(03) 9020 2905PORTFOLIO POINT: Winding back the risk in your SMSF by switching from equities to bonds? Not so fast!
It’s taken as a given in the investment world that the older you get, the more conservative you become (or should become) as an investor.
With youth on your side, you can afford to take risks in order to grow your capital base. Whack it all in shares and property and hope that time, which you’ve got, works its magic. Well, not quite, but certainly being overweight in shares and property can make sense, if you have faith that they produce better long-term returns.
However, as you age, the potential risk that a major event for equities poses to your investment capital can be too much to bear, so an increasing caution becomes the order of the day.
When that occurs, so investment theory goes, capital should be gradually shifted from the higher risk (or growth) assets of shares and property to lower risk (or income) assets of cash and fixed interest.
There is zero volatility in cash in a bank. There is some level of volatility in the pricing of bonds. There is more volatility in property. And shares, well, there are still scorch marks in our frontal lobes as how much they can jump around.
The “average” investor is considered (roughly) to require around 60-70% of their funds in growth assets. With that level of exposure to growth assets, the expectations are for a reasonable return above inflation. (But don’t go looking at the most recent five year returns of any “balanced” investment/super for proof, because you won’t find it there.)
As you get older and move into capital protection mode, that 60-70% in shares and property should actually become 60-70% in cash and bonds is the general theory. Less volatility. Less risk.
Enter what’s known as “longevity risk” (click here for a previous column, 17/6/09), which is the threat off you outliving your money.
The best way of beating longevity risk is to have too much money in the first place. As that’s not likely to happen to most, another way of combating it is to have your money growing fast enough that it can keep pace with both inflation and your income needs.
Legg Mason Global Asset Management has put together a research paper that takes a look into whether that traditional asset class allocation will serve people well over time. While the basis of the paper is to push two of their new managed funds, the basis of what they’re saying is still worth consideration.
There are three interesting arguments they make: that a retiree’s need for income is paramount; their ability to make the most of a zero tax environment (particularly from income streams from super) is under-appreciated; and the existing products (annuities) are too expensive for what they offer.
Legg Mason asserts that loading up your portfolio with cash and bonds (Australian and international) is a recipe for investments that will fall behind inflation.
JAMES AND JAMIE: PLEASE GRAB GRAPH 3(A) FROM THEIR REPORT. I CAN’T ISOLATE IT TO INCLUDE IT.
What they did point out – while not startling – was the following:
- Cash and bonds don’t provide a good enough hedge against inflation. Cash provides reducing real income, while diversified international fixed interest will likely suffer from Australia’s high dollar and low returns on the US interest rates.
- There are identifiable assets and asset classes that will provide an already high, but more importantly rising, income stream
- They nominate equities with low debt and histories of high yields, plus property and infrastructure assets.
- Not enough funds/products out there take enough notice of the zero tax rate of retirees.
- To keep investments ahead of inflation, Australians will need to have a higher weighting to equities, but to those equities with lower volatility in their income streams, rather than volatility in pricing.
While international bonds have had good returns recently (Vanguard international fixed interest has returned 8.64% for the three years to April 30, 2011), that strong performance is likely to be eroded in the coming years because of twin factors of Australia’s high exchange rate returning to normal and ongoing low interest rates in the United States.
Underlying Legg Mason’s argument is that investors need to have more of their money in assets that have already strong income streams (yields and distributions), but are also in industries that will have some protection against inflation because those assets’ performances are tied to the general economy.
“The Superannuation market has to date not done a good job at targeting products to specifically meet the needs of low and 0% tax payers. Australian equities offer retirees unique advantages through franking credits on dividends as these are fully passed through to 0% tax rate investors. Ignoring this franking pass through forgoes significant return,” Legg Mason correctly point out.
Given the problem of longevity, dipping into capital to prop up decreasing income streams is a serious concern. Dipping into capital to fund income requirements means less capital to earn income on for next year.
Legg Mason suggests it would probably be more wise to almost ignore the shift from gradual defensive shift from a 70-30 growth/income asset split to a 30-70 asset split. Maintain the 70-30 asset split, but keep more a focus on income from the 70% that is in the growth sector.
“At this point, retirees will not just need return in the form of income; they’ll need sustainable growth in that income to maintain their spending power, ensuring they can retire in comfort. That dividend stream will need to at least match inflation so they can meet future rising costs, such as increased utility bills,’’ Legg Mason says.
“(The) Australian equities market delivers franking benefits to Australian retirees but not all stocks on the ASX are suitable from a dividend paying perspective. High growth companies such as mining stocks naturally don’t pay significant dividends. It makes sense to focus a retiree’s Australian equity portfolio on naturally more mature businesses that produce surplus cash flows and hence high sustainable dividends.
“The emphasis on the word sustainable needs to be highlighted here. Companies with excessive debt levels and those that may face dilutive re-capitalisation risk should also be excluded from a retiree’s portfolio. This also talks to building a fundamentally lower risk portfolio for retirees from the respective asset classes like Australian equities and the real asset space to deliver on investor preferences for lower volatility of capital.”
“Real” assets, according to Legg Mason, are infrastructure and property.
The main reasons?
The first is that Australian equities provide a yield off a growing asset base. With shares, a dividend yield of 3.5% on $100 worth of assets this year will become a 3.5% yield on a base of $105.50 in a year (assuming constant growth).
And bonds are not without volatility in their pricing. The volatility in income from Australian bonds is 4%. The volatility in Australian share prices is 17%. But the volatility in income from Australian shares is just 8%. (Figures from Legg Mason.)
Where does that leave SMSF investors? All super funds have a maximum tax rate of 15%, but those who are in pension phase have a 0% tax rate.
The main point of Legg Mason’s argument is that the shift with age from growth to income in a portfolio, particularly in SMSFs, doesn’t make sense if you want to maintain the income from your portfolio in retirement. There are many Australian companies, infrastructure assets and property investments that will provide the income streams required to sustain rising expenditure in retirement.
If a super portfolio is to be “de-risked” in retirement, then perhaps that can be achieved by changing the nature of the equity holdings that make up the growth aspect of the portfolio.
While the following are not recommendations, this could be achieved by a shift from the likes of BHP and RIO, to the likes of Woolworths and infrastructure assets – those that pay reasonable dividends and should have growth aligned with growth in the broader economy.
Eureka Report readers are aware of the benefits that franking credits can have to super funds. And while there is plenty of research that argues that portfolios that are focussed on income at the expense of growth will suffer worse performance from a total shareholder return perspective (TSR includes income and growth), than the total returns offered by growth stocks, the security of strong and rising income returns, for the loss of some growth, will be an easy decision to make for many.
Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.