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.
Jon Kalkman’s article.
I sent you an email earlier about the above, and am so incensced that I have done some illustrative work on $1 mil put into “Blue Chip” ANZ shares in July 2007.
$1m would have bought about 37,037 shares @ $27 a share. This would have produced dividends of $5.78 per share since then, to December 2011. $1.28 per year, + 100% franking.
37,037 X $1.28 = $47,407 + 100% franking = a return of about 5.6%.
Less a capital loss of about $6 per share ($222,222) @ $20 per share and going down.
How Jon Kalkman produces his fantastic returns is a matter for him. Maybe he was smart enough to buy in March 2009.
As a simple man all I can ask is, like Pauline Hanson said “Please explain”???
Your site is still worth reading.
Yours sincerely,
John Sheraton.
John Sheraton was “incensed” by my article. Leaving aside the fact that no one would have $1 million invested in one company, this is how the maths stack up.
He spends $1 million and buys 37037 ANZ shares at $27 in 2007.
The ANZ dividend in 2007 was $1.36 so his income was $50,370. With his imputation credit refund his total is: $71,957.60 (7.2%)
The ANZ dividend in 2008 was $1.36 so his income was $50,370. With his imputation credit refund his total is: $71,957.60 (7.2%)
The ANZ dividend in 2009 was $1.02 so his income was $37,777. With his imputation credit refund his total is: $53,968.20 (5.4%)
That is why he needs to hold a cash buffer to smooth out the variability in dividends
The ANZ dividend in 2010 was $1.26 so his income was $46,666. With his imputation credit refund his total is: $66,666.00 (6.7%)
The ANZ dividend in 2011 was $1.40 so his income was $51,851. With his imputation credit refund his total is: $74,074.00 (7.4%)
The projected ANZ dividend in 2012 is $1.48 so his income is expected to be $54,814. With his imputation credit refund his total is: $78,306.00 (7.8%)
If he had spent his $1 million on ANZ shares on 20 December 2011 when the price was $20.41 he would now own 48995 shares (ignoring brokerage).
In that case:
The projected ANZ dividend in 2012 is $1.48 so his income now is expected to be $72,512. With his imputation credit refund his total is: $103,589.42 (10.36%)
You can argue with the capital “loss” produced by a falling share price. The ANZ share price was much lower again in March 2009. On that basis he has made a capital gain since then. To me, it is all paper losses and gains but the dividends and imputation credits are money in the bank. The share price is volatile – we know that – but if I am holding my ANZ shares for 25 years, today’s variations are not going to mean much and who knows what the price will be then.
The dividend in 2011 is already higher than 2007 after the worst financial crisis for 80 years. Whether that represents high yield depends on the price he pays for his shares – it was ever thus.
In the meantime, it is hard to argue with the growth of the income stream.
The dividend growth on the previous year is
2009 -25%, (GFC)
2010 23.5%
2011 11.1%
2012 5.7%
That growth in the income stream is the power of the strategy – and the fact that I am not selling any assets.
Isn’t it strange that advisers and their clients believe they can continually sell real assets (units) in the retail super funds to fund their pension for 30 years and they are then surprised that they run out of money. What is particularly crazy is they are selling units into a volatile market so that falling prices means they need to sell even more units to generate the same cash pension. When the units are gone, folks, there will be no more pension.
Jon
An excellent article & one that I wholly agree with. I believe a SMSF is so much better than having your Superannuationin in a company where you have no control over their investment decisions.
I like the concept of aquiring fully franked Australian shares in companies such as Telstra wherein you will receive good dividends plus franking credits.
However, perhaps some mention could of been made regarding the required annual withdrawal amounts which are from approx. 4 – 6% annually depending on your age which would need to be transferred out of the SMSF into a stream that is fully taxed.
The minimum pension payments increase with age, as your website explains. If I can get 7% yield I will be over 84 years old before the income produced by the portfolio is insufficient to pay the pension. At that point I need to sell some shares to produce the cash to cover the shortfall. As the minimum pension increases I need to sell more shares.
But I do not need to spend this cash – I just need to transfer this cash out of the SMSF to satisfy the pension requirements. I can transfer the cash to another ownership vehicle, buy the same shares and the income stream continues as before. The big difference then is that instead of the franking credits being refunded, they are then used to offset the tax payable on this income. That is how I can transfer the portfolio to my children over time – that, and off-market transfers (in specie) of shares from the SMSF to myself.
Jon
john in his article $1 million can last forever, states he can pass the smsf onto his children, but he didnt say how, can you give me some pointers please.
Recently a friend was bemoaning the fact that he had 10,000 Telstra shares and its share price had fallen significantly (not helped by the Government’s NBN fiasco). However, when we worked out the yield he was getting via dividends and imputation credits, he became enlightened to your concept of looking at income returns and not short/medium term share prices. A good article. Thank you.
I recently read a commentary by Alan Kohler on ” Business spectator” that I think is indirectly very adequate in addressing the above.It is entitled “Greenspan shrugged”,and was published on 14 October 2011, one of many articles written by very erudite business and financial journalists. This article is still available on the website.
Yes i agree with the the excellent article and follow the same process myself and overcome the required annual withdrawal amounts by still being on a transitional to retirment pension whereby the excess money if you dont spend it can be reinvested in your smsf as an undeducted contribution.
Any income produced by the fund that is not required to pay a pension belongs to the fund.
It can be reinvested within the fund or taken as a higher pension.
It is NOT an undeducted contribution.
Jon
Interesting article, would Jon Kalkman care to share which shares his SMSF holds to produce the type of income security over the longer term?
Look for shares where the dividend is better than 4.9% – in today’s market that is easy – and look for dividends that are fully franked. Full franking means that the dividends represent only 70% of the total income so the refund of the franking credits will take the total income (dividends and franking credits) to 7%.
Also look for shares with a solid history of paying dividends, especially those that grow their dividends over time.
During the GFC, Australian share prices dropped by over 50%. Dividends from the all ordinaries dropped by only 22%. CBA’s dividend dropped by only 14%. Woolworth’s dividends continued to grow.
When you stop focusing on capital gains or losses and look at what this investment can actually deliver as money in the bank, investing in shares for income provides a fantastic income stream for retirees who use a SMSF.
It is also a fabulous passive investment. No maintenance, no tenants, no insurance, no management worries.
Did I tell you about the fantastic yield……?
Jon
A valuable contribution by Jon Kalkman, to understanding some very important SMSF attributes and investment lessons. The concentration on the day to day share price fluctuations does have a most detrimental effect. Commentators announcing that they are completly out of the market and suggesting ALL others should follow, can naturally add to the stampede to the exits! I assume that Jon would agree that we need to be aware of “what’s going on in the market” because markets and situations can change and previously great ” franked dividend paying companies” can go out of business or, be shadows of their former worth” perhaps because of market changes, legislation, etc. One does need to be aware of trends such as “on-line shopping” and be prepared to sell investments judged to be “at risk” or face expected returns to be reduced.
I am not saying I never sell a share. There is nothing wrong with selling something that is looking expensive to buy something that looks cheap, especially if that increases the flow of dividends. Of course I need to be aware of economic trends and to exit shares that look like the earnings stream is slowing.
The point is that this share trading is based on the company fundamentals, not in response to changes in share price. Falling share prices increase the temptation to add more good dividend-paying shares to the portfolio at a lower price.
With this portfolio we have bought is a life-long income stream, just like an annuity that grows faster than inflation.
We call it our orchard. As long as we do not chop the trees down (and consume the capital) we can live off the fruit in perpetuity.
Jon
I agree with the comments from John Sheraton above.
The writer of the article makes a good point about the value of a SMSF over participating in a retail Super Fund where units have to be sold to fund retirement income.
But I question his discarding of the importance of diminution of capital. Unless your dividend yield and imputation credits at least balance the diminished capital investment, I can never accept that it’s just fine to ignore what share prices are doing.
If you learn enough about technical analysis of the market to understand how to ride an uptrend, then exit as this begins to turn down, thus preserving your capital and profits, you’re going to be in a healthy position to buy back in (obviously purchasing many more shares than you sold) when an uptrend returns.
Meantime, at the start of the GFC it was possible to lock in a five year term deposit at 8% (tax free in pension phase) and even now there are plenty of opportunities for over 6%.
I’m much happier with cash, government guaranteed, at 8% and some at 7% than a roughly equivalent amount coming in from dividends and franking, when the invested capital is falling as it is at present.
If the writer, or anyone supporting his approach, can show that the dividends and franking balance the loss of capital over the last four or so years, I’m happy to reconsider.
Of course we would all like to be in shares when they are going up and cash when they are going down. If you have found a way to do that, congratulations, you will make a lot of money. Maybe you can help the rest of us simple souls by ringing a bell to tell us when to exit at the top of the market and again to tell us when to pile back in at the bottom of the market.
The fact is that timing the market is extremely difficult to do. You are up against some of the smartest and best resourced people in the business, because speculating on prices is the main game in the share market. But it is a zero-sum game – for every winner there is a loser. Even though we all like to believe we are all above average, history shows the main losers in this game are the mum and dad investors who end up buying high and selling low and vowing never to return to the market. They do it through managed funds and also through their super funds.
If you are betting on prices, dividends become an afterthought. There is no guarantee that you will be holding the share before they go ex-dividend, and there is no guarantee that you will have held them for the 45 days to be eligible for the imputation credit. So a retiree would need to confident enough in their trading ability that they can pay themselves a regular income and still not make any capital losses.
In my experience, most successful traders have an outside income source and their trading adds a bit of sizzle and excitement to their investing/speculating. If you have the expertise, the inclination and most of all the time to watch this fickle beast so carefully, I say good luck to you.
Like most retirees, I just want an income stream that protects me from inflation. If I don’t have to sell, my capital ‘loss” may soon be a capital “gain” so what difference does it make. I am reasonably confident that after 25 years I should be ahead. I would not be at all confident of that outcome if I was trading.
Jon
An interesting article that raises as many questions as it does answers; I got the impression that the strategy was perceived as one that is risk-free by using historical averages across all shares as a rationale that your own would all do as well. Peter Ellis pointed to a logical downside to the author’s theory in that companies go out of business and the effect that would have on your annual income and capital.
The risk profile and psychology of investors when they see their original $1m capital being eroded will vary greatly with some not accepting more than a 10% loss and others losing resolve once 50% has disappeared and still decreasing. If one or more of your shares no longer performs and have lost say 50% and becomes a sell because you now hold struggling companies, it will take 100% gains in some other share(s) or spread across your portfolio to get that capital back to maintain your income performance. You will likely have to forfeit income to replenish the underperformers or start trading temporarily. Replacing lost capital is easier said than done unless you believe debt fuelled investment will come back again like the noughties and quickly recapitalise you.
Volatility and the risk to your capital, including your psychological wellbeing if holding most of your retirement capital in the same shares over a long period, is probably anything but risk-free on a number of fronts, nor could you guarantee the income or capital gain over time.
Peter
Over the last decade, the Woolworth’s dividend (as cents per share) has been as follows:
2002 33
2003 39
2004 45
2005 51
2006 59
2007 74
2008 92
2009 104
2010 115
2011 122
If I was your fund manager and you had no idea how I invested your money, these returns look pretty impressive. There is no GFC evident in these returns. Now if you overlay the share price on to this you see periods of capital “gain” and “loss”. But if I am not selling, all you and I only need to focus on is the 369% increase in returns over a decade. That is before we consider the growth in the share price over the same period.
I am not saying that Woolworths is guaranteed to continue that growth for the next 25 years. Nothing in life is guaranteed. I am saying that short term price variations are just “noise”. What matters is the quality of the company and the returns it produces for it’s shareholders.
Investing is a game of probabilities not certainties. Given the history of Blue chip Australian companies to generate wealth for their shareholders, I am confident that our portfolio will provide :
- Attractive yields with tax-advantages from imputation credits
- A predictable, reliable low-risk income stream flowing from assets growing faster than inflation
As a result we have hitched our future to the Australian Economy. Our income stream and our lifestyle is linked to the profitability of Australian companies and the growth of the Australian economy. That gives us great peace of mind in retirement.
Jon
When I was looking for an investment strategy in 2003 I read an article by a retired accountant saying that he invested in shares with a fully franked dividend, and that he was doing well. I tried to follow that plan but bought a few speculative shares, and these have largely gone downhill. During the GFC I turned to term deposits and so far am happy with them. But their rate is falling, so perhaps it is time to look again at the sort of shares Jon Kalkman suggests. Thanks Jon for an interesting article.
I have always had doubts about Managed Funds in Super and the Way it was managed for self interest for high fees. This article is the only one that makes sense to me. The issue is definitely managing risk. The only problem is that the instruments that are created to short the market are distorting the price of shares, but if the dividend still rises and the company is sound its price distortion is not so much an issue as i see it. I would like to continue to receive info Thanks John very informative.
Jon’s remarks from above in quotation marks::
“Of course we would all like to be in shares when they are going up and cash when they are going down. If you have found a way to do that, congratulations, you will make a lot of money. Maybe you can help the rest of us simple souls by ringing a bell to tell us when to exit at the top of the market and again to tell us when to pile back in at the bottom of the market.”
I’m not sure why the sarcasm is necessary. Or invoking the cliche about bells being rung at the top and bottom of the market.
I simply put forward my contrary point of view which is that I will never relegate preservation of capital to lesser importance than seeing the dividends flowing into my account twice a year.
And I don’t know anyone who consistently picks the absolute top and bottom of any trend. But it is not difficult to limit loss of profit to, say, 5% or for a very safe company 10%.
I started my SMSF in 2004 when the XJO was at around 3300. Simply stayed in the market with between 20 and 30 companies until it was clear that assurances by so called experts that Australia would not be affected by the overseas difficulties were hollow indeed.
Sold everything in early 2008, certainly not right at the top, but only giving back a small amount of profit by the time the downtrend was pretty clear. i.e. the XJO was at about 6000 pts.
To me this makes much more sense than watching your profits disappear as the market loses 50% of its value.
“The fact is that timing the market is extremely difficult to do. You are up against some of the smartest and best resourced people in the business,”
Are they really that smart? How many of them accurately predicted the GFC? How many of them – even when the writing was all over the market, not just on the wall, continued to say oh don’t worry, it will all be fine? Most of them, in fact.
So I would question that they are any smarter than any reasonably intelligent person who is prepared to be across global situations and think about how these are likely to affect Australia.
” because speculating on prices is the main game in the share market. But it is a zero-sum game – for every winner there is a loser.”
I don’t care about what anyone else is doing. I don’t mean to be rude, but to say that for every winner there is a loser is a bit simplistic. People have different reasons for selling and buying all the time. They may have set a profit target, reached that, and exited.
They are ‘ winning’ there, if you like, but whomever buys those shares on the other side of that transaction may consider they have acquired a bargain depending on the fundamental value they ascribe to that company.
“Even though we all like to believe we are all above average, history shows the main losers in this game are the mum and dad investors who end up buying high and selling low and vowing never to return to the market. They do it through managed funds and also through their super funds.”
I completely agree. But these are people who haven’t taken the trouble to become financially literate and who are essentially just having a bit of a punt.
“If you are betting on prices, dividends become an afterthought.”
Correct. I’d never buy a company for its dividend / franking credit alone.
It must also have good growth potential.
“In my experience, most successful traders have an outside income source and their trading adds a bit of sizzle and excitement to their investing/speculating. If you have the expertise, the inclination and most of all the time to watch this fickle beast so carefully, I say good luck to you.”
I don’t consider myself a ‘trader’. To buy into an uptrend and stay there, often for years, until that trend reverses, is not imo ‘trading’.
I have no outside income source.
I am well and truly past the stage of wanting “sizzle and excitement”, or experiencing that sinking feeling when the market is down 100 pts on the open etc. And my Trust Deed doesn’t allow for shorting. Hence I’m quite happy to sit on the sidelines with my initial capital and subsequent profits largely intact until the world sorts itself out and the current volatility gives way to a clear uptrend.
The tax free interest is considerably more than I need to live on so I’m still well ahead each year.
“Like most retirees, I just want an income stream that protects me from inflation. If I don’t have to sell, my capital ‘loss” may soon be a capital “gain” so what difference does it make. I am reasonably confident that after 25 years I should be ahead. I would not be at all confident of that outcome if I was trading.”
I completely understand what you’re saying here and agree. And I get that many people are quite happy to see their capital going down as long as they have a decent income on a day to day basis.
I’d possibly take that view myself if I were still 30, even 40, but as someone already retired I’m just not happy to see that capital (which may one day be needed to fund a decent level of aged care) being eroded by the sort of markets we are seeing over the last few years.
I’m distrustful of the philosophy that that capital loss might one day be a capital gain.
Sure it might, but it might also be an even bigger capital loss. Think about ABC Learning, Babcock & Brown and quite a few others, all of whom were market darlings for a while.
Thank you for the discussion. We can all learn from considering different points of view.
To Peter Harvie: agree with your comments.
The growth of dividends over time, which is faster than inflation, is seemingly not in dispute. That, and the attractive yield shares provide inside an SMSF, is the central premise of my strategy and my defense against longevity risk.
If you choose to be more active in the market to extract some capital gain or avoid capital loss, that is fine – but you don’t need to – you can just go fishing because the dividends keep going up. Clearly trying to time the market carries its own risks, particularly for novice investors.
So the discussion hinges on how active or passive you want to be in the market. That would seem to be a personal choice.
Thank you for the discussion. The market only works because we all have different opinions about stocks and different outlooks on the future. That diversity of opinion has clearly been on display here.
My compliments of the season to all. Happy retirement planning.
Jon
Very well crafter article Jon! I couldn’t agree with your strategy more.
Peter Thornhills book Motivated Money echoes the same retirement planning using high-dividend paying shares and is well worth a read.
Keep up the good work.
Peter Thornhill at http://www.motivatedmoney.com/ puts the case for dividends from Australian shares much better than I can. I agree: Read his book!
It is interesting though that in his book, superannuation hardly gets a mention and SMSFs not at all. In addition, the importance of imputation credits are hardly mentioned.
When you harness the growth of dividends over time, the tax advantages of SMSFS in pension phase (ie. they are tax exempt) and the tax advantages of imputation credits you have a really powerful income-producing machine. In a nutshell, imputation credits are totally refunded in pension phase because they are tax exempt and this adds substantially to the dividend income produced by shares (up to more than 40% in most cases)
You just have to make sure that you have enough income in all circumstances so that you are not forced to sell shares to pay for living expenses at a time when prices are low. That means a) enough capital; b) a safety buffer of cash to smooth out fluctuations in dividend receipts. We hold up to 3 years of forward pension payments in cash.
With this risk to our income security well managed, we are insulated, both financially and emotionally, from market volatility. For us, the risk to our income security is more important than the risk posed by volatility.
With this risk management we can look forward to a high yield and an income stream growing faster than inflation because it comes from a growth asset.
That is the answer to longevity risk.