrowing limits. His performance pay is tied to the value of the loans made by the bank. • The bank’s corporate headquarters sees the rise in loans, and with the assistance of the rating agency (on a fee for service basis) transforms these customer debts into triple A rated DRINKBONDS, and ALKBONDS. These securities are then traded on the markets worldwide. No one really understands what these abbreviations mean and how the securities are guaranteed. Nevertheless, as their prices continuously climb, the securities become top selling items. • One day, although prices are still climbing, a risk manager (subsequently of course fired due to his negativity) of the bank decides that slowly the time has come to demand payment of the debts incurred by the drinkers as Heidi’s bar. PGS Superannuation

7. However, they cannot pay their debts. • Heidi cannot fulfil her loan obligations and claims bankruptcy. • DRINKBONDS and ALKBONDS become worthless. • The suppliers of Heidi’s bar, having granted her generous credit and having invested in the securities are faced with financial ruin. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor. And the credit agencies make record profits having just given a triple A rating to some dodgy short selling scheme. • The bank pays record performance bonuses but is saved by the Government following dramatic round the clock consultations by leaders from the governing political parties. • The funds required for this purpose are obtained by a tax levied on the non-drinkers. PGS Superannuation

8. Know Your Super! Two Types of Funds * Accumulation Funds * Defined Benefit Funds - two types a) separate interest b) non-separate interests Two Phases * Growth * Payment PGS Superannuation

9. Accumulation Funds • FLV is simply the account balance on any given date. • All accumulation funds create separate interests when split, - the Al Capone Effect!! • Trustees are required to create separate interests through the SIS Act - to maintain their tax preferred status! • Practitioners should be aware of the type of investment choice made by the member such as: • Balance funds • All Equities • Cash • Investment choice is one of the keys to looking after your client’s interest for an accumulation fund. PGS Superannuation

10. Looking After Your Client - Accumulation Funds - CASH • More people have moved their super into cash than ever before. • Cash returns have been consistent - small but positive. Unlike other superannuation asset classes, capital has been preserved. • If the client is the non-member spouse, the optimal position is to split super at the current date. This maximises the superannuation asset value. • If the client is the superannuation member, the super valuation can be at a past date such as date of separation. This minimises the asset value. • The neutral position would be to value at separation, then add interest at the cash rate. • This excludes post separation contributions and places both parties in the same position they would have been if super was split at separation. PGS Superannuation

11. Looking After Your Client - Accumulation Funds -Non-Cash • These asset classes cover balanced funds, high growth, all equities etc • The key to looking after your client’s interest is to be informed. • Practitioners need to know: • Investment returns at separation and current date • Whether contributions have been made • Whether super was in the growth or payment phase. PGS Superannuation

12. Looking After Your Client - Accumulation Funds - Equities • Investment values peaked in Nov 2007, bottomed in March 2009. • Along the way, some ups, some downs - more like a wave. • The lag between obtaining a FLV and executing a splitting order has the potential to seriously disadvantage the client. • It is most important that the order reflects the current worth of the superannuation. PGS Superannuation

13. An Example • Assume that only the husband has super, no contributions have been made, the asset class is Australian shares and the split is 50%. • Assume husband’s retains $50,000, wife $200,000 and super at $400,000 is used to equalise assets. • The pool: • Other assets $250,000 • Super $400,000 • Total $650,000 • Equal share $325,000 • Super falls 50% from date of FLV to drafting of orders. Equal share now $225,000. • Practitioner can choose one of the following strategies to cover the above scenario: • Write the order as a formula • Include a clause in the agreement that updates the FLV prior to finalisation • Ignore if advantageous to client PGS Superannuation

14. Illustration of Impact • At Negotiations • After fall Wife Husband Other assets $200,000 $50,000 Super ($400K) $125,000 $275,000 Total $325,000 $325,000 Wife Husband Other assets $200,000 $50,000 Super ($200K) $25,000 $175,000 Total $225,000 $225,000 PGS Superannuation

15. Scenarios Explored(a) Formula • Write the order as a formula • Need to check with the trustees to see if they will accept a formula. If so, formula is: • Negotiated base amount + (a - b)*s, where • a = current FLV • b = FLV used in negotiations • s = percentage splitgoing to the non-member spouse • Eg - previous split $125,000, FLV $400,000, fall in FLV = 50% • Formula = $125,000 + ($200,000 - $400,000)* .5 = $25,000 • Same as revised base amount as per previous slide • Note: protects the member against share market downturns but does include post separation contributions. • Formula could be extended to exclude these but troublesome to identify. Alternatively, could use approach in following slide. PGS Superannuation

16. Scenarios Explored(b) Formula excluding contributions - unit price approach • If Trustees are unlikely to agree to a formula or if post separation contributions are material, then the settlement agreement could be phrased as follows: • The base amount of $125,000 has been derived using the FLV at date of separation being $400,000 when the unit price for that fund, being an all equities fund, was 2.4444. The base amount will be adjusted to reflect the latest practicable unit price just prior to the orders being finalised as per the formula: • Adjustment = ($400,000 x current unit price/2.4444) x percentage split • Eg. If current unit price had fallen to 1.2222, then adjustment to base amount would be: • $400,000*1.2222/2.4444 x 0.5 = $100,000 • Old base amount = $125,000 less adjustment = $25,000 • The above approach means that orders would reflect the latest FLV whilst excluding post separation contributions. Neutral to parties as unit price could go up or down. • If fund does not have unit prices, used Q Super unit prices but make sure fund type is appropriate - ie balanced, high growth etc. PGS Superannuation

17. Percentage splits for accumulation schemes. • Some trustees will reject type b orders (%) in the growth phase. • Percentage splits would pick up all post separation contributions. • Where super is used as a balancing item, a percentage split will only pick up a portion of the change in the FLVs. • Eg, • Wife Husband • Other assets $200,000 $50,000 • Super $125,000 $275,000 • Total $325,000 $325,000 • Percentage split =$125,000/$400,000 = 31.25%. Applying 31.25% to current FLV of $200,000 gives $62,500. • Correct base amount for wife is $25,000 (see slide 15) PGS Superannuation

18. Small Adjustments • Small adjustments may not be worthwhile. • Consider using a threshold percentage which needs to be exceeded before activating the revaluation clause. • Eg, The following clause will only be operative if the change in unit price from separation to current value (rise or fall) exceeds 5%. PGS Superannuation

19. Defined Benefit Funds • Much more complex. • Two groupings of DB funds • Fully defined • Hybrid schemes • Fully defined - usually a multiple of salary and years of service linked to contributions rate. Public Sector Scheme for Commonwealth Employees is an example. • Hybrid -as well as an DB component, has an accumulation interest. Military Super is an example. PGS Superannuation

20. How to Protect Your Client - DB • FULLY DEFINED DB SCHEMES • These types of schemes are not influenced at all by the investment market. • The investment risk is taken by the employer. • Eg assume, member contributes at 5%, accrued benefit multiple is 4.00 and super salary is $50,000 in Nov 2007. In March 2009, abm is now 5.0 and super salary is $60,000. Equity has increased from $200,000 to $300,000. • Member’s share has fallen and the hole has been filled by the employer. • The employer gains when investment markets are above average and lose in the GFC. PGS Superannuation

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22. Employers take the pain for DB PGS Superannuation

23. Defined Benefit Schemes and Family Law Values • Fully Defined - The FLV will progressively increase over time. • Where the DB is a lump sum only, (Eg UniSuper, Telstra), the FLV will always be less than face value of the member statement. At age 65, it will be equal. • Where there is a pension component in the DB scheme, the FLV will be less than the member statement up until the mid forties (+/- 5 years), and then the FLV will be greater than the member statement value. • For fully defined DB schemes, practitioners should protect their clients by valuing at date of separation and excluding all post separation contributions. • Practitioners should never use the member statement value in lieu of the FLV. PGS Superannuation

24. Defined Benefit Schemes and Family Law Values • Hybrid DB Schemes • Care needs to be taken as the FLV can decease due to the fall in the accumulation component. • In some DB schemes, the benefit is defined in terms of the member component. For these schemes, the FLV can fall dramatically. An example is the Commonwealth Super Scheme. • To protect your client’s interest, use current day valuations and exclude post separation contributions. PGS Superannuation

25. How to Protect Your Client -Percentage Split or Base Amount? • Who wins, who loses! • Winners:- NM = non member. M = member. • Neutral solution • Split at date of separation. • Apply interest/investment earnings that would have been earned since DoS. • Excludes all post separation contributions. • Puts both parties in the same position they would have been if the super was split at separation. PGS Superannuation

26. Payment Phase • Applicable to: • defined benefit schemes paying pensions, and • Account based pension schemes, eg allocated pensions. • FLV for DB is a discounted NPV of future income streams. Generally, the FLV will decrease over time and approach zero towards end of life expectancy. • FLV for account based pension scheme its surrender value (ie as an accumulation account). Its value is depended on the state of the investment markets. • In payment phase, superannuation is being consumed. • The amount consumed since separation needs to be explicitly addressed by the practitioner. PGS Superannuation

27. Defined Benefit Pension Example • Consider the case of Joe and Mary. Joe is in receipt of a defined benefit military pension of $30,000 pa. Separation occurred 3 years ago. • Neutral solution is to value at date of separation, (say $400,000) and then add the amount of pension foregone. ($30,000 x 3 x 50%) = $45,000. A 50% split would be $200,000 + $45,000 = $245,000. • The above would give a percentage split of $245,000/$400,000 = 61.25%. • Orders will generally be for a percentage split (type b order). PGS Superannuation

28. Accumulation Based Pension Example • Neutral solution - • Current day value, plus • Pension consumed since separation • The FLV is dependent on the investment market, and any material change in value would disadvantage one party, if the FLV at separation was used. • The amount of pension consumed since separation should be considered as this can be significant. • Orders will generally be for a base amount. PGS Superannuation

29. In Conclusion • Practitioners need to know: • Type of scheme. • Growth or payment phase. • The investment market between separation and current date. • Impact on client on percentage split or base amount orders, and • The advantages of a neutral solution. • The GFC and market volatility has heightened the risk for the practitioner of not being informed. PGS Superannuation

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