- Why $1 million can last forever: Mark’s investment approach
- August 2017: Mark confirms his investment approach
- So, what impact did the introduction of a $1.6 million transfer balance cap have on Mark’s SMSF pension portfolio?
- Response from SuperGuide readers to Mark’s investment approach
- For more articles on how much super is enough…
Note: This article is an edited and abridged version of an article written by one of our readers 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)’. The reader believes it is possible for $1 million to last forever by relying on dividends from Australian shares. His own SMSF experience is proof that it works for him. He noted however that his approach does not involve a diversified asset portfolio and he believes such an approach would not be appropriate for those who need to sell assets to pay pension payments.
About 6 years ago (in late 2011), we published an article written by a SuperGuide reader, about the possibility of retaining $1 million capital in your SMSF and living off the dividend income from shares, even after meeting minimum pension payment requirements.
Due to the considerable time that has passed, we have removed the article from the SuperGuide website, but essentially the reader argued that his large asset allocation to Australian shares was actually a smart approach to ensuring that money did not run out over a 30-year retirement.
SuperGuide is not promoting or denouncing this view, but we have decided to re-publish an edited and updated summary of the reader’s approach (without disclosing the reader’s identity). At the end of this article, we have also included some of the debate that occurred between the author of the original article, and other SuperGuide readers.
For ease of reading, we call the author of the original article, Mark.
Mark suggested that his investment portfolio looks like heresy when measured against the orthodox modern diversified portfolio designed to manage (volatility) risk. He believed that financial planners and their employers (providers of managed funds), are focused on volatility risk, that is bumpy returns. Mark argued that managing volatility risk 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.
He noted that actuaries understand life expectancy and longevity risk, and he believes actuaries understand that dividends from Australian shares offer the best protection against longevity risk, precisely because dividends grow faster than inflation.
Mark’s main point is that with sufficient income, he can sit out any downturn in his SMSF, so falling share prices have no effect on his investment strategy, and in any case, his income depends on company profits and dividends, not prices. He suggested that as long as he is not selling any assets, volatility is not a risk he needs to manage.
Mark distinguished his situation from a retiree in a commercial super fund. He said: “If I’m in a [commercial] 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).”
He summed up the above comments by stating that he gets to eat his cake and have it too: he gets high yield and that income stream is growing faster than inflation.
He explained that the problem for retirees is adequate income now and adequate income after 30 years of inflation. He suggested the following: “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: Mark’s investment approach
Mark explained (in December 2011) if he has $1 million in his SMSF invested in Australian shares with full dividend imputation, he receives about 5% in dividends and another 2% cash refund from the Tax Office as the imputation credits are fully refunded in pension phase. His SMSF generates $70,000 per year.
He argued that dividends are linked to profits by a fairly constant pay-out ratio so that dividends increase as company earnings increase. He believed that if history is any guide, his dividends grow by an annualised rate of 7 or 8% per year, which is greater than inflation. Rewording his explanation, if he can manage to live on $70,000 this year, he is better off next year without the need to reinvest any income. He also does not need to sell any shares.
He suggested that since his income is growing faster than inflation and his capital remains intact, his $1 million can sustain him for as long as he lives, and theoretically he can pass the portfolio on to his heirs.
With this strategy, Mark stated that his SMSF portfolio generates about 15% total return, comprised of 7% income and about 8% average growth.
Mark accepted that the market value of his SMSF portfolio will be volatile but his SMSF income depends on dividends, not prices. Mark argued that dividends are far less volatile than share prices, and unlike a retail super fund where each pension payment is the sale of assets (units) at current prices, Mark’s income depends on earnings, not sales.
According to Mark, because volatility is not a risk he needs to manage, he can afford to hold a less conservative portfolio than would be required if he was in a commercial super fund (that depends on the sale price of assets for each pension payment). At the time, he wrote: “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 forever, or at least until the minimum pension payments exceed the income produced by the SMSF.”
Mark planned, at age 85, to sell some shares to satisfy the minimum pension requirement and repurchase them in another ownership vehicle and allow the dividend stream to continue as before. He said eventually, at age 120, the increasing minimum pension payment requirements will remove all of his money from the SMSF and ensure that the income from the portfolio is taxed normally.
He noted that the tax is higher outside super, so in his eighties and older, his overall income will be lower, but given that the growth in income from dividends has exceeded inflation for 25 years there should still be more than adequate income and he should still not need to sacrifice capital to pay for living costs.
August 2017: Mark confirms his investment approach
SuperGuide requested Mark’s views on his investment approach in light of the July 2017 super changes, in particular, the introduction of a $1.6 million transfer balance cap.
Mark confirms that his investment approach still works for his SMSF. He points out however that the orthodox view of investing (that is, a portfolio of shares increases risk), and therefore diversification is paramount. He believes diversification is a sound approach for most people because funding a long retirement usually means spending capital, as the income produced is insufficient to pay for living costs.
Mark notes: “Spending capital means selling assets and that means being faced with the volatility of market prices and the danger of selling assets at a time of low prices. The problem is that the diversification introduced to dampen down the effects of price volatility also reduces the overall portfolio return and therefore increases the need to sell assets to meet income needs.”
Mark reiterates his main message that applied 6 years ago, and still applies today: if a retiree has sufficient capital to produce sufficient income then the problem, of selling assets at a time not or your choosing, does not arise.
He says: “Therefore if I do not have to face a volatile market price, my asset allocation can pursue the best return both in income and growth. That is why I favour Australian shares.
“Unfortunately, the universal orthodoxy on diversification never makes that point because it assumes that everyone needs to sell assets in retirement to pay their expenses and therefore everyone needs diversification. This is regarded as normal and all retail and industry super funds work on that assumption of de-accumulating assets in retirement.”
Mark concedes however that there are not many retirees like him who have sufficient capital to generate sufficient income (and hence the diversification principles don’t have to apply), and the investment needs of this group of retirees (that don’t need to be concerned with diversification) is not catered for by the financial services industry.
He suggests that a less lazy approach to financial advice would be to acknowledge that the need for diversification is a function of the size of the retirement nest egg you start with, and that aim of retirement planning should be to get everyone to the point where they do not need to sell assets in their retirement.
So, what impact did the introduction of a $1.6 million transfer balance cap have on Mark’s SMSF pension portfolio?
According to Mark, the new $1.6 million transfer balance cap left the main elements of his strategy intact. He says: “The income generated in a superannuation pension fund retains its tax-exempt status and imputation credits remain unaffected by these new super rules. In addition, the money I draw from my super pension fund after age 60 is also tax free.
“Because my portfolio contains only Australian shares and cash, my super pension fund pays no tax, the fund receives a tax refund (imputation credits) for the company tax already paid on the dividends, and I pay no tax on my pension because I am over 60. The effect of this tax arrangement is that I still average over 7% income (after-tax). Any capital growth is just a bonus. As long as I have sufficient income and a safety net of cash to cover any volatility in dividends, I never NEED to sell shares for income. Price volatility is not a risk I need to manage.”
Mark says the strategy outlined above has worked for him for 10 years, including through the GFC. He qualifies his comments by stating that this strategy works for those people who have enough capital to generate enough income to live on. If that is not the case, “retirees are basically condemned to a balanced fund, running out of money and ending their days on the Age Pension! But we all regard that as normal.”
If you’re interested in reading a selection of reader comments about Mark’s investment approach, then click on the box below titled ‘Response from SuperGuide readers to Mark’s investment approach’.
Response from SuperGuide readers to Mark’s investment approach
For more articles on how much super is enough…
If you are seeking more information about how much super is enough to live comfortably, then check out the following SuperGuide articles:
- How much super do you need to retire comfortably?
- Setting a retirement target: Living on more than $60,000 a year
- Retirement: Want to live on $100,000 a year?
- The super challenge: At what age should I retire?
- Retirement: Today’s dollars, and why $1 million can’t last forever
- Crunching the numbers: a $1 million retirement (7% and 5% returns)
- Low yields: A $1 million retirement on 3% or 2% returns
- Crunching the numbers: a $1.6 million retirement
- SuperGuide $1 million Retirement Reckoner: How does it work?
- Life expectancy: Will you outlive your retirement savings?
- Moving targets: Come on, how much super do I really need?