PORTFOLIO POINT: Don’t surrender to the gloom – super is a superior retirement savings vehicle. Here are some other super investment options to consider.
There appears a real danger that Australians are going to give up on superannuation as a preferred wealth creation vehicle.
A survey released this week shows disturbing pessimism. The number of people who rate super as a below average way to save for retirement doubled in just six months to more than one-third of Australians. The number of Australians who are “very” or “extremely” worried about the impact of crashing equity markets on their super fund nearly doubled from 11% to 21%.
Who could blame them? While the returns for the most recent 12-month periods for balanced funds are scary at -18%, the longer-term returns – on which the industry constantly tells investors to focus – aren’t exactly thrilling reading. Research house SuperRatings reports that for the 10 years to January 31, returns for the average balanced fund are just 4.93% a year, after fees and taxes. The five and seven year returns are similar, at 4.7% and 4.4%.
Hardly something to get you shovelling money into their super fund now, is it?
It is important to remember a few things about super.
- The tax on super is considerably less than money invested in most people’s individual names.
- The current returns on super look so sickly because we have suffered an extraordinary market event.
- Markets will eventually, inevitably, bounce back.
Take the same investments from the 5, 7 and 10-year average returns above and put them in the same, non-super investment for someone on an average salary, and the returns will be worse, purely because of the higher taxes to be paid on investments in personal names.
But we know that it can be difficult to hold the line at the moment. The All Ordinaries is teetering near five-year lows. And no-one can rule out a further step-down for the market.
So, are investors to sit on the sidelines? Or is it time for investors to broaden their investment horizons a bit?
In the neverending quest by investment houses to provide consumers with opportunities to satisfy their needs, it has been a busy start to the year. In the four weeks since the end of the summer holidays, a number of investments that have been “tailored to these trying times” have been launched. By tailoring, I mean “structuring”. And while they won’t be for everyone, there are certainly elements that will appeal to some investors.
With all structured products – and this is certainly the case with the following products – the element of protection provided within the product does come at a cost. That is, you can’t have your cake and eat it too. If you want to limit your downside, there is a price to pay, which may be having your upside limited. No matter what the product, the element that provides the insurance comes with a premium.
These costs can include:
- Upside limited to a certain percentage in order to limit the downside.
- Opportunity cost of capital protection.
- Lack of liquidity. Some products have limits on the ability of investors to exit.
The filter that I have used for this list is that it is available for SMSF trustees to invest (although they are also available for non-super investments and there may be wider options). They are not recommendations, just examples of the types of investments that are currently on offer.
This investment is designed to give people a two-year exposure to the ASX200 index with a capped upside. This style of investment is generally referred to as a “deferred purchase agreement (DPA)”. An investor can get $100,000 exposure to the ASX200 with a once-off premium.
With Link, for $11,950, an investor can get exposure to the ASX200 with the upside limited to 20%, or a gain or $20,000. The second option requires an initial outlay of $14,500 and would provide a maximum gain over the two years of 30%, or $30,000.
This is the amount at risk. If the ASX200 does not rise, or falls, over the two-year period, the investor will lose their initial investment. If the value of the $100,000 exposure to the ASX200 rises by only a total of 10% over the two years (that is, about 5% a year), then the investor will only receive $10,000 at the end of the two years, which would be less than the $11,950 or $14,500 that was initially invested.
How this might work: An investor with $500,000 to invest, who wants to participate in the market, but wants to limit the potential downside. The investor would normally have 30% exposure to the stock market. For an initial investment of $21,750, the investor could get exposure to $150,000 of Link over the ASX200. The remainder, or $478,250, could be put in a term deposit (we’ll assume the term deposit return is 4.5%).
At the end of two years, where would this investor be? At worst: If the market continues to tank, the investor will have lost the $21,750, but the interest on the term deposit will have taken the investor to $522,261. Best case: If the ASX200 does gain 30% or more over the two year period, the investor’s exposure to the ASX200 would have risen in value from $150,000 to $195,000, leaving the investor with a gain of $45,000. Add back in the term deposit return of $522,261 and you’ve got a top end possibility of $567,261.
The investor gains some exposure to investment markets (reduced risk, but limited upside). The investor knows the range in which their money will be at the end of the two years, that is somewhere between $522,261 and $567,261.
The cost and protection element? If the investor were to put 30% of the $500,000 into direct equities, and the remainder into cash, and the market were to rise by 40%, then the investment would be $592,209. If the market fell 40%, the investor would have $472,209.
Commonwealth Bank Capital Series Australia
This is a fairly typical capital protected investment, offered via a “bond + call structure” (for explanation, see boxed off area below). The investment is also linked to the ASX200. It runs for approximately 5.5 years from early April.
For super investors, a cash investment of $100,000 would give exposure to the underlying ASX200 index, with the benefit of capital protection. If the index grew by 70% over the 5.5 years of the investment, then the $100,000 initial investment would be worth $170,000.
Downsides? The investment in the index is not an accumulation index and therefore does not cover dividends.
Bond + call protection
With bond + call protection investments, the majority of the money (usually about 70-80%) is placed into a zero coupon bond (ZCB) that will grow back to the original protected sum at maturity. That is, if you put in $74 into a ZCB that is going to earn 5.5% for the next 5.5 years, you know that it will grow to $100.07, giving “protection” for the original investment of $100.
The remainder, or $26, is used to buy a call option over an index. In most cases, the manufacturer will try to ensure that the $26 will give the investor 100%, or more, “participation” to the underlying index. That is, if the underlying index doubles, then the value of the $100 original investment will rise to $200, doubling the investors money.
UBS Rolling Self Funding Instalment (SFI) Warrants
In November, I broke the story in Eureka Report that Westpac, the last of the major providers, had withdrawn from the self-funding instalment warrant market. There were a few small players remaining in the market at the time. There was talk of certain parts of the SFI market, particularly the longer dated warrants, would never come back.
UBS has now released what it claims is a new generation of SFI warrants to the market, which it calls Rolling SFIs. UBS claims this is a “next generation” SFI warrant.
They work similarly to regular SFI warrants (link to November article here). However, each June, if the underlying shares have fallen significantly, UBS can decide to not roll the SFI over, which may lead to a cashing event, or to UBS offering a new SFI with lower gearing (thereby requiring a cash top up from the investor). UBS argues that this will provide extra protection for both investor and UBS itself. The interest rate for the loan will be set each year based on the cost of the protective put option (which will be determined by the performance of the underlying stock in the previous 12-month period).
UBS’s Rolling SFI will allow SMSF investors to get additional gearing in their super fund, for those that it is appropriate for. However, the “next generation” part of the deal appears to be that UBS can terminate the warrant early, to stem losses. In theory, this should keep the cost of the warrant down.
Bruce Brammall is author of Debt Man Walking – A 10-Step Investment and Gearing Guide for Generation X