SMSFundamentals | Jun 02 2011
SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
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By Greg Peel
It is agreed that the Baby Boomer period began post-war but it can be hard to find agreement from different sources on when it actually ended, that is when Generation X took over. A popular choice is 1964, so let's thus assume Baby Boomers in Australia are those born between 1946-64. Taking 65 as the retirement age, 2011 then becomes the year the first of the Baby Boomers retire.
Given the Baby Boom is defined as a time when the tendency was for families to have three, four, or more children, that boom ended when Gen-Xers decided maybe two is enough. Kids are costly mongrels for one and besides, the world is becoming overpopulated. But if a couple produce only two offspring, then zero population growth is achieved (ex immigration). What's more, shifting from population boom to population flatline means the proportion of pensioners will eventually outweigh the proportion of taxpayers. The retirement of the first Boomers suggests the shift has begun.
It should be the goal of every working Australian not to receive the age pension, because if you don't it means you have too much money. Clearly this is the goal of a smurf (SMSF manager), otherwise why bother trying to manage one's own retirement fund? Superannuation is compulsory in Australia, but to date the focus of the super industry has been on those still in the workforce and not on those who have now retired or are about to retire. Such was the finding of the recent Cooper Review:
“…the panel notes that post retirement product innovation, while showing promising signs, is still at a relatively embryonic stage in Australia.”
In simple terms, working provides an income which stops at retirement, so the goal of super is to provide asset growth up to retirement so those assets can be converted into income thereafter. The focus of the Australian super industry has been very much centred on growing portfolio value. Perhaps in a perfect world, and assuming no financial legacy is intended to be left, the amount of super accumulated by a worker would last that worker in retirement right up to the day of departure, such that a retired life was enjoyed and there's just enough left in the kitty to cover funeral expenses. But it is not a perfect world, and there is a rather big problem.
Our beloved aged are simply refusing to pop off.
When the Australian government first introduced the retirement pension for men in 1909, the average life expectancy for a man was 55 years. A man aged 65 today is expected to live to 84. Standard of living, nutrition, health awareness, medical progress – all of these things mean we are expected to live longer today than our parents, and our children are expected to live longer than us. For the government, this is an exacerbating factor on top of the Baby Boom becoming the Oldie Boom. For superannuants, it means a retirement portfolio cannot simply be drawn upon until ultimate demise because on average there just won't be enough. Retirees must continue to invest in order to ensure they are supported right into dotage.
Retirees need an income to live on, but they must also continue to invest in growth to maintain that income over time. ANU research suggests male Boomers have a 34% chance of living beyond 90, and female Boomers have a 50% chance. That's 25 years of retirement representing (at 90) 28% of one's life. The super industry, as the Cooper Review has found, has been focused on getting superannuants to retirement but not on looking after them in retirement. Once they get there, the industry assumes, they will just invest in some yield instrument like bank bills or an annuity. But while such instruments provide income, they do not provide growth.
So until the super industry does manage to get its act together on retiree investment products, retirees are somewhat betwixt and between. That is, of course, unless they are smurfs, because smurfs have the opportunity to tailor their own investment portfolios to strike the right balance between income needed now and income needed in the future, for which asset growth is also needed now.
Of course, if one successfully invests for growth rather than income up to and through retirement, then income needs can be met with sporadic asset sales. Ongoing growth provides a replenishing pool. The emphasis here is on the word “successfully”. Growth in financial assets does not, as we know, simply trace a straight line. A large proportion of equity investment is assumed in any growth portfolio, for example, which as we can see by the following graph is problematic:
The graph shows the movement of the ASX 300 accumulation index (total return, meaning price plus dividends) from November 2000 to November 2010. The average annual total return of the Australian stock market over decades is around 9% per annum, and to turn $100 into $220 is to achieve, with compounding, about a 9% per annum return. But if one were to “get off the bus” somewhere before 2010, that is to retire and collect one's super, there would be a very big difference in getting off in mid-2007 for example than getting off in late 2008.
Even getting off in 2002-03 proved disappointing for retirees at the time and encouraged a big increase in super self-management. There have been few more volatile periods in investment history than 2005-09, but the reality is there are always volatile periods in stock markets over time. If retirement lasts 25 years, there's a very good chance of a volatile episode which might work for the retiree (eg like a 2007) or might work very much against (eg like a 2008). One might be sitting pretty one day and queuing up for food stamps the next.
Of course, no one suggests investing all your money in equities alone is a good idea, which is why super funds offer products based around the standard “balanced portfolio”. At the simplest level a balanced portfolio might be 60% equity, 30% fixed interest and 10% cash, for example. The “balance” is largely one of risk/reward with a 30% “defensive” element of fixed income against the growth volatility risk of equities plus 10% cash for some flexibility. It is not really a balance of growth and income required to live on.
Moreover, your standard balanced fund invests in equities by index-tracking. An index such as the ASX 200 or 300 is simply the proxy for “equities”. If stock prices fall, well it's not the fund manager's fault. “You wanted 60% equities and that's what we gave you”. An index in theory should strike a balance between growth stocks and yield stocks, or cyclicals and defensives. In Australia, the financial sector is the largest sector by weight and that's typical of most countries. But we also have a disproportionate weighting of the materials and energy sectors. And given the commodity export industry drives the Australian economy, the tendency is for any equity portfolio to have a solid weighting in, for example, BHP.
BHP and friends provide little in the way of yield and rely on growth. Banks are meant to provide yield and they do, fully franked what's more, but in this century the focus has been very much on growth. Once again, that was great in 2007 but by 2008 bank stock prices had collapsed and banks were slashing dividends and raising capital which diluted return.
A cash flow stock like Woolies should be defensive, because come hell or high water we all have to eat. But even the Woolies share price rocked and rolled over 2005-09 and it offers a modest yield. The boom, the GFC and the subsequent retail downturn have caused havoc with the David Jones share price, but DJs has always been supported by a strong yield.
Did you know that as an eight-year investment, David Jones has provided a better total return than Rio Tinto? And we are in a mining boom combined with a consumer slump.
These various examples indicate why it is dangerous for the retiree to rely simply on stock index investment, or worse still to invest in some smaller portfolio made up only of well known large caps, for example, even if equities only represent a proportion of the total of portfolio. By the same token, if a retiree leans too far to the defensive side, ensuring income but sacrificing growth, the risk is the money runs out.
What to do?
The Retiree's Balanced Portfolio
Every retiree will boast a different level of asset value at retirement, and those with more can assume more risk for growth while those with less will need to secure more income. Portfolio allocation needs to take such differences into account. But for the purpose of this exercise, let's consider an “average” retiree. To do so, we will enlist the help of financial planners ipac and Strategy Steps, along with fund managers Charter Hall and Legg Mason.
Outsourced super funds tend to be more passive than active given their assumed lengthy time horizon, so for example they might simply index-track the equity portion as discussed above. You as the unitholder will sit there watching the stock market crash and burn on the nightly news, but there's not a lot you can do about it. A smurf is usually a more active manager, taking more interest month to month or even day to day in portfolio decisions. This means the smurf is also totally exposed to all the anguish and anxiety that comes with self-managed investment. And as we all know, it is only human nature to dither before getting in on the upswing just before the market tips over, or worse still, to hold on too long and then panic in the downswing and end up selling just before the trough.
Unfortunate investment decisions such as these are more unfortunate for smurfs. Holding off and then selling at the low crystalises losses and wipes out potentially years of asset growth. If you then cower in a cave with your cash and miss the bounce you've made the situation doubly worse. If only you had been in a coma for a year! Or at least holidayed on a desert island with no phone reception. Your portfolio might still be about the same value it was before. In the meantime, your mate with the outsourced super fund is fine.
FNArena publishes a lot of tips about how to be a good trader in its Take Note section, but like many things what looks easy on paper is never nearly that simple in practice. What is thus helpful is the establishment of a portfolio which recognises both growth and income segments.
Strategy Steps likes to consider a retiree portfolio split into two “buckets”, a little one and a big one. The little one is a yield portfolio intended to provide the retiree with sufficient income to last two-three years. The big one is the growth portfolio intended to provide security of longevity in retirement. If there's only two-three years of income available over 25 years then the contents of the growth bucket is used to top up the income bucket over time.
(Note that a third bucket could come into the picture too between the little one and the big one for capital-guaranteed growth investments).
The theory here is exemplified by the period 2007-2009. On the assumption that markets, particularly stock and listed property markets, will recover after a crash then knowing you have two-three years of secure income means you can weather the storm as the level of your growth bucket rapidly reduces before eventually refilling once more, often rather quickly. You have avoided the overwhelming desire to panic and just get the hell out lest you find yourself in the soup queue.
Securing that income, via fixed interest investment for example, also means you can afford if you want to be a little more risk-aggressive with your growth portfolio. Maybe this means a weighting to high growth potential but low yield stocks, or maybe even some low-end gearing, such as investing in some instalment warrants or handing a bit over to some hotshot geared hedge fund.
Alternatively, Strategy Steps suggests, you can achieve the same income/growth balance not by dividing your whole portfolio into separate, distinct buckets, but by taking the bucket approach with each asset class in your portfolio. For example, the equity portion of your portfolio might include growth stocks (eg junior miners, cyclical industrials) and income stocks (eg utilities, Telstra) and the property portion might contain an investment flat you hope will appreciate in value and some REITs for yield. Your fixed income portion could have a mix of term deposits and hybrid corporate debt (which offers yield plus a call option on stock price appreciation).
However you arrange your buckets, the point is that you maintain enough income investment to keep you going in times of negative growth and enough growth investment to maintain that income investment over time. Strategy One above has the advantage of stopping you from panic selling but is less growth-aligned than Strategy Two. Strategy Two provides a greater growth profile buy you still have to control your own emotions.
Legg Mason's portfolio managers also believe the current industry approach to superannuation portfolio allocation is outdated and misconceived. Typically, they note, a “growth” portfolio is designed for the worker featuring 70% growth assets and 30% defensive assets and then a “conservative” portfolio is designed for the retiree featuring 30% growth assets and 70% defensive assets.
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Looking at the equity portion alone, Legg Mason points out that fund managers are only concerned with beating benchmarks and have no focus on income, that those benchmarks are market cap measurements which ignore dividends, that no consideration is given to the individual's specific tax rate and that focus on capital can lead to aforementioned poor decision-making by fund-holders in times of volatility.
By contrast, Legg Mason believes retirees need “a sustainable income stream, protection from inflation and a portfolio that is low risk. To expand a little further, retirees will require the bulk of their investment return to come in the form of income in order to meet their cash flow needs as they age. Secondly, so that they can maintain spending power and retire in comfort, that dividend stream will need to grow with inflation so they can meet future rising costs, such as increased healthcare spend. Finally, lower volatility in their invested capital base will become vital”.
Basically, Legg Mason believes “a whole new way of thinking” is required about the way investment products for retirees are built.
Retirees do not just need income, they need sustainable growth in that income to maintain spending power in the face of inflation and the rising cost of expenses such as utilities and health. If the equity portion of a portfolio is designed to reflect a market cap index then that allocation has not only ignored dividend streams but also the important implication of franking credits on those dividends. As noted earlier, your typical Australian equity index will contain a high weighting to mining stocks which pay little in the way of dividends. Nor will gearing levels be considered. Retirees should avoid stocks with excessive debt that may face dilutive recapitalisation. Emphasis needs to be placed on more mature businesses which produce surplus cash flows and thus high sustainable dividend streams.
Equities do, however, provide a natural hedge against inflation, given a strong economy implies earnings growth and a strong economy leads to RBA rate increases in order to curb inflation. But on the fixed interest side – the popular defensive portfolio portion – RBA rate increases reduce the value of assets such as government bonds or bank bills. Yields are fixed on entry and fall behind in real terms as inflation rises.
As an alternative to bonds and bills, “real” asset investment in property or infrastructure can provide inflation protection given rents (ie property rents but also equivalents such as road tolls or airport charges) typically track inflation via a CPI-adjusted or some other pricing mechanism.
It is also popular within standard industry portfolios to include a global equity or even fixed interest allocation. Retirees must recognise (assuming they are not planning to resettle in Tuscany) it is Australian outcomes they need to set their portfolio up for. At the moment, for example, US inflation is as good as non-existent while Australian inflation is threatening to run away. A strong Aussie may be beneficial when buying imported goods but works against investing offshore.
Unlisted funds such as unlisted property are another element a portfolio might contain. Unlisted funds can provide the investor with much lower levels of price volatility over time than listed funds (which are subject to market emotions) but consideration must be given to liquidity and whether or not published unit prices are truly reflective of market levels. Unlisted funds which do not provide regular access for redemption and regular mark-to-market asset pricing can prove dangerous. Unlisted funds which satisfy the criteria can reduce portfolio volatility.
Legg Mason has distilled its risk/reward assessments of popular asset classes with the retiree in mind by producing the following “traffic light” indicator. The green light indicates where the needs of retirees (and other income seekers) are being met, the amber light suggests risks are partially but not completed covered, and the red light is a warning to retirees to beware.
I noted earlier that the Woolworths share price has taken investors on a volatile ride over the past decade despite supermarket investment being considered as defensive. An important point to note however, which Legg Mason points out, is that Woolies' dividends, while modest in nominal yield (4.5% at present), have grown reliably over the same period with low volatility. Note the following graph with Woolies' share price in black and dividends per share in red. As long as the investor resisted an emotional urge to sell in the GFC then Woolies has actually proven the sort of investment suitable for the retiree.
Over the past ten years, Australian equity prices (ASX 200) have exhibited an average of 17% volatility. By comparison the defensive stalwart of Australian fixed income has exhibited only 4%. The typical industry super fund seeks to strike a balance between the two whether aiming for growth for the worker or being conservative for the retiree, but equity investment is based only on price benchmarking with no consideration for dividends. Yet dividends per share (ASX 200) have exhibited only 8% volatility. Dividends in the right stock offer growth unlike fixed interest, but volatility is much closer to that of fixed interest rather than that of equity.
And that's exactly the sort of philosophy the retiree needs to apply to a portfolio, whether doing so in terms of buckets or traffic lights or both or any other helpful analogy. A retiree needs to focus on both income and growth, or quite simply income growth, while still applying individual risk/reward considerations. A retiree must also be much more focused on tax implications given the specific tax benefits granted the superannuant.
In ensuing features, SMSFundamentals will provide smurfs with information about suitable investment opportunities either for complete self-management or in products provided by managers which are tailored to the smurf's criteria as either a worker or a retiree, along with other relevant news and information.
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