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Don Hamson
Expert
+ Don Hamson

Don has twenty five years investment management experience and founded the Manager in 2006. Don is an equity holder in the Manager. Don has considerableexperience at managing equity portfolios and has written a number of white papers on after tax investing and has spoken at many conferences and seminars on this subject. Prior to founding the Manager, Don was Head of Active Equities, Asia Pacific and a member of the global Senior Management Group at State Street Global Advisors,responsible for over $10B in active and enhanced equity investments.

Don previously held various positions at Westpac Investment Management, including Chief Investment Officer, Head of Equities where he managed the $1B Tax Effective Share Fund, a Westpac appointed director on the board of Hastings Funds Management and was instrumentally involved in the mergers of BT and Rothschild. Prior to Westpac Don was a senior analyst atQueensland Investment Corporation.

Don was a Lecturer in Finance at the University of Queensland (UQ) for six years, and was a Visiting Assistant Professor at the University of Michigan Business School. Don has a PhD in Finance and aBachelor of Commerce with First Class Honours and a University Medal from the University of Queensland.

Top tips for investing in retirement

Friday, March 31, 2017

By Don Hamson

Retirees are treated differently from a taxation perspective, are more reliant on an income stream from their investments, and likely to have a lower risk tolerance, so it makes sense that they would take a different approach to investing.

Dr Don Hamson has spent the past decade thinking about the things that pension-phase investors need to consider when investing in equities and shares. Outlined below are his top tips for making successful investments in retirement.

1. Tax matters - but not in the way you think

Retirees have different needs to accumulation phase investors, and tax is one of the big differences. In particular, the role of franking credits is crucial, while capital gains tax is not an issue at all.

One failure of the Australian investment industry is that franking is largely invisible, with investment returns conventionally reported pre-tax, excluding franking. Pick up almost all investment surveys in Australia and there will be no mention of franking credits.

But for a pension-phase investor, the difference is significant.

Chart 1 highlights the tax differences between pension, super and the highest individual tax rate. For the pension investor, $1 of pre-tax capital gain (short or long) or unfranked income (interest, rental, overseas dividend, unfranked dividend) is worth $1. However, $1 of fully franked dividend is worth $1.43 since the pension investor gets a $0.43 franking credit refund. Franked dividends are also worth the most for super investors at $1.21, with long-term capital gains worth $0.90 while the other two returns are worth $0.85.

This clearly highlights why taxed investors would prefer low turnover strategies to reduce the time value of capital gains tax (CGT). However, for pension investors there is no cost to realising or delaying realising a capital gain, as they pay no CGT. So the common perception that low turnover strategies are tax efficient is not correct for pension investors.

Chart 1. The After-Tax Value of $1 of Pre-Tax Return


Source: Plato, ATO using current tax rates, including Medicare and Federal Deficit Levies

2. Income matters - and so do franking credits

Retirees have different needs to accumulation phase investors. They need income to live off, are likely to be less risk tolerant than working investors, and their investments within pension-phase superannuation are tax free.

This should be reflected in both the design of retirement-phase products, and in the way they’re measured.

When assessing investment products for retirees, some of the most commonly used benchmarks can be a blunt instrument. Generally, income returns are calculated without regard to tax or franking credits, while observations that Australian shares have suffered from a ‘lost decade’ of poor returns don’t give sufficient credence to the income generated over that time.

On its own, price growth of Australian shares is underwhelming. Over the 10 years to the end of 2016, the ASX/S&P200 price index has tracked predominantly sideways as highlighted in Chart 2. In price terms, it started where it finished, and still hasn’t got back to its pre-GFC highs recorded on November 1 2007.

Chart 2. Australian shares over the past 10 years to 31 December 2016


Source: S&P

But equity investing is not all about capital growth. When dividend income is added, the Australian ASX/S&P200 has actually returned 4.5% p.a. over the past 10 years to 31 December 2016. Not a great return, in our opinion, but certainly better than 0% for capital growth. The average official overnight cash rate averaged 3.8% p.a., while the average one-year term deposit interest rate averaged the same 4.5% p.a. as the dividend yield, both over the same 10-year period.

However, the 4.5% p.a. term deposit income didn’t include franking credits, which the dividend income stream did. Australian pension phase superannuation investors get a full refund of franking credits, so for them, franking credits represent extra income.

Using the S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt) we calculate that franking credits have increased the total return for tax exempt investors like pension-phase super, charities and low income Australian investors by 1.6%p.a., giving a tax exempt total return of 6.1%p.a., over the 10 years to 31 December 2016.

Chart 3 highlights the difference in return from an investment in the Australian S&P/ASX 200 price index, S&P/ASX 200 accumulation index and S&P/ASX200 accumulation index including franking for tax exempt investors.

Chart 3: Australian S&P/ASX200 cumulative returns with and without dividends and franking credits – 10 years to 31 Dec 2016 based on investment of AUD$10,000.


Source: S&P. Price = return on Australian S&P/ASX200 Index; Accumulation – return on S&P/ASX200 Accumulation Index; Tax Exempt = return on S&P/ASX200 Franking Credit Adjusted Annual Total Return Index (Tax Exempt).

3. Growth matters - even in retirement

Ultimately, income has to be generated from underlying capital, so most pension-phase investors need to protect - and even grow - their nest egg. This total return focus is key to managing longevity risk and when done well, it’s why shares play an important role in retirement portfolios.

Even as an income-focused investor, we believe in building portfolios that generate capital growth over longer time periods, despite the subdued capital growth of the Australian market over the past decade. For instance, since the start of 1980 to the end of December 2016, Australian shares have risen approximately 10 fold in capital value, with dividend income growth generally keeping pace with that capital growth.

So, while retirees might be currently attracted to Australian shares for income, we believe it is a good idea to ensure that one captures both the income and capital potential from Australian shares over the longer term.

4. Regulation matters - pension asset tests have moved the goalposts

This year has already presented a number of challenges for self-funded retirees. The government’s asset test changes have crimped part-pensions for many people in addition to the raft of new superannuation rules set to take effect in July.

Looking at the first issue, the impact is significant. We estimate that a home-owning couple with $800,000 in other assets had (until 2017) received $567.15 per fortnight in part pension and we expect this will fall to just $47.70 per fortnight, a reduction of over $500 per fortnight or $13,500 per annum. Similarly, a single home-owner part pensioner with $550,000 in assets will miss out completely on a part pension, losing some $365 per fortnight or nearly $10,000 per annum.

So what can pensioners do to offset the pension changes? The government suggested1 that part pensioners can make up for the loss of income by drawing down on their assets. For instance, in the $800,000 couple example, the pension reduction can be offset by drawing down 1.7% of that $800,000 in assets each year.

Alternatively, if the $800,000 in assets earns 7.8% p.a., then based on our calculation the pensioner can offset the loss in part pension without drawing down. We think this is a better option, and is more consistent with the way pensioners behave.

Can a 7.8% p.a. return be achieved in the current low yield environment with Australian official cash rates currently at 1.5% and 10-year Australian Government Bonds currently yielding less than 3%?

It will certainly be difficult, particularly for conservative strategies with large weightings to cash and bonds.

Thankfully, Australian equities provide some of the strongest income opportunities available in the world today. For an Australian pension-phase investor who gets a full refund of franking credits, we’ve shown that the S&P/ASX200 yields approximately 6% p.a.* in income with about a quarter of this due to franking credits.

But high-yield Australian equities have the potential to earn even higher rates of income. For instance, Australian banks currently yield around 8-10% p.a. on a grossed-up basis for franking.

However, pension investors need to balance risk and return, and so putting all their eggs in the Australian banking sector may not be a wise strategy. Pensioners investing at least part of their assets in well-diversified equity products (both Australian and Global) that produce the required 7.8% p.a. return should help preserve their capital base.

Overall, I believe that strategies dedicated to managing from a pension perspective are better placed to maximise returns and income for pension investors than the traditional “one size fits all” approach adopted by most Australian fund managers.

* Total return of 6.1%p.a., over the 10 years to 31 December 2016 for S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt).

[1] http://www.budget.gov.au/2015-16/content/overview/html/overview-26.htm

Author: Dr Don Hamson, Managing Director, Plato Investment Management.

This is a sponsored article from Plato Investment Management.

Plato Investment Management Limited is a Sydney-based Australian and global equities boutique with over $3.5 billion in funds under management. On 9 March, the first listed investment company (LIC) managed by Plato launched. The LIC is open to Australian investors, providing the opportunity to invest in an actively managed, diversified portfolio of Australian shares with an income focus. To learn more, visit www.plato.com.au.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

 

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