This article is written by Jon Kalkman, a regular SuperGuide reader, a self-funded retiree and
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
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
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
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.
Great article also you could use ETF’s that track the index like the asx300 which gives you excellent diversification top 300 stocks and also worth 80% of the Australian market. The yield is averaging 4.5% at the moment and you still get the dividends , for 0.15% to 0.35% fees I’d say its worth it for those that don’t want to spend as much time tracking their stocks, more fishing time
regards GAry
Correction you still get the franking credits I meant.. on top of the 4.5% divy yield.
You could adopt this strategy with a portfolio of properties. Provided the income generated from rents is enough to cover your living expenses as well as the cost of management, maintenance and repairs, you would be set for life because the income flowing in would keep pace with inflation. Then it does not matter how long you live because your income-producing assets remain intact for your whole retirement.
I prefer shares as my income producing assets for the long rather than property because:
- my yield is higher (because of the refund of imputation credits)
– so I need less capital outlay to generate the same income
- my costs are lower – no management, maintenance and repairs
- better liquidity – easier to sell part of my holding if required
- better capital gains in the long term – depending on which expert you listen to
– my income grows faster
– dividends depend on by company profits and economic growth
– rents depend on tenant affordability and wages growth
At last someone who actually addresses my situation. I followed this strategy at the start of last financial year by selling most of the not so good shares (dividend wise) in personal names and contributing to my SMSF and buying high yielding shares. This was the first year after retirement where I could do this and gain a deduction for personal contribution to offset the capital gain ( I had held many shares for a long time). I also used 6% as average yield but although I knew about imputation I hadn’t calculated it out. Thanks Jon for that 2% will mean I should get 7-8%. The last financial planner I used before setting up SMSF showed a calculation she showed to my wife with the capital running out when she was 120 and said she should be fine. With plenty of capital I couldn’t work out why this was the case but her model had expenses increasing with inflation but not the income. I see now the reason you have explained is that they sell the shares to fund the pension. Don’t or can’t they rely on dividend streams?
The portfolio is now heavily into banks and of course Telstra. I don’t worry about the share price anymore but only the dividends and all the recent ones are increased over previous year.
The only possible problem is that actual profits might reduce and dividends might follow although the banks appear to be addressing that by keeping their interest rates higher and unfortunately jobs cuts.
Thank you again Jon, I now have a much better worded argument to show someone significant in my life.
Retail and industry super funds are married to unit-based managed funds. It is the only way to be fair to people joining and leaving the fund and it allows funds to blend different asset classes to balance risk and return. Coincidentally, managed funds also generate the highest fees for fund managers and advisers.
Typically in accumulation phase, you buy units in one or more funds with each contribution. The number of units purchased depends on the current unit price. The daily unit price is calculated by taking the current market value of the underlying assets in the fund and dividing that by the number of units on issue. That is, the current unit price reflects the current market value of the underlying assets. If the fund hold predominately shares, those unit prices will be quite volatile.
What matters is the size of your unit holding, not today’s cash value because that changes daily. Drag out some super statements and check..
When you retire you sell some or all of your units in your accumulation fund for cash and with that cash you buy units in a pension fund. Because pension funds pay no tax, it makes no difference if the increase in the value of the underlying assets comes from improved market prices, asset sales or from income. So the units in the pension fund represent both capital and income.
Once a pension begins it cannot accept any more contributions. So each pension payment to you is funded by the sale of some of those units. If unit prices rise it means you need sell fewer units. If unit prices fall as they did in the GFC you need to sell more units. But since the number of units you had is set at the beginning, it is only a matter of time before all the units are sold and the pension stops. The real question is how long that will take. Periods of low prices wreak havoc on pension funds because the the units are being consumed far more quickly. Either way a retail or industry super fund is selling off your units with each pension payment – you will end up with nothing but hopefully that happens after your own use-by date.
If you try to pursue higher returns to make the pension last longer by selecting a fund with more growth assets you increase this volatility risk. If you attempt to try to manage volatility risk by holding predominately conservative assets such as fixed interest or cash you increase your longevity risk because the investment return will be insufficient.
If you see your unit holding as your “share” of the underlying assets in the retail or industry pension fund, your pension payments are only made possible for by the regular sale of your assets . How long do you think this can go on before until there are none left?
Now consider my strategy.
My yield is high because of the added income from imputation credits.
My income grows faster than inflation because the income is generated by growth assets.
Most important, no assets are sold to generate my income, so these same assets can generate more income next year and the year after and so on.
Moreover volatility is not a risk I need to manage.
A retail or industry fund will not let me do this. A SMSF allows me to do this with exceptionally low fees.
Jon K
even if you’re psychologically immune to the 50% drop in share prices in late 2007, early 2008, this single-asset class, ‘never mind the value feel the width’ strategy is very risky as made clear during the GFC when corporate dividends were cut 25% , and then were further diluted by cheap equity raisings
and even if you were to believe that you could pick shares that never cut divs and you didnt care about highly fluctuating share prices, how many people can afford to just live off investment earnings and not eat into their capital?
According to the Westpac / ASFA Retirement Survey a couple who own their own home needs $55,000 per year to have a comfortable retirement. If my share portfolio can achieve 7% income, I need $800,000 to achieve such a comfortable retirement. A portfolio skewed to income can achieve 9% income from dividends and imputation credits. In that case I need only $620,000.
If I am eligible for a a part age pension from Centrelink (and on these levels of assets I would be after age 65) my share portfolio only needs to be $500,000. The income would be 7% thus generating $35,000 plus a part pension of $786.90 per fortnight or $20,459.40 per year for an annual total of $55,450.40
At 9% my portfolio with a part pension from Centrelink only needs to be $350,000 because the dividends and imputation credits generate $31,500 and the combined part pension on that level of assets would be $989.98 per fortnight or $25,739.40 for an annual total $57,239.40
In each case the Centrelink pension grows with inflation and the dividends grow faster than inflation. There is no need to sell assets to fund retirement expenditure.
Show me another retirement investment strategy where I can generate a comfortable income in excess of $55,000 per year from retirement savings of only $350,000 that also keeps pace with inflation until the day I die.
I wish you’d shown me one Jon because unfortunately you haven’t! The assumptions are getting a bit fanciful l now.
If something sounds too good to be true, it generally is. What you are proposing is very straightforward. If reliably making $55k pa, year in, year out, with very low volatility, on retirement savings of only $350k was possible without ever having to touch your capital, everyone would be doing it.
i am not a Centrelink age pension expert but i don’t think with these levels of actual and deemed income that you would be eligible for a full age pension
and while 7% earnings from 5% divs and 2% imputation credits is realistic, I don’t think 9% is – certainly not from a sufficiently diversified portfolio
Also – what about the fact that you only get paid twice a year at interim and full-year dividend time?
Cashflow management aside, you’re not getting 7% on money sitting in your bank account so your overall portfolio return is not as high as you think it is!
“If I am eligible for a a part age pension from Centrelink (and on these levels of assets I would be after age 65) my share portfolio only needs to be $500,000. The income would be 7% thus generating $35,000 plus a part pension of $786.90 per fortnight or $20,459.40 per year for an annual total of $55,450.40″.
Jon, are the above figures for a couple? Have you actually checked your assumptions with a Centrelink Financial Services adviser?
I’m currently a completely self funded retiree. I’m having a house built which will absorb some of my capital which is presently generating income so I’ll become eligible for a part pension. In order to be clear about my future financial situation, before giving the go ahead on the new house, I’ve had some very helpful discussions with a Centrelink Financial Services person.
The calculation re how much pension is granted is considerably more complicated than I’d thought.
It also makes a significant difference to the first year’s part pension according to when the funds for the new house are withdrawn from the SMSF. There are options to take this withdrawal as a lump sum or to call it ‘pension payment’. The difference plus the financial year in which the money is withdrawn has a surprising number of ramifications.
I’d just suggest perhaps having a talk with Centrelink before you make too many assumptions about how they will regard your situation.
PS I wouldn’t be quite so cavalier about your assumptions on dividends always remaining intact.
There is much mess still in Europe, the Australian economy is showing signs of strain, and I doubt I’m the only one who is less than optimistic about the future.
Bob
I have a friend in his 70′s who follows this strategy. He is eligible for a part pension from Centrelink and at his age he is more interested in income than growth. His portfolio is biased towards Telstra and financials – mature businesses with sustainable profits high payout ratios.
His portfolio generates 9% income after the refund of his imputation credits.
Let’s assume his portfolio has a current market value of $500,000. His portfolio generates $45,000pa at 9% yield. His part pension is affected by the incomes test and the assets test. The income test is measured against his deemed income, not his actual income. Centrelink deem he earns 3% on the first $74,400 and 4.5% on everything above that. Therefore his deemed income is $21,384 (when his actual income is $45,000). This will reduce his full pension down to $860.17 per fortnight compared to the full pension is $1139.40 for a couple who own their own home.
Under the assets test, his full pension is reduced by $1.50 per fortnight for every $1000 over $265,000. His $500,000 in assets will thus reduce his full pension to $786.90 per fortnight.
Both tests are applied and the lower figure is the one used. In this case his Centrelink pension is limited by the assets test – irrespective of the income he earns. His $786.90 part-pension is $20,459.40 per year. Between his SMSF and his part Centrelink pension he has over $65,000 per year. He is presently holidaying in Europe for 14 weeks. This is not fanciful – this is real.
When the share market has a dip, the market value of his assets decline and so he is entitled to a higher part age pension under the assets test but his dividends from hid SMSF are largely unaffected. Conversely any growth in his share prices will reduce his Centrelink pension.
The reason everyone is not doing this is because they have been convinced by the experts that shares are for capital gains made on quick profits and that makes volatility is the big risk. Instead many prefer to hold residential property for the long term for income and lower volatility (mainly because of the poor liquidity) when the yield is demonstrably lower.
If you hold shares for the long-term for income (just like property) the yield is higher and price volatility is not an issue The tax advantages of shares combined with the tax advantages of a SMSF in pension phase make this a strategy that is difficult to beat.
Cash flow issues do not exist. We hold between 2 and 3 years forward pension payments in our SMSF bank account to smooth out the volatility of dividend payments. The dividends from each stock are paid into that account twice per year. The tax refund for the imputation credits is also paid into that account once per year. We pay ourselves a monthly pension from the same account. As long as there is more money flowing in than flowing out we never need to sell anything.
Don’t take my word for it. Do your own sums.
JK
i forgot to add that yield is obviously a function of the price at which you bought a share so is different for everybody.
If you adopt this strategy now when shares are at historical lows (by some measures but not by all), you’ve got a much better chance of it working than someone who tried to do the same thing in October 2007
the greatest chance this strategy has of working is when the local economy is strong but share prices are depressed for non-domestic reasons
like all equities-based strategies, it’s success very much depends on a form of market timing
“The reason everyone is not doing this is because they have been convinced by the experts that shares are for capital gains made on quick profits and that makes volatility is the big risk.”
(from Jon’s post above).
I would suggest that the reason many are not doing this is because they have as their first priority the preservation of capital, something which is far from guaranteed if you take the position of only focusing on yield.
Robert D. Arnott and Clifford S. Asness investigated whether dividend policy, as observed in the payout ratio of the U.S. equity market portfolio, forecasts future aggregate earnings growth.
They found that the historical evidence strongly suggests that expected future
earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low.
In other words, companies that pay high dividends are signalling their strong earnings expectations and represent better growth prospects. By contrast, companies that retain profits through low pay-out ratios usually signal inefficient empire building. Their findings offer a challenge to market observers who see low dividend payouts as a sign of strong future earnings to come.
It seems that a portfolio that focuses on income (or cash-flow) may also have the best growth prospects. That implies my portfolio may represent the best of both worlds – high yield and strong growth as well.
You are quite right. The dividend yield depends on the price you pay for the share. The present market is significantly undervalued due to a lot of negative sentiment out of Europe. Let us assume that the market grows by 30% in the next 12 months to catch up with the US S&P 500.
In that case, my friend’s portfolio will grow from $500,000 to $650,000 and so his grossed up yield of $45,000 is no longer 9% but closer to 7% of the then market value. Yes the yield will drop but his dividend income does not – he still gets his $45,000, or whatever it grows to next year.
It just means that people who wait for the market to settle down – become more normal – will have to pay 30% more for the same income stream that my friend enjoys now. This reminds us that we should buy quality assets when they are cheap.
However, as the value of his assets rise due to a rising market, his Centrelink pension falls due to the assets test. In fact his Centrelink pension falls from $20,459.40 to $14,609.40. You can see why he is not much interested in growth.
Thanks for this thought provoking article John and also for the extensive period over which you’ve continued responding to comments.
I am wondering how you would view investing the majority of one’s SMSF in one or more of the large listed investment companies – say Argo or AFIC – that have demonstrated performance at low fees over periods of decades. They are both offering yields around 5% at the moment.
They give a diversified exposure to the ASX ( and thus the Australian economy) with a stated emphasis on dividend returns. To me this seems like an even easier way of allowing you to go fishing and let your orchard grow!
Ray
I think LICs such as Argo or AFIC are exactly what retirees should be looking for. They invest in Blue Chip shares and they pay regular dividends that are fully franked. In fact, AFIC has never not paid a dividend since the 1930′s.
As you say, you have all the advantages of managed funds in terms of diversification and professional management with none of the structural problems. So you can go fishing in the knowledge that your income stream is secure and you have no worries about what to buy or when to sell.
You are, however, paying for something that you can easily do yourself. Even though their on-going management fees are very low by managed funds standards – 0.12% compared to up to 2% – it still means that if your portfolio is $1,000,000 you are paying $1200 per year for the service. If you look at their underlying portfolio, it is really easy to copy their approach.
It is like real estate – you can pay someone to manage it or you can do it yourself – your choice. I find that by doing it myself I get to tailor my portfolio to get a higher yield and I can pounce on opportunities such as buy-backs etc as they arise.
The other thing you need to be careful of is that sometimes LICs share prices are quite different to the value of their underlying net tangible assets (NTA). Sometimes they trade at a discount – in which case you get a bargain – other time they trade at a premium.
LICs make it easy to start this retirement strategy as they encapsulate the principles of using the tax advantages of shares with the tax advantages of SMSFS pensions while the dividend income stream continues to grow. LICs could form a core part of your holding and/or their portfolio could be be used as your model. Happy retirement.
Jon
the thing I love about shares is that there’s never a bad time to buy them
when the market’s going up – buy today so you don’t miss out on tomorrow’s gains!!
when the market’s going down – buy today because low prices are a bargain buying opportunity!!
Jon, i’m afraid that your example of share price impact on yield is misleading by omission and reveals your pro-equities-bias. Your hypothetical only countenances a potential share price increase. What if prices fell instead of rose?
And the analysis is highly deficient for not referencing the most recent example whereby this strategy came an absolute cropper. Anyone adopting it when the ASX was at its 6828.7 peak on 1/11/07 would not only suffered massive capital impairment but also suffered large cuts to income as most of the ASX100 recapitalised with highly dilutative equity raisings, not to mention those companies which reduced dividends to preserve capital.
Jon, i’m afraid that your example of share price impact on yield is misleading by omission and reveals your pro-equities-bias. Your hypothetical only countenances a potential share price increase. What if prices fell instead of rose?
And the analysis is highly deficient for not referencing the most recent example whereby this strategy came an absolute cropper.
Anyone adopting it when the ASX was at its 6828.7 peak on 1/11/07 would not only suffered massive capital impairment but also suffered large cuts to income as most of the ASX100 recapitalised with highly dilutative equity raisings, not to mention those companies which reduced dividends to preserve capital.
I totally agree with Bob Amery’s comments above.
Jon, you are making a lot of assumptions, none of which may turn out to be factual, especially given the gathering global storm clouds.
I understand the superficial attraction of high yield, but will never find this an acceptable exchange for significant capital loss.
the strategy might work sometimes but it troubles me that it’s shortcomings are glossed over, particulalry in light of what we’ve been through in the lasta 4 or so years
equities are risky. even blue-chips, which are quite deceptively named – even Woolworths was restructured in the 80s with a loss of shareholder value
look how many apparently sound companies have blown up shareholder’s equity – Ansett Airlines, HIH, Pasminco, OneTel, ABC Learning, Centro, Babcock & Brown, Allco
if you had just one of these in your portfolio you would have permanently lost part of your income stream and a chunk of capital
you can bet that in the 20-30 years you’ll be retired there will be more corporate collapses and a few of boom/bust cycles on the share market
the value of imputation means we should by all means have direct equities as part of our strategies but complete dependence without a safety net is only for those who can afford to lose money and i dont know of many retired people in that position
I have read people’s comments in response to Jon’s article over the past few months and make these comments:
Yes the stockmarket is risky (and always will be). If people are seriously concerned about companies going under, stockmarkets going down and preserving their capital then maybe the stockmarket isn’t for them. After all risk and reward are related.
With a well balanced and diversified portfolio with a clear investment strategy then you should be able to ride out the ups and down of the market (despite being burnt at times) and come out with an average investment return 8% pa or greater.
Personally I think Jon’s strategy is quite sensible and straighforward. Of course, if the market gets a head of itself (as it always does) take some profits and put aside to take advantage of the down times. Better still go for a nice long holiday with the wife and family.
My major concern is that many people lack a clear investment strategy and invest willy nilly, react emotionally to the day’s financial headlines and then sell exactly at the wrong time (the greatest destructor of wealth).
Clearly we all have different perception and tolerance of risk. My strategy will not suit everyone, but it suits me. I retired at the beginning of 2008 just at the start of the GFC and watched as the market value of my shares declined, In 2009, the dividends also declined but nowhere near as much as the decline in prices This simply showed the importance of having a cash safety buffer because it meant that we did not need to sell any shares at low prices. There was some dilution of shares at the time but you would hardly know that now from the present earnings per share.
Since 2009 the dividend income (and associated imputation credits) have continually increased faster than inflation. We have never sold any shares to pay for living costs. We have sold some shares to buy other shares and increased our dividends. If we never need to sell assets to pay for our retirement, and our income stream is growing with inflation, it follows that our income should be secure until we die.
Dividends keep growing because companies do not pay out all of their profits. Most pay-out ratios are around 60%. The retained profits are reinvested in the business to grow the profits and dividends in the future. For shareholders this is effectively an internal provision for inflation. No other asset class does this. It means that property, fixed interest or cash investors need to set aside and reinvest some income to grow the income stream in the future. Most people do not do that and so inflation erodes their purchasing power.
According to Professor Piggott from UNSW, 50 per cent of males currently aged 65 will survive beyond age 84. That is the familiar life expectancy figure. What is less well known is that around 5 per cent of that cohort will survive beyond age 97. Similarly, 50 per cent of females now aged 65, will survive beyond age 88, but around 5 per cent will survive beyond age 100. Some individuals will survive longer than that. This suggests that if I am going to plan my retirement with a 95% certainty that I will not run out of money, I need to plan for a retirement of at least 30 years.
On that basis, the volatility of shares is irrelevant but the enhanced returns of shares from both income and capital growth over 30 years is very relevant indeed. For me, all other asset classes carry an unacceptable risk that I will run out of money. Therefore I am prepared to put up with the volatility of shares, especially as I have no NEED to sell – ever.
It also suggests that ALL retirees need some exposure to shares. Naturally the level of that exposure is determined by your risk tolerance. But often your longevity risk takes a back seat to your tolerance of market risk. Hopefully this conversation has led more people to reconsider their longevity risk.
As this is my final contribution to this conversation, I wish all readers well in their retirement planning and thank everyone who participated. As we all expect to be in the surviving 5%, I would like to start this conversation again in 30 years time to see how we all fared in our chosen risk/reward settings. Should be fascinating. Good luck.
Jon
if u r aged about the 60 mark u would have lost 50% ot the super u had so there is not to many with 1million dollars and remember super started in 1985
so the article is a joke really for most of us
It is certainly true that you need substantial capital if you want to live on the income produced. The critical question is how much capital. My comments were in response to articles written by Trish Power in which she said that $1 million was not enough super to retire on and that maybe even $2 million was not enough. I disagreed because with my strategy $1 million is enough. Moreover, if you are over age 65 and eligible for a part-age pension, you need a whole lot less super to make it work.
The important point is that even if your are wealthy, your financial adviser will put you in managed funds so that you will eat your capital until it is all gone. My strategy preserves my assets for an uncertain life expectancy.
Jon,
Like many others, found your article and comments very interesting- thankyou
Whilst I protected capital in our SMSF during the GFC in Term deposits and still have some paying 6.7% for the next 4 years, I feel I need to increase my investment in high dividend shares
Would appreciate your views of investing in one of the high income ETF’s as compared to direct shares
Mike
The magic ingredient in the strategy is the refund of imputation credits to a SMSF paying a pension. Because a pension fund pays no tax. this is a refund of tax already paid – by each company. (It also happens in retail and industry funds as well but somehow we never hear about that) I do not know enough about ETFs to comment on how they treat imputation credits.
Otherwise ETFs are just like Listed Investment Companies (LICs) and they are essentially managed funds that trade on the market. The essential difference is that LICs are companies and can retain after-tax profits, managed funds are trusts that pay no tax and are required by law to distribute all their profits where it is taxed in the hands of the recipient. You need to do your own research to understand which category ETFs fit into. As we have seen, one of the reasons dividends keep going up is because companies can retain and reinvest some profits.
I refer you to my response to Ray about LICs on 23 April. It is really a choice between doing it yourself or paying someone a fee to do it for you.
JK