Yesterdays People by Gail Gibson - HTML preview

Chapter 17: Making the money last

In this section we will tell you exactly what investment is about. We will deal with investments in more detail in our series on wealth. In this chapter we will give you an introduction so you know what you need to have in a portfolio. I am going to start off giving you a warning.

All investments carry some degree of risk, and one of the most effective ways to manage this risk is through diversification, or by spreading your investments across different asset classes such as cash instruments, property, bonds and equities, as well as across different regions and sectors.

Most financial advisors will tell you that they want you to be invested in safe (cash based) investments and they will be most likely be wrong, unless you have oodles of cash, they are condemning you to a life of poverty if you survive too many years. Remember we expect to live twenty to forty years after retirement and advisors have been trained to think of ten years as a maximum.

Cash is the safest investment type but it will not serve you well if you survive for more than a few years after retirement.

Cash makes people feel safe! We find wealthy people with very little cash may still feel more financially distressed, than poor people with relatively more cash. While cash is part of the hierarchy of retirement income needs for a retiree, we know the same effects are felt by people in their mid-30s holding cash- namely, that they feel wealthier than people with investments that are not cash.

We therefore need to deal with the psychology of cash.  If you are educated, then you are able to deal with this psychology and you will be more likely to be emotionally OK without wads of cash. We recommend holding some cash during periods of volatility, but want to make you able to remain solvent, keeping you invested in other asset classes.

If you have a twenty to thirty year life expectancy you should feel better about being invested for the long run in a mix of equities and other investments.

Since we need to educate you to be less likely to be panicked when markets are volatile, I will start by introducing you at a high level to my world of finance.

Risk

Risk is simply the chance of between 1-99% of events turning out differently than you would expect. People are created differently. When something happens we call it an issue and then it is dealt with as a fact, but risk is not a fact, it is a situation that may occur. People deal with risk differently. Risk in financial planning for retirement, is the chance you will lose some or all of your money.

I am more risk adverse than my husband, but less risk adverse than my daughter- that’s okay because it means we get a balanced view of our risk by using three different risk profiles. A person who enjoys gambling, is inclined to enjoy risky investing, but then you have the person that panics when they lose any money at all. That person is risk adverse. Unfortunately, to make money you need to take some risk. Even cash can be a problem as banks can go into insolvency and inflation can erode the buying power of your money. Fear and anxiety about market behaviours (volatility), coupled with a low-growth environment, often drive retirement investors to low-risk investment options such as cash, in an attempt to protect their capital.

How much risk to take, is a personal question and depends on many factors. The most important is how many resources have you got? The more resources you have, the more risk you can take.  Fortunately many people have studied risk and as a result have created what we can call optimal portfolios for retirees.

Investment types

There are many different investment types which we use for retirement funding. Let’s have a quick look at them and how they tie into risk and the length of time or term that we need to hold them.

The standard investments which we normally use are equity- shares, cash (Deposits, income and money markets), bonds and property.

Equity

Investments in equity are in shares and these shares are traded on a market (exchange). There are different types of shares and each has a risk attached to it. As a rule we want a share that has good dividend income and the price of the share grows by inflation.  The dividend, is the profit in a company and declaring a dividend allows for part of those profits to be divided between the shareholders. The dividend yield, is found when we look at the price of the shares and the dividend that is declared. For retired persons we want high dividends, so we look at the more mature companies. A technique called fundamental analysis is used to ensure the company is still a good buy, in a managed share portfolio. Fundamental analysis looks at the fundamentals of the company, including the sector in which it operates to ensure the products are still good for the sector. They will also look at the country they operate in and the risk in those countries.

Another method of analysing shares is technical analysis- this is where you use graphs to map trends to determine the correct price for a company’s shares.

Shares are also known as securities or equity. Such investments vary considerably. Good quality shares are good for the retiree since they have a built in inflation beater, called dividends and additionally should provide capital growth. The companies will want to grow their markets and hopefully bring in more money to give higher dividends, which keep pace with inflation. The share price will vary considerably during the company’s life time, depending on various factors, not always related to the company itself. These factor are just like any other market, since the share price is based on a willing seller and willing buyer, so it will depend on how many sellers of shares there are, to how many buyers of shares want them. Trades in shares will be executed at the prevailing market price, quoted by the relevant recognised exchange for that security, at the time the stockbroker executes the trade.

The easiest way for an ordinary man on the street to own shares is through a wrapper, such as a mutual fund, collective investment scheme or unit trust. The share ownership in these wrappers may be managed by a portfolio manager, who will charge a fee for the service. We call using a portfolio manager active investing, as the portfolio manager or managers should be able to beat the market performance of the same share portfolio that is not managed.  A portfolio that is not managed is a passive portfolio and often goes by the name of an exchange traded fund or ETF. History has not been kind to most active managers, as many have not really justified the cost of their portfolio management fees in recent years.

For those who dislike the risk in share ownership, there is an alternative.  It is known as a smart beta fund or shares. Beta is the term used to measure risk. When the term “smart beta” is used it simply means the unit of return is greater for the unit of risk. Smart Beta is a blend of active and passive investing because it follows an index, and considers other factors in choosing the stocks from the index. It is also known as passive smart indexing investing. Smart Beta funds don’t have managers trying to beat the market, making them cheaper than a traditional actively-managed fund, but more expensive than a passive portfolio.

We have to use equities in a portfolio, as historically equities will provide the highest returns in the long run.

Property

Property follows equities in return, but the risk may be higher.

You can own property in a direct form- we call that bricks and mortar, or indirectly via a professional property management company.  Property has two legs in income producing- it can bring in rental and provide growth. You can speculate by buying a property to sell, at a hopefully higher price, or buy to let (rent). Unfortunately property also has direct costs- costs of ownership, other than the purchase price, these costs include municipal charges, maintenance, damage, loss of rental income and the threat of area degradation. Unlike the share markets, property markets move very slowly and there will be years when prices will not move at all.

To buy a property to rent look at:

• Income (rental) producing –can the growth outpace inflation and will the rental pay the bond?
• Positioned for capital growth – will grow in real value over time?
• Location
• Easy to maintain – watch out for those gutters, geysers and gardens!
• Easy to manage – keep an eye on let-ability, can you outsource management easily?

Many people buy a flat to rent out in order to bring in income, but often find the costs and time to manage this investment outweigh the income. Understanding the tenant market demands, when buying, is not easy and pitfalls are many. Before you commit to buying property, it’s important to calculate the potential yield on the property. Good research can mean the difference between having a sound investment and a monthly expense. A single property can give a high risk to the investor.

Using a property fund, which invests in publicly-listed real estate companies may give you residential, industrial and retail properties. By investing in a fund, you can have stocks in different properties types such as shopping malls, office blocks, and townhouses, this lowers the risk of property investment. Property performance will be dependent on factors such as the country growth and business investment in the country.

Investing in property syndicates, with single developments, is an area to exercise extreme caution, unless you have money to lose. Rather go with established and listed property funds.

Bonds

Bonds will give a higher return in the long run than cash, but have not beaten property and equities.

The bond is a loan instrument. When you loan someone money you want a reward, for the risk you take, in loaning the money. Bonds are loans the bondholder (the investor) makes to the issuer in exchange for the return of the investor's principal (initial amount paid to buy the bond) plus interest (coupon). Bond interest is called a coupon because, before electronic trading, investors were given paper certificates when they purchased a bond, and attached to each certificate were coupons for interest payments. The owner of the bond would detach the coupon and take it to the bank where they would receive their money.

Bonds are good for stabilising the portfolio, as payments to bondholders are normally honoured. Junk bonds are an exception to this rule, as the issuer of the bond may not be able to make the bond payment. Bonds have different time periods from short term of 1 to 5 years to long term bonds that are 30 years from maturity. Maturity is when the bond pays the capital back to the investor. One of the ways people can create a retirement portfolio is to purchase bonds with a maturity rate that ties into the different times. We call this a bond ladder, and as an investment strategy it has limitations, since inflation and the length of life are not known.  Bonds can have fixed or floating interest rates. Fixed rates stay the same throughout the bond’s life. When you buy a bond of 1 million with a fixed 6 percent coupon, you receive 6 percent of the 1 million in interest every year. Because the bond pays 6 % to you, if the interest rate falls then the bond price will increase on the open market as people will want to lock into a higher interest rate. The bond will increase in price. If the interest rate goes up, the bond becomes cheaper.  If the bond has a floating rate when the interest rate changes, it will change the amount you receive as the coupon.

Some financial advisors put bonds into the cash category, as they bring in income - I do not. A bond price can be volatile and can easily lose money, if you need to sell in a hurry. When stocks fall in price (a bear market) bonds often offer the better value, and diversify the risk in a portfolio.

For this reason some bonds should be held in all portfolios. However certain countries have bonds that return negative amounts. While capital is guaranteed, negative returns do not appeal to me.

Cash

Cash is the safest asset class, but it provides the lowest return in the long run. The cash amount a retiree should have is dependent on their own personal circumstances but at least three months cash reserves should be on hand at all times. I like money market and income funds as the interest they return is higher than in a normal savings account. The money is normally available in 24 hours in these money market funds. The drawback is the high minimum amounts needed to be left in the funds to keep the account open. Deposits should only be used to lock in high interest rates or for those people who tend to be undisciplined with cash amounts.

Foreign investments

Fund managers will chase high returns across borders. In emerging mar from geographical and political risk to investment performance and currency risk.  Currency risk can be explained as buying a book today for ten currency units, but tomorrow that same book costs nine currency units, so you have made a 10% loss in buying that book.  IT can also work the other way, in which case the book is an appreciating asset. Buying in a foreign market is considered a higher risk due to these factors.

Endowments

Endowments are an insurance provided wrapper for your underlying assets, a bit like a plastic bag for a number of sweets. This plastic bag is an expensive investment, cost wise, but the endowment is a good savings vehicle for high tax paying individuals. An endowment should not be used for anyone that has not first used the tax free or retirement tax deductions available. If there is a tax deductible interest amount, then this should first be used, before considering an endowment. Endowments suit wealthy people and trusts, but are often miss-sold to other investors, as they pay high commissions to the financial advisor. They are expensive administration wise and have early withdrawal penalties. My hackles rise when a financial advisor offers them to certain clients as they are not a good choice in investment vehicles.

Low-tax income is created in an endowment, by making partial surrenders of the policy. The tax is paid by the insurance company at a determined fund tax rate on the gross interest and net rental income earned by the investment. This is advantageous to investors with a marginal tax rate exceeding that fund rate per annum. However, a capital gains tax liability is incurred by the investor who buys a second-hand endowment policy to get these low tax surrenders. If you have a marginal tax rate of 40% and the predetermined fund tax rate is 30%, then you can see the investment makes sense. However if the marginal tax rate is 30% or lower, then the person will pay more tax in the fund than in their personal capacity.

For the high tax investor the endowment does give some advantages. Since the benefits are tax-free on maturity, the investor need not take the proceeds when the policy matures. Instead, the proceeds can be left with the life office and allowed to continue to grow as a tax-sheltered investment. The investor then can partially surrender a portion each year as a tax-free income to supplement their income.  For example if the policy  grows at 9% per annum, the investor can withdraw the 9%, free of tax, without decreasing the capital or getting taxed on the income.

Spending in retirement

A good financial planner will break the asset allocation across stages recognising the changing needs of the investors across the lifecycle. They will understand that spending behaviour will change throughout the retirement phase.

You are hearing the term financial planner in this section. I must explain what this designation means. It is given by a professional financial organisation which is internationally respected as the pinnacle for financial advisors to aspire to. As a Certified Financial Planner, you should be more educated and better trained than regular a financial advisor, when it comes to giving advice for retirees. Financial planners, have intensive and on-going training to carry the designation certified Financial Planner. In this training we are taught to look at three distinct phases of retirement. Effectively for every 5 years a retiree ages, the spending is expected to reduce in by approximately fifteen percent (15%). Understanding this trend and being able to work out the inflationary value of the currency at that point means we can create target date funds or life stage portfolios to suit the retiree.

Portfolios

A portfolio is simply a collection. In our context of retirement planning it is the investments a person will have. It’s like a ladies handbag in that you put in the bag, the make-up, the money, tissues and possibly (in my case) the kitchen sink.

When we create the portfolio with the investments, we will give the overall return in the portfolio by weighting the assets return in that portfolio as a whole. Portfolio and investment returns will be influenced by:

• economic forces (such as lower GDP and investment globally);
• disruptive factors (such as regulation, technology and geographically oriented politics);
• The investment mix: and
• Investment challenges (such as unrealistic return expectations, lower returns, and people’s extended lifespan).

In a retirement portfolio we will have different assets such as; equities, bonds, cash, property and non-traditional investments. In equities we may have different classes of equities. Risky but high performing shares, and low risk shares that may give us a good dividend (income yield) or growth shares that we believe will grow to help us cope with inflation twenty years down the line.  You may be invested in various property and bond investments. Money markets and income funds may be included in cash.  You may put non-traditional investments: tank containers, collectable items and private business interests. You normally would not have portfolio items that you need for personal use, such as your retirement home in a portfolio, although these items are also considered assets in your estate. The portfolio is there to make you money. As financial planners, we may use non-traditional asset classes such as hedge funds and exchange rates.

Hedge funds are a specialised group of assets, in which ownership is not in the asset but in the right to buy or sell the asset. They are for highly sophisticated investors and beyond the scope of this particular book. We will investigate them in our wealth series.

Stock selection works hand in hand with asset allocation to provide diversification. It is important to diversify, as if some equities do not perform, hopefully the other equities, property or bonds will ensure we do not have to sell portfolio assets at a loss.

When we create a portfolio, we create to a model. For a risky portfolio we may put in the portfolio with certain requirements such as 80% or more in assets and alternatives, to diversify the risk we   maybe add 15% property, and 5% bonds and cash. We call these asset selections weighting of the portfolio. A portfolio overweight in cash will be 50% or more invested in cash investments and cash equivalents such as short term bonds. Investments are not static and will change in value. To keep the model we do a portfolio exercise in which we rebalance the portfolios, by selling high performing assets and buying low cost assets we think will perform, in the underweight asset classes. We call this exercise dynamic allocation.

Dynamic asset allocation is simply an investment strategy where an investor makes long-term investments in certain asset classes or securities and periodically buys and sells those securities in order to keep the allocations in their original proportions. Dynamic asset allocation is used to balance the asset mix in the portfolio to suit market conditions.

Dynamic allocation is important in retirement income planning. Equities are normally the growth assets and can be a villain or the hero of a portfolio. Diversification can help, but the ability to move between asset classes is fundamental in the performance of a retirement portfolio.

Life stage planning and portfolios

Another technique used to help us in planning for retirement is life stage planning. We can divide our pension years in to three stages:

1. 1st period: a continuation of pre-retirement lifestyle. You will likely copy your pre-retirement spending.
2.  2nd period: less active, health and energy begin to decline, some discretionary spending tapers off. Between 70 and 80 a retiree will normally be spending 50% less than a person in their late 50s.
3. 3rd period: most discretionary spending stops, replaced by rising healthcare expenses we expect a 10% reduction at age 80 to 85, followed by another 10% reduction at age 90.

Now you understand these stages we can help you build target date funds or life stage portfolios created to meet these phases. Just remember there is no such thing as a perfect retirement portfolio!

1st retirement period.

The first decade after retirement spending patterns reflect the interests. Interests include food, hobbies, home improvement and travel. A traditional portfolio with a standard approach is the allocation of 60 percent equity and 40 percent bonds. This portfolio mix is often preferred at this point by many financial planners. For the more risk conscious and involved retirees, they may want up to 75% of the money in equities.

The 60 % equity is put into various equity investments which may include property and offshore.

The bond investment is divided between bonds with different maturities from one to five years and cash.

We should consider all the factors continually. When we decide on our portfolio mix, we must be aware it requires periodically rebalancing the portfolio. Rebalancing a diversified portfolio involves actively shifting money on a regular basis from assets that have performed well to those that have been l