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Greetings!
Welcome to the latest edition of The Financial Fortnight That Was. This edition looks at the level of investments needed in retirement, provides a summary of the movements in markets over the past fortnight and looks at the impact of fees on managed fund performance. We hope that you find the material informative and relevant. Enjoy the read!
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A Quote for Consideration
"Some investments do have higher expected returns than others. Which ones? Well, by and large they're the ones that will do the worst in bad times."
William F. Sharpe Nobel Laureate in Economics, 1990, Stanford Professor of Economics, as quoted in Money Magazine's July, 2007 issue
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Financial Topic Demystified
Level of Investments Needed in Retirement
A common question we are asked in our meetings with prospective clients is what level of financial assets will be needed in retirement? Sounds like a simple question but there a number of factors that need to be considered.
The following is taken from Scott Francis' Eureka Report article - Tap your super, but how much? published 18th February 2008.
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One of the most profound questions we face in planning our financial future relates to how we turn a lump sum (such as our superannuation balance) into an income stream. For people at, or close to, retirement this is significant because it is how much of their future life will be funded. For people thinking ahead to retirement this is also crucial because it builds a picture of how much is needed for retirement - or for stopping work early and living off their assets.
The Government has been kind to people planning the process - judicious use of superannuation means that most people can ignore tax because at retirement the income stream from a superannuation fund is tax-free (if over 60 and, in practice, for the majority of people over 55).
That means we can ignore tax consequences, but it does not help us calculate the rate at which we withdraw money. The research on withdrawal rates shows that the rate at which we can withdraw money from a lump sum is related to the mix of assets we have: more growth assets (shares and listed property) mean a higher expected return, which allows a slightly higher drawdown rate. (The drawdown rate is the percentage withdrawn from a portfolio each year - a 4% drawdown on a $1 million portfolio is $40,000 a year. Throughout this article the drawdown rate also assumes that drawings increase each year with inflation).
Among the best work done in this are is two research papers, both from the United States; they offer very interesting thoughts on the drawdown process. It is important to consider this issue of drawing from a portfolio in an Australian context, which is subtly different from the American experience, and we finish by looking at this.
The first paper, Asset Allocation and Long Term Returns, by Stephen Coggeshall and Guowei Wu of Morgan Stanley, was published in July 2005 by the Social Science Research Network.
What is the best mix of stocks and bonds to use as an asset allocation for a portfolio that is being drawn from? Bear in mind that Coggeshall and Wu's article is US-based. It uses data from a period of almost 80 years - 1926 to 2004.
It starts by looking at the returns from holding shares for different periods of time, and holding periods started in each year of the study. For example, in looking at the 20-year returns, it looked at periods starting in 1926, 1927 and so on. It found that although the average annual return from shares was just over 11% for the period of the study, the period of time shares were held was crucial in managing the volatility of a portfolio.
- Over one year share returns ranged from - 44% to 61%.
- Over five years, - 14% to 28%.
- Over 10 years, - 3% to 20%.
- Over 15 years, 0.5% to 19%.
- Over 30 years, 8.3% to 14%
The study then looked at the returns from bonds, the proxy for fixed interest investments. It considered only high-quality fixed interest investments, rated AAA and AA.
Bonds had a significantly lower return - 5% over the period studied. When bond returns were compared to stock returns there was a 90% probability over any five-year period stocks would outperform bonds. Over 10 year periods that increased to 95%. Over 15 years it was 99% certain that stocks would outperform bonds, based on the author's data. This led them to state, "Bonds are riskier than stocks for holding periods of about 15 years or greater."
It also raised the question of asset allocation: how much of a portfolio in stocks and how much in bonds (high quality fixed interest)? For shorter-term needs - up to 10 years - bonds are favoured. However, for the part of the portfolio that has a timeframe of more than 10 years, where you can be confident at the 90% level that stocks will outperform bonds, then stocks are favoured. Given that many people are looking at 30, 40 and 50 year retirements, then a strong allocation to stocks is implied.
The second article, Guidelines for Withdrawal Rates and Portfolio Safety During Retirement, by John J Spitzer, Jeffrey C Strieter and Sandeep Singh of the State University of New York, appeared in the US Journal of Financial Planning in October 2007.
This paper was similar to that by Coggeshall and Wu in acknowledging that asset allocation - particularly the amount of the portfolio exposed to growth assets - was important in determining how long a portfolio could fund retirement.
In this case, a 30-year retirement was assumed - which is probably reasonable for someone thinking about retiring at age 60 and living to age 90.
The paper looked at various asset allocations between stocks and bonds (high-quality fixed interest investments). It then expressed as a percentage your chances of running out of funds prior to the end of the 30 year period. It found:
For a portfolio with 30% exposure to growth assets:
- Almost 0% chance of running out of assets if you drew on them at 3% a year.
- 5% chance of running out of assets at 4% a year.
- 25% chance of running out of assets at 5% a year.
- 40% chance of running out of assets at 5.5% a year.
For a portfolio with a 60% exposure to growth assets:
- Almost 0% chance of running out of assets at 3% a year.
- 7.5% chance of running out of assets at 4% a year.
- 18% chance of running out of assets at 5% a year.
- 27.5% chance of running out of assets at 5.5% a year.
For a portfolio with a 90% exposure to growth assets:
3% chance of running out of assets at 3% a year.
10% chance of running out of assets at 4% a year.
20% chance of running out of assets at 5% a year.
25% chance of running out of assets at 5.5% a year.
It is interesting to note that there is actually a small increase in the chances of running out of money in portfolios where the withdrawal rate is small when the exposure to growth assets is increased. This is because if you start with a high exposure to growth assets, and there is a strong collapse in the value of growth assets, this will negatively affect your portfolio value.
The Australian context and income
I see two practical differences between the Australian and the US markets (where these papers were written). Although the returns from markets have been very similar, the makeup of returns is different. Australia has the benefit of franking credits, which allow the tax-effective payments of dividends. While the yield of the sharemarket is currently 3.6%, add to that franking credits and the gross yield increases to 5% a year.
We also have a well-developed listed property market segment, which is characterised by the payment of strong income - even if the income is not as strong as it has been historically. Currently the income is 6% a year.
A portfolio made up of cash (yielding 6.25%), fixed interest investments (6.75%), Australian shares (5% gross) and listed property (6%) means that the income of the portfolio would allow a drawing rate of about 5.5% - without having to touch any capital.
The only risk to this income stream would be a decrease in interest rates, and therefore lower interest being received from the cash and fixed interest investments.
An advantage of the Australian situation is the generous access to the age pension. People with less than $839,500 can receive some part-age pension under the more generous asset test that came into force in September last year. For many people this many act as a "safety net", were they to receive very poor investment returns for a period (such as a repeat of the 1987 sharemarket crash or a period of very poor returns like the early 1970s). This may encourage people to be more aggressive in their asset allocation in pursuit of higher returns, with the knowledge that there is a safety net under them.
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So how do we apply this for our clients?
When thinking about how to draw money from a portfolio, this cannot be done in isolation from the asset allocation of the portfolio. A drawing rate of up to 5.5%, increasing with inflation, seems to be achievable, provided the portfolio value is monitored over time. (Remember, the minimum withdrawal rate from a fund in pension phase is 4%.)
Basically, this means that someone requiring the equivalent of $55,000 of income in today's dollars in retirement would need financial assets of $1 million (in today's dollars) to sustain this rate of draw down. (N.B. This is a very general calculation and individuals should get specific financial advice relating to their particular circumstances.)
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On the Lighter Side
Three market analysts went out hunting, and came across a large bear. The first analyst fired, but missed, by a metre to the left. The second one fired, but also missed, by a metre to the right. The third analyst didn't fire, but shouted in triumph, "We got it! We got it!" |
Market News
Market Indices
Since our previous edition, Australian and global sharemarkets have continued to experience downward movement. The S&P ASX200 Index has fallen 2.59% from the 7th to the 21st of March. It is now down 12.53% from the same time last year and down 19.12% for the calendar year (2008) so far. The S&P Global 1200, a measure of the global market, has fallen 0.28% over the same period. The index is down 6.03% from the same time last year and down 11.20% for the calendar year so far.
Emerging markets have also experienced negative movement with the MSCI Emerging Markets Index falling 4.69% since the 7th of March. It is still up 10.92% from the same time last year but down 15.13% for the calendar year so far.
On the other hand, Property trusts have experienced positive movements since the 7th of March with the S&P ASX 200 Property Trust Index rising by 2.61%. However, the index is down 31.60% from the same time last year and also down 23.65% for the calendar year so far.. The S&P/Citigroup Global Real Estate Investment Trust (REIT) Index, a measure of the global property market, has risen 4.57% over the same period. It is down 23.79% from the same time last year and down 5.47% for the calendar year so far.
Exchange Rates
As of 4pm the 20th March, the value of the Australian dollar had fallen since the 7th of March with the Aussie dollar down 1.45% against the US Dollar at .9154. It is up 14.11% from the same time last year and up 3.83% for the calendar year so far. Since March 7th the Aussie has fallen 1.99% against the Trade Weighted Index now at 68.9. This puts it up by 5.19% since the same time last year and up only 0.29% for the calendar year so far. (The Trade Weighted Index measures The Australian dollar against a basket of foreign currencies.)
General News
Since our last edition the Australian Bureau of Statistics has released the latest employment with Australia's unemployment rate falling to 4.0% for February 2008. The ABS has also released the latest population estimates suggesting that the population had grown by 1.5% for the year ended 30th September 2007.
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Courier Mail Article Update
Since our last edition Scott Francis has had an article of his published in the Money section of the Courier Mail - 24th March edition. Click on the link below to be taken to this article:
Grab hold of the dividend or reinvest? - Scott looks at the pros and cons of receiving dividend payments or reinvesting them through a company's dividend reinvestment scheme. |
Why the ASX is making retirees see red - but their financial adviser should be making themsee past the red? Scott's Financial Happenings Blog - Posted Monday 24
March 2008
Saturday's Australian included an article from Geoffrey Newman, 'Seeing red - retirees have a lot at stake when the stock exchange takes a tumble'. There is no doubting the assertion contained in the headline. As retirees move from relying on personal income earning activities such as work and small business ownership to a more passive approach of income earning through investments. For most retirees, to achieve the income levels they require (after taking out the effect of inflation) will involve investing in volatile asset classes such as stock markets.
But how much should a retiree have invested this way and what is the real impact on their investments if stock markets fall?
The article written by Newman quotes Hans Kunnen, head of investment research at Colonial First State. Kunnen suggests that most good financial advisers should be putting two to three years of income in cash and the rest in growth assets. We disagree slightly with Kunnen and suggest that at least four years is a more realistic allocation to non-volatile assets such as cash and fixed interest securities. Here's why.
As a minimum, investors should be looking to protect against having to sell volatile shares for a period of 7 years. This does not totally count out having to sell down volatile assets after a long period of downward movement, there have been bear markets for longer than 7 years, but the risk of having to do so is significantly reduced.
By holding four years of income in non-volatile assets, you are able to draw down on these assets plus have these assets added to through income from investment returns. At present levels, cash interest is running at approximately 7%, fixed income 7.5%, Australian share dividends 4.1% plus 1.4% franking credits i.e. 5.5% in total, international share dividends of 3% and listed property distributions of 7.3%.
Similar income returns going forward should see non-volatile assets last for at least 7 years before needing to contemplate the possibility of selling down volatile assets during a bear market.
Therefore, our approach at A Clear Direction is to focus on income planning with our clients. The key question we ask is how much income a retiree will require in retirement. From this point we then determine what allocation of assets will be required to produce this amount of income without needing to sell volatile assets such as Australian shares, property (direct or through listed property trusts) or international shares. In particular how much of the portfolio should be held in cash and fixed interest securities.
Through this process of determining asset allocations when establishing and maintaining an investment portfolio, investors, especially retirees, will be putting in place a strategy to be able to ride out bear markets without actually realising any capital losses by selling volatile investments at the worst possible time. The paper value of their investments will fall but paper values don't matter until they become realised through changing non-cash items into cash. Based on historical evidence, volatile assets will bounce back in value and restore, and then improve their value.
This approach does not make investors immune from the emotions caused by rough times like we are experiencing now, but it sure helps them sleep a bit easier at night.
Regards,
Scott Keefer
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We hope you have enjoyed reading the latest edition. If you have any comments or suggestions for future topics please do not hesitate to get in contact.
Have a great fortnight!
Cheers,
The Two Scotts
The Financial Fortnight is a publication of A Clear Direction Financial Planning. It contains general financial advice. Readers should check this advice with a professional financial adviser before acting on any of the material contained in this email. |
Scott Francis & Scott Keefer
1 Park Road - PO Box 1688
Milton QLD 4064
(07) 3876 6223
A Clear Direction Financial Planning is an Authorised Representative (No. 283723)
of FYG Planners Pty Ltd ABN 55 094 972 540
Australian Financial Services Licensee (No. 224543)
Registered Office: Level 1, 10 Wilson Street Burnie Tas 7320 | |
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