This came as a surprise to investors because mortgage funds were often positioned as a safe alternative to cash investments but with the attraction of a slightly higher rate of return. After all, the underlying investments were bricks and mortar and the presumption was that these investments were ‘as safe as houses’.
This article considers what went wrong and the strategy implications of a frozen fund.
Why can a fund be frozen?
The GFC resulted in a number of mortgage funds and some property funds being frozen towards the end of 2008. This is not the first time funds have been frozen, as many property funds were frozen in the late 1980s and early 1990s. So what leads to a fund being frozen?
Managed funds allow investors to pool money together to achieve diversification and access to assets that may not otherwise be available with smaller amounts of money to invest. Investors receive units in the fund and are able to sell their units by putting in a redemption request to the fund manager. Figure 1. shows how managed funds work.
During normal operations redemptions can be lodged any time and are generally paid within a week or month. Often the underlying assets may not be liquid or easily sold within this period for a fair price so the manager uses cash and/or contributions from new investors to pay the redemptions. If there is a high demand for redemptions and the requests are likely to exceed the cash and liquid assets, the trustee may put a redemption freeze on the fund. This is partly due to the trustee’s obligation to treat all unitholders equally, including redeeming and remaining unitholders.
Under the Corporations Act 2001 redemptions in a managed fund must stop (freeze) if the fund is no longer liquid, that is, less than 80 per cent of assets can be easily redeemed within the period required to pay redemptions. This situation tends to affect managed funds holding illiquid and bulky assets such as property and mortgages.
The reason for the freeze is to stop or limit redemptions to allow the trustee to sell assets for a fair value. Without the freeze action, the trustee may be forced to sell assets at ‘fire sale’ prices. This would disadvantage remaining unitholders because their returns would be affected by the realisation of assets at a discount to the market price.
When the GFC struck, money for lending became scarce and the price of borrowings increased substantially. Mortgage funds were flooded with redemption applications. The trustees were forced to freeze redemptions to protect remaining unitholders. With a few exceptions, most mortgage funds are now allowing redemptions.
What access do unitholders have to money?
If a fund is frozen, redemptions will be suspended (or limited) until the liquidity position improves. This blanket freeze applies to all unitholders and the trustee is not able to approve redemptions for individual investors. As liquidity improves, the trustee may offer all unitholders the ability to request a withdrawal within a certain time period. If the total requests received exceed the amount of liquid funds, withdrawals will be paid on a pro-rata basis. This allows everyone an equal chance to redeem some money.
These offers must be made:
- in writing
- in accordance with the fund’s constitution or the Corporations Act
- to all unitholders, or all unitholders in a particular class, and
- be open for at least 21 days.
The Australian Securities and Investment Commission (ASIC) can change legislation to allow special withdrawals and throughout the GFC ASIC exercised this power to allow:
- Hardship relief – funds could accept partial redemption requests from unitholders experiencing severe hardship. The fund needed to apply to ASIC for approval to pay redemptions under hardship and the amount payable is capped.
- Rolling offers – funds could make unitholders a rolling withdrawal offer to pay a series of redemptions over the course of the year.
Centrelink impact
Investors in frozen funds may not be able to access their money to meet living expenses. This may cause hardship as the money is assessed for Centrelink purposes, reducing income support entitlements, but cannot be used to pay living expenses. Investors caught in this situation can apply for hardship concessions to Centrelink. As a general rule, investors will fall into one of the following four categories.
- Shares/units dropped in value, but not frozen. Investors can choose to request a means test review to reassess income and assets. This may lead to higher income support payments.
- Withdrawals frozen but regular income still paid. Investments are still included as assessable asset and income under normal rules.
- Withdrawals and income payments are both frozen. The investment is still included as an assessable asset. The investor can apply to Centrelink for a temporary exemption under hardship provisions.
- Company has failed. If a receiver/administrator has been appointed, the investor can apply to Centrelink for an exemption.
Impact on account-based pensions and superannuation
An account-based pension is required to meet the minimum pension payments each year. If the minimum pension is not paid, the account is no longer considered to be a superannuation income stream and the tax exemptions on earnings no longer apply.
In effect, the money is considered to be back in accumulation and all earnings recommence to be taxed at 15 per cent in the fund.
During the GFC this created concerns for investors who needed to sell assets at lower prices to create cash to pay the pension payments. But this was even more concerning if the underlying assets had been frozen and payments could not be made.
If a fund fails to meet its minimum pension payment due to factors beyond the trustee’s control, such as not being able to liquidate assets due to some of these being frozen assets, it is generally unlikely that a breach of operating standards will occur as the contravention is not intentional or reckless. However, despite this, the pension tax concessions may still be lost.The Government provided relief over the last few years by lowering the minimum pension requirement by 50 per cent in the first few years. In 2011/12 a 25 per cent reduction in the minimum pension requirement applies.
Similarly, the GFC and frozen assets may have a detrimental impact on a trustee’s ability in to pay a super death benefit. If a superannuation income stream is commuted to pay a death benefit, it must be paid before the later of:
- six months from date of death
- three months from grant of probate or letters of administration
- six months after legal action over entitlement is finalised
- six months after contacting potential benefit recipients, if the identification caused delays.
If paid outside these periods, it is a member benefit rather than a death benefit and may incur higher rates of lump sum tax. The ATO does have discretion to still consider the payment to be a death benefit, but this discretion does not extend to circumstances where the payment delay was due to frozen assets.
Within a self-managed superannuation fund, a solution for pension payments could be to introduce new members who can inject liquid assets to make the payments. This might be harder (but not impossible) with a death benefit scenario, although insurance strategies could help this situation if they had been set up properly when insurance was purchased.
Case study
The implications of frozen funds can be far-reaching. Consider Tobias, who set up a self-managed superannuation fund five years ago with himself as the only member. He was conservative in his investment approach and was going overseas to work so wanted a ‘set-and-forget’ strategy.
He invested most of the money in his SMSF into a mortgage fund which has subsequently been frozen. Tobias is still living overseas and his brother (who lives in Australia) fulfils the trustee duties on Tobias’ behalf using an Enduring Power of Attorney. Tobias stopped making contributions when he left Australia but taxation obligations and fees have used up all his liquid funds.
He now has fund expenses to pay and faces a serious dilemma. If he makes a contribution (as a non-resident) to inject liquidity into the fund he will breach the ‘active member’ test (see the definition following) and the fund will become non-complying. This incurs significant taxation penalties.
If Tobias is not able to redeem money from his frozen investment he may need to add a new member into the fund who is able to make contributions into the fund.
Active member test
If active (contributing) members exist in a super fund, at least half of the balance held by all active members needs to be held by active members living in Australia.
Summary
Investors in frozen funds may be unable to access all or part of their funds for a long period of time. Investors who rely on the distributions to fund their living expenses are more severely affected by the freeze. In this circumstance, retirees should review their income needs and/or look at their other assets as a mean of providing the income required. This may mean that they are forced to redeem other assets at a time when financial markets have dipped.
Some unscrupulous organisations may attempt to take advantage of frustrated investors stuck in frozen funds by offering a significantly discounted price to buy their units. In most cases, it is not worth accepting such offers to sell unless the investor is very desperate for the money.
Understanding the risks and how managed funds operate is an important step for all investors. Every investment carries some form of risk and an assessment needs to be made on the likelihood of the risk eventuating and how detrimental it would be for that particular investor. Liquidity risk is just as important as market volatility to take into consideration.
Disclaimer
The information contained in this article is based on the understanding Strategy Steps Pty Ltd ABN 14130045242 AFSL 333649 has of the relevant Australian legislation as at 1 February 2012. The information is of a general nature only and is intended for use by financial advisers and other licensed professionals only. Advisers should determine the appropriateness of any strategy to the needs of a specific client and the client may need to be referred to their tax or legal adviser prior to implementing any recommendations that you may make based on the information contained in this publication.
