Don ‘t rely on dividends

PORTFOLIO POINT: If you’re worried about your funds’ income, listen up. The next couple of months are going to bring some shocks.

If 2008 was a “nightmare for capital”, the sequel in 2009 could well be a “black hole for income”.

With the way the investment stars are lining up, this seems to be increasingly likely and the implications for self-managed super fund trustees and self-directed investors – in particular those who are drawing incomes to survive – are serious.

What does it mean for a portfolio if some investment decisions were made based on the tenet that it would be an “unlikely event” that dividends would be slashed? Which many of us have, of course. Surely, companies, particularly the big ones, don’t pay dividends they don’t think are sustainable.

We’ll get a truer picture of this over the coming days and weeks – the first profit season of 2008 starts shortly. Companies will, for the first time comprehensively, begin to detail the damage that was caused in 2008 and detail their optimism/pessimism for the year ahead. However, we’ll have to wait until May for most of the major banks (Westpac, National Australia Bank and ANZ in particular).

SMSF trustees and DIY investors – particularly those living off, or drawing an income from their fund or investments – should have an eagle eye on their company’s dividends.

Why? Because throughout the foundation-trembling equities crash that we witnessed, healthy dividend yields were the security blanket that many were holding on to.

“Well, at least they’re still paying dividends”, or “the dividends haven’t been cut”, or “how can you lose when they’re paying a yield like this”. Much of this seems highly likely to change.

Many rely heavily on dividends and distributions as their sole form of income. For those trying to maintain the capital in their super fund, living purely off the dividends, particularly in the early years, allows members to extend the life of their super fund’s capital. This means the reporting seasons of February and May will be watched with a great deal of nervousness. For them, the declarations of dividends and their outlook will be absolutely critical.

WithAustralia’s stock market now roughly half its November 2007 high, “the market” is clearly pricing in big falls in dividends. Commercial property funds have been a bigger investment disaster than equities and have already seen distributions slashed. Cash returns are plummeting thanks to the Reserve Bank’s aggressive stance on interest rates (which is, if you rely on interest income, about to get worse). There’s a glimmer of light in the bond/fixed interest market (seeAlanKohler’s piece from January 19).

Let’s take a $1 million SMSF portfolio. Let’s say that $1 million was at the end of 2007.

(Out of interest, if the fund has taken the average sort of clip that a balanced portfolio has, then our $1 million fund is now worth, in very rough terms, about $750,000. A fall of perhaps 25% for calendar 2008 would not be unusual for a fund invested 60% growth, 40% income.)

Of the four asset classes (cash, fixed interest, property and shares), we have pretty clear indications for the sort of returns that cash is likely to produce this year. (For the purpose of this exercise, I will default to the performance of index manager Vanguard for historical performance figures.)

The income return from property (assuming Vanguard’s Property Securities Index Fund) fell by 60% to the end of 2008. The distributions declared from fixed interest (Vanguard’s Australian and international fixed interest funds) fell sharply in 2008. (However, this was made up for by rising bond values.)

When it comes to cash, the speculation is quite clear as to what’s going to happen here. The Reserve Bank has cut official cash rates from 7.25% down to 4.25% and is expected to cut far deeper in the coming months. The official cash rate could hit 3%, possibly lower. If you had 20% of your portfolio in cash, then the income from that portion of the portfolio (assuming a reasonable interest rate) has probably fallen about 30-50 per cent, comparing calendar years 2008 and 2009, depending on the RBA’s zeal. And it could fall substantially further.

So, what could we be looking at in 2009? Let’s assume a balanced fund and base it on $1 million of assets. We’ll assume the asset split is the following:

• Cash – 20%, or $200,000
• Fixed interest – 20%, or $200,000
• Property – 10%, or $100,000
• Shares (combined Australian and international) – 50%, $500,000

We’ll assume that the return on fixed interest doesn’t fall (this is, of course, possible). And for property, we’ll assume that the deep cuts in paid distributions from last year don’t get any worse, although this is also possible, as industry giantWestfieldannounced yesterday that it would likely be cutting distributions by up to 9% this time around.

Table 1: Balanced fund investment income.

For the Australian and international shares portion of the portfolio, I’ve assumed an overall dividend return of 5% for 2008. There was no great general movement in dividends during 2008. But, in looking ahead, I’ve assumed a 30% across-the-board cut. That might be a worst case scenario, as the big companies have been able to raise capital on the market to this point.

Falls of this magnitude in shares, when added to estimates for the other returns, would see the income produced by a balanced fund this year fall by nearly 22%, based on 2009 over 2008.

What can a SMSF trustee or member do?

As always, keep an eye on your direct investments and find out what they declare in the coming reporting season. If the income is that important to you, skip straight to the dividend section in the report (and then come back and read the front). It’s not just important as to what they declare as their actual payment this time, but look for what they say about the future.

Accept that some of them will fall significantly. Others might hold up, or not fall too much.

You need to take both a holistic view (what has happened to the income in your entire portfolio) and an individual view, as you can’t let someone who has always paid a dividend get away with cutting them completely.

Bruce Brammall is a financial adviser with Stantins and author of Debt Man Walking – A 10-Step Investment and Gearing Guide for Generation X.