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 (7% and 5% returns)’. 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.