How $1 million can last longer than you

This article is written by Jon Kalkman, a regular SuperGuide reader, a self-funded retiree and SMSF trustee and a retired school principal. Jon’s comments are in response to the SuperGuide articles: ‘Why can’t $1 million last forever?’ and ‘Crunching the numbers: a $1 million retirement’. Jon believes it is possible for $1 million to last forever by relying on dividends from Australian shares, and his own SMSF experience is proof that it works.

My portfolio looks like heresy when measured against the orthodox modern diversified portfolio designed to manage (volatility) risk, but I believe (and the actuaries agree with me) that my large asset allocation to Australian shares is actually a smart approach to ensuring the money does not run out over a 30-year retirement.

Financial planners and their employers (managed funds), are focused on volatility risk, that is bumpy returns. That is what traders do, but with increased life expectancy, retirees need to be very concerned about longevity risk, that is, the risk that they will run out of money.

Actuaries understand life expectancy and longevity risk. They argue that dividends from Australian shares offer the best protection against longevity risk, precisely because dividends grow faster than inflation.

My point is that with sufficient income, I can sit out any downturn in my SMSF, so falling share prices have no effect on my investment strategy, and anyway, my income depends on company profits and dividends, not prices. As long as I am not selling any assets, volatility is not a risk I need to manage. If I’m in a retail super fund however, I am selling assets (units) every time I take a pension payment, so price volatility is now a big problem, that can only be addressed by adopting a less aggressive and more balanced portfolio (fewer shares) and therefore producing a lower long-term return and which will therefore increase my longevity risk.

Secondly, the amount of capital I need to generate sufficient income is smaller for shares than other asset classes because the yield is so high inside my SMSF. If I can get 7% after-tax yield from my shares inside my SMSF, I only need half the capital to produce the same income than if it is producing only 3.5% after tax and costs (e.g. for a property investment).

So I get to eat my cake and have it too. I get high yield and that income stream is growing faster than inflation.

The problem for retirees is adequate income now and adequate income after 30 years of inflation. You only get at the guts of the retirement problem by getting retirees to focus on the correct risk. With enough income, it is not volatility risk. So the aim of financial planning should be to get people to the point where their capital generates enough income now and it grows over time. Then it does not matter how long they live!

Why $1 million can last forever

If I have $1 million in my SMSF invested in Australian shares with full dividend imputation, I receive about 5% in dividends and another 2% cash refund from the Tax Office as the imputation credits are fully refunded in pension phase. My SMSF thus generates $70,000 per year. (If I have Telstra in my portfolio I can generate 12% income.)

Dividends are linked to profits by a fairly constant pay-out ratio so that dividends increase as company earnings increase. If history is any guide, my dividends grow by an annualised rate of 7 or 8% per year, which is greater than inflation. In other words, if I can manage to live on $70,000 this year, I am better off next year without the need to reinvest any income. I also do not need to sell any shares.

As my income is growing faster than inflation and my capital remains intact, my $1 million must be able to sustain me for as long as I live, and then I can pass the portfolio on to my heirs.

With this strategy, my SMSF portfolio generates about 15% total return, comprised of 7% income and about 8% average growth. I will leave it to you to explain to your readers why your retail super fund can only generate 8% income and growth before inflation.

There is no doubt that the market value of my portfolio will be volatile but my income depends on dividends, not prices. Dividends are far less volatile than share prices. Unlike a retail super fund where each pension payment is the sale of assets (units) at current prices, my income depends on earnings, not sales. Volatility is not a risk I need to manage and therefore I can afford to hold a less conservative portfolio than would be required if I was in a retail super fund that depends on the sale price of assets for each pension payment.

Clearly, if I am not paying exorbitant fess to fund managers, and I am not required to hold a conservative portfolio to safeguard me against the volatility introduced by the active trading of my fund manager who was recommended by my adviser, my $1 million is sufficient to sustain me for ever, or at least until the minimum pension payments exceed the income produced by the SMSF.

At age 85 I can sell some shares to satisfy the minimum pension requirement and repurchase them in another ownership vehicle and the dividend stream continues as before. Eventually, at age 120, the increasing minimum pension payments will remove all my money from the SMSF and ensure that the income from the portfolio is taxed normally.

The tax is higher outside super, so my income then is lower. Given that the growth in income from dividends has exceeded inflation for 25 years there should still be more than adequate income and I should still not need to sacrifice capital to pay for living costs.

My point is that with sufficient income, I can sit out any downturn, so falling share prices have no effect on my investment strategy and anyway my income depends on company profits and dividends, not prices. As long as I am not selling any assets, volatility is not a risk I need to manage.

© Copyright Trish Power 2009-2014

Copyright for this article belongs to Trish Power, and cannot be reproduced without express and specific consent.


IMPORTANT: SuperGuide does not provide financial advice. Comments provided by readers that may include information relating to tax, superannuation or other rules cannot be relied upon as advice. SuperGuide does not verify the information provided within comments from readers. Readers need to seek independent advice about their personal circumstances.

Comments

  1. Bob Coleman says:

    Jon, I’m not surprised your article continues to generate interest. My wife and I are in our mid 50′s. I spent the last years of my finance career in the managed funds industry as a portfolio manager for a large institution. As a result I was also exposed to its subsidiary industry; financial planning. It saddens me that between them, these two industries take so much off investors for such little value returned. I favoured direct property investment for many years and built a reasonable sized portfolio, following the models proposed by Yardney et al. In retrospect we built more wealth from two owner occupied property transactions than we did from the property investment portfolio over the same period, and with much less effort. Reading your article was a watershed moment for me. We have almost completed our transition from direct property to Australian shares within a SMSF. I play with part of our portfolio using research from Fat Prophets and Motley Fool but the majority is in ETF’s. My next step is to duplicate my preferred portfolio (‘SYI’ from SPDR) in direct share investments and avoid even their relatively modest fee structure. A heartfelt thank you from the Coleman Family.

    • Jon Kalkman says:

      Thank you Bob for your kind comments. Coming from someone with extensive experience in the finance industry your comments are special indeed.

      It is indeed a watershed moment for many people. It is not rocket science but it does take a paradigm shift to see shares in a new way. The media, market analysts and traders (speculators) would have us all focus on shares as growth assets with extreme volatility (and liquidity) combined with lots of colour and movement. It all makes for scary and sensational news.

      Instead, shares should be seen as representing a claim on the profits of real businesses. Although dividends are not guaranteed in that way that bonds are, if history is any guide, shares produce the highest income of any asset class in the long run. It may be boring but it is an income stream in perpetuity.

      The best part for a retiree is that the income flowing from shares increases with time. For the last 30 years the Australian share market has returned on average about 11% annual return, made up of 7% growth and 4% dividends. A growth of 7% means that the market value of the shares will double in 10 years – because the underlying profits have also doubled in that time. Since the dividend is a relatively constant proportion of the share price (4%) it means that the dividend will also double in 10 years. Since I sell no assets to fund my retirement I can look forward to an improving lifestyle every year. How many retirees can say that?

      The only point of using a SMSF is to utilise all the tax advantages on offer. So instead of basing my calculations on a 4% dividend yield, I work on a 7% yield. So I actually get a 14% return (7% growth and 7% dividend) on my investments. For that I must accept some volatility in the market price of my assets but since I am not selling assets, that volatility is of little concern to me. Moreover, I know that in the long run the market price of my shares will be higher than I paid for them because the underlying profits continue to grow. For a long term retirement that looks like a good deal both for growing income and growing asset prices.

  2. Justin Glen says:

    Property versus shares. I just turned 50 and have always negatively geared into property. I have found that I can get more leverage with property. If I have $100,000 cash or equity in my home a bank will loan me another $400,000 so I can buy a $500,000 investment property. Alternatively a bank would loan $100,000 secured against a share portfolio allowing a $200,000 investment in shares. That is if you are game for a margin loan. If the property market and share market doubles in value over 10 years I’ve made $500,000 with property and only $200,000 with shares. The extra $300,000 from the property investment easily compensates for reduced yield.

    • Jon Kalkman says:

      I am impressed that after two years this idea is still generating responses.

      Justin is quite right the leverage available in property is greater than shares. You can borrow more and you never get a margin call

      But I was talking about retirement and his negatively geared $400,000 loan would consume 80% of his income to service the loan. As a retiree I need all the income I can get to pay my bills and so in retirement I have no loans. Negative gearing is an accumulation strategy not a retirement strategy.

      Most negative gearing is done outside super so that the loan costs can be used to reduce the tax on personal income. It is then difficult, but not impossible, to move that property portfolio inside super. But in retirement it makes sense to have assets inside super to take advantage of the tax benefits offered. My super fund pays no tax because it is in pension phase. In addition the fund gets a tax refund for imputation credits for the company tax paid on Australian shares and, because I am over 60, I pay pay no tax on the money withdrawn from the fund. These tax advantages add up to a significantly higher yield than that available from property and that means a significantly lower capital base needed to generate sufficient income to live on without selling assets.

      Later on in retirement it is likely that some assets need to be sold to fund living costs, either because of the mandatory withdrawals from super or because I need the money. With shares I can sell a parcel as required. With a property I need to sell the whole thing, I cannot just sell a bedroom, and if I hold the asset outside super I have a large lump of capital gains tax in one financial year.

      Negative gearing makes sense for high income earners in accumulation phase but for income it is hard to beat the tax advantages of shares combined with the tax advantages of super in retirement.

  3. David McGeorge says:

    Thank you Jon for your thought provoking article. As a couple in our early fifties and with in excess of $1M currently in our joint SMSF, your suggested approach is very interesting. In fact, I would like to trial your method on part of our funds over the next couple of years. I was wondering if you might be willing to disclose what shares you are currently holding and what percentage they make up of your overall fund ? I’ve personally held some of the shares you’ve mentioned (e.g. ANZ Bank, Westpac, etc.) for almost 20 years and enjoy the dividends they have produced. But this will be the first time that we would be investing in shares within our SMSF and your experience would be much appreciated.

    • Jon Kalkman says:

      David
      The shares in my portfolio are drawn from the S&P ASX 200. They are mature business with reasonably generous payout ratios. Growing businesses tend to need more capital and thus they tend to retain profits (as opposed to distributing them as dividends) to grow the business for the future. They may have more profits and dividends in the future but I need to pay my bills now.

      But for the same reason, chasing yield for its own sake can be short-sighted. If a company distributes 100% of its profits as dividends, there is no capital retained and reinvested for future growth. If you are in your your early fifties, you will need inflation-protected income for the next 40 years, so you want your dividend income stream to grow over time. It is a question of whether you want your income now or in the future. An older couple may well make a different decision.

      The other consideration is; if you buy Australian companies that pay company tax in Australia, you are entitled to a tax credit for that company tax already paid. If you hold this portfolio inside your SMSF, paying a pension, the fund pays no tax so these tax (imputation) credits are refunded in full. So this tax refund is extra cash to the fund. If your fund is still in accumulation phase, the fund pays 15% tax on the income it earns. In that case the imputation credits are likely to more than offset the tax payable.

      I found my stock broker really helpful in setting up the portfolio I needed to produce enough income from my capital so that I was never forced to sell shares at a bad time – when prices are low. That way I am insulated against volatility.

      It also helps me to sleep well at night to know that I have a cash reserve of between 2 and 3 years forward income requirements as protection against a deep and protracted fall in dividends.

      I have been doing this now for 5 years during the worst market conditions in a generation and all I can say is – “it works!”

  4. Bob_amery says:

    ..and just on your point that …Mr Kalkman “could hold a diversified stable of Australian companies paying a regular and tax effective dividend”…you seem to gloss over the definition of a dividend….a dividend is not a guarantee, nor even a promise..it is a residual amount that may or may not be paid by the Board of Directors in their discretion out of company profits, assuming profit is made in any given period…in terms of secure income streams; dividends don’t provide them. Unlike interest on corporate debt there is no contractual obligation to pay a dividend…and a dividend can be reduced arbitrarily by a fall in profit, dilutative equity raisings, a change in the payout ratio or ‘just because’…

  5. Bob_amery says:

    well let’s take a look at Mr Kalkman’s portfolio and examine its performance then, Geehawk!

    if it doesn’t contain blue chips, what’s in there? Leighton Holdings? Qantas? Hastie Group? Billabong? David Jones? Myer? Boral? Metcash? speaking of which, Metcash is raising a dilutative $325 million to help fund a business model that Merrill Lynch describes as ‘broken’. This should give the DPS a whack around the ears

    if you’d bought into any one of these companies back in December 2011 on the basis that you wanted to live on their dividends you’d be a very sorry investor today sitting on massive capital losses and wishing you’d just put your money in a term deposit at 6%. No, there’s no franking but there’s no risk of loss, either and you can sleep at night.

    Did you also realise that a year ago a year ago earnings per share growth was expected to be 20 per cent. It is now close to zero..surely this dispels the misnomer that dividends are an inflation hedge?

    it’s about time we stopped talking ‘what if’ scenarios and generalisations and started talking specifics. I agree that it’s far better to back-test using real data and/or focus on actual portfolio results rather than simple mathematical ‘what ifs’ . Hence i think the only way to settle these competing views is for Mr Kalkman to reveal his investment performance in terms of both income and capital. If not his approach is unfortunately not much more than a flawed hypothetical that is being undermined on a daily basis by the very asset class he purports to rely on for his retirement wage!

  6. I endorse Bob Amery’s comments above. It’s pretty hard to imagine the dividend and franking stream on the above, especially e.g. RIO and BHP with their low yields, would come even close to making up for the diminution of capital.

    • Geehawk says:

      I don’t recall the investor saying he owned AIO BSL RIO BHP etc like some of you allude. Mind you, BHP was $9 back in 2003, been a nice rise since then if you had the wisdom to buy quality assets in difficult times rather then fleeing to cash. If franked income was targeted you wouldn’t buy those types of stocks anyway. Jon is an astute investor and not blindsided by industry benchmarks. He could sit in a nice balanced managed fund and worry over what distribution he or may not get every six months…or he could hold a diversified stable of Australian companies paying a regular and tax effective dividend…..smart.

  7. bob amery says:

    For those of you thinking Mr Kalkman’s idea of living on dividends (assuming you’ve got $1m in capital) is a sound one, check out the price falls of these ‘blue chips’ over the last 13 mths. Do you think you’ve got the stomach to sit on those kinds of capital losses, hoping that they’ll continue to pay dividends?

    Stock (ASX Code) Price at 29 April 2011 Price at 20 June 2012 Price change
    Rio Tinto (RIO) $83.37 $57.72 -31%
    Qantas (QAN) $2.13 $1.16 -46%
    Asciano (AIO)* $4.98 $4.40 -12%
    AMP (AMP) $5.54 $3.94 -29%
    BlueScope Steel (BSL) $1.84 $0.33 -82%
    Toll Holdings (TOL) $5.67 $4.15 -27%
    Fortescue Metals (FMG) $6.38 $4.91 -23%
    ANZ Group (ANZ) $24.32 $21.75 -11%
    BHP Billiton (BHP) $46.29 $32.60 -30%

  8. Hi Jon,

    Just wanted to say it was a good constructive article and follow-up comments. And I can concur that with the client’s on our books that held throughout the ~2008 part of the GFC mostly recovered with respect to their capital by 2010 (generally holding Top 50 ASX).
    The blue-chip dividend income has been growing steadily through this period so realistically the trustees/ (pension member) have not been too concerned. Yes its also very pleasant when the client receives their refund cheques (most of which is franking credits, you mentioned. I think the largest one we have seen this year was about $84.000 but that was a slightly larger fund). It will be interesting to see the next round of 2012 FY SMSF returns.

    Mark

    • Jon Kalkman says:

      According to Michael Yardney, writing in the Yahoo7 website on 23 May says:
      >The average gross yield for well located properties in Australia is around 4%, but let’s be generous and say you earn a 4.5%
      >This means if you own $1 million worth of properties with no debt, you’ll get $45,000 rent.
      >You still have to pay rates and taxes and agents commissions and repairs; leaving you with something like $35,000 a year. (3.5% net yield) And then you may have to pay tax on this income.
      >That means you need an unencumbered portfolio worth at least $4 million to earn that $100,000 a year after tax.
      >And no mortgage debt, otherwise your cash flow will be lower.
      >And of course you’ll also need to own your own home with no debt against it.

      He is talking about owning and holding his assets for the long term and just living off the income produced. So am I.
      He is suggesting that the yield from property after costs and after tax is 2.5%
      My shares held inside my SMSF have a yield, after costs and after tax, of 7%+
      Ah yes, property has lower volatility, but volatility cannot be a problem if the asset is held for the long term. Go figure.

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