Tag Archives: Financial Planning
Constructing a retirement portfolio in a low return world
By Robert Wright /February 18,2022/
Portfolio construction is a much-used term that can be misunderstood. Fundamentally, the term portfolio construction refers to the process of selecting investments to create the optimal balance of risk and return.
By mixing different types of investments and different asset classes, portfolios can be built in a way that maximises the return for any given level of risk.
This concept of risk is fundamental to portfolio construction. The key to effective portfolio construction is understanding that each individual experiences risk differently and investment needs change dramatically as people’s priorities change over the course of a lifetime.
Risk tolerance
Depending on what stage of life they are at, individual investors can have quite different goals.
An investor early in their career can afford to seek higher returns from their investment portfolio by taking a higher level of risk because they have more time to make back any downturns in markets.
They also have less need for income from their investments than someone approaching or in retirement and can weight their portfolio towards growth assets.
A younger investor can be less concerned about inflation than a retiree because they can rely on wages growth that can maintain their purchasing power. They can also afford to lock up investments for a longer period without worrying about liquidity because they have time before they need to draw down on their assets.
In contrast, retirees tend to be more concerned about capital preservation because they need to draw on their asset pool throughout their retirement.
As they are no longer earning income from work, they need to draw income from their portfolio. This means they should consider weighting their portfolios towards income-generating assets.
Any increase in inflation erodes a retiree’s purchasing power as it costs more to maintain standard of living which means their capital can be eroded faster than planned.
And liquidity is critical for a retiree as assets may need to be sold quickly – for example if there is a medical emergency – without punitive valuations.
The concept of sequencing risk is also a critical difference between early and late-stage investors.
Sequencing risk
Sequencing risk refers to the risk of being forced to sell investments after a fall in valuations. A younger investor can typically ride out market volatility and even buy more assets when valuations are low.
However, late career investors and retirees who are forced to sell assets at low prices to fund their lifestyles have no way of regaining the lost value. A sensible portfolio construction process can protect against this.
Hedging risk
A question that often comes up is the role of downside protection in portfolio construction. The answer is different depending on where an investor is at in their investing journey.
Take the example of a pre-retiree and a younger investor with portfolios split equally between equities and bonds going into the global financial crisis (GFC) – with and without downside protection using options strategies.
Without downside protection, the retiree would have seen a pullback in the value of their assets of about 25 per cent and, because they were drawing down on their assets to live their life, they would not have been able to fully participate in the subsequent recovery.
Had they used downside protection on their portfolio, they would have been back on track by 10 years later.
The same is not true of the same strategy deployed by a younger investor. Without downside protection, young investors just keep buying into the market through a downturn and continue to accumulate assets.
But with downside protection – which comes at a cost – they see a drag on their returns, lowering their ultimate savings. It’s a reminder of the difference between younger and older investors.
Human beings also have the potential to make mistakes in their investing lives. If a retiree investor facing the same kind of GFC drawdowns suddenly became risk-averse and shifted their portfolio to 30:70 equities and bonds, this would be an understandable and apparently rational decision to preserve assets.
But markets recover. If that retiree waits until the storm passes and takes three to five years to switch back their allocation to 50:50, they would be 30 per cent worse off than if they did nothing at all.
Asset allocation
So, what assets should retirees look for?
In our view, the key is to seek out desirable risk attributes and not simply take the approach of investing by asset class.
In Australian equities for example, franking credits offer a good income stream for retirees by refunding the tax paid by the underlying companies. It should also be noted, however, that in seeking a higher exposure to Australian equities in pursuit of franking credits, a portfolio will acquire other concentrations of risk, for example: exposure to China. Good portfolio construction should consider and diversify away these concentrations.
In direct assets, infrastructure offers good opportunities for retirees. Many infrastructure assets earn a return on an availability basis regardless of actual usage or economic conditions, providing a stable income. The key consideration for direct assets is liquidity, as holding large allocations of illiquid assets could mean having to disproportionately sell down liquid assets, like equities, at an inopportune time if larger sums of cash are needed for, say, a medical emergency.
For bonds, the traditional defensive characteristics may not be available in a world of near zero interest rates and the potential of rising inflation.
In the last 30-40 years we have seen a terrific run in markets, particularly with bond rates coming down from as high as 16.5 per cent in the case of 10 year Australian government bond yields almost 40 years ago to near zero now. The performance was further buoyed by lower tax rates, falling tariffs and the rise of globalisation.
The corollary of this is that throughout those 40 years, forward return expectations have been declining.
In fact, a fund with a traditional asset allocation split 60:40 between equities and bonds is near its highest ever valuation level.
We believe this means return expectations from investment portfolios should be expected to be lower going forward until interest rates normalise.
Inflation is also a looming threat to portfolios. US annual consumer price inflation pushed up beyond 6 per cent in October of 2021 and there is a risk that price pressures associated with deglobalisation and decarbonisation defy the widely held ‘transitory’ thesis and stick around.
Goals-based investing
Given lower expected returns and higher inflation, what’s the right portfolio response?
Doing nothing is one approach – simply accept that returns are going to be lower.
Another approach is to increase risk – adding riskier, more leveraged asset classes will improve the probability of getting a return but also increase the probability of losing money.
A third approach is to lower your expectations. This means not changing how portfolios are constructed but accepting the likelihood of lower returns and perhaps adjusting things elsewhere in your life accordingly. In our view, this isn’t of much use or comfort however to today’s pre-retirees and retirees.
And the final – and more important – approach is to adjust strategy to those areas most likely to achieve objectives. This could include taking a goals-based approach to investing.
For example, a retiree could decide that rather than taking a traditional asset allocation approach to portfolio construction, they instead want to take on the goal of protecting and maintaining their standard of living in retirement. That goal might be measured by providing returns equal to the consumer price index plus 3.5 per cent as an example.
By focusing on the desired outcomes rather than simply considering traditional asset class allocations, investors can consider including alternative investments and strategies that may not be available under a traditional approach.
Source: AMP Capital
Should you use property to fund your retirement?
By Robert Wright /February 18,2022/
Superannuation, shares, property, cash, other investments; a dizzying number of options are available when it comes to living comfortably through retirement.
Financial advisers often promote a diversified portfolio to reduce the risk of concentrating ‘all eggs in one basket’. Still, Aussies love their property, with more than 2.2 million of us opting for investing in property, with almost 60% of those aged 50 or over holding property investments.
Aside from simply owning a secure place to live through retirement, investing in property can also provide regular post-work income and might offer some assurance as a ‘safe’ investment option. Property is a physical asset and can seem less volatile than other investments, particularly when heading into a phase of life that holds uncertainty and where you may think: “What happens if I outlive my savings?”
But different risks and tax obligations in retirement can alter the attractiveness of investments and, when it comes to property, there are a range of strategies that offer different pros and cons when using it to fund retirement.
Living off rental income from an investment property
On the surface, living off rental income in your retirement is an attractive prospect. But you may need to first make sure the lifestyle you want doesn’t exceed your investment property’s returns, taking into consideration any mortgage repayments, taxes and maintenance costs, as well as factoring in for times when the property may not have tenants.
Many people find they need multiple properties in their investment property portfolio to generate enough income to support their retirement lifestyle.
Pros of living off rental income
Capital appreciation: If you’ve owned a property for a while or have made significant improvements, chances are it may have grown in value – and may continue to do so. Growth in value can also mean higher rental rates and returns.
Interest rates are at all-time lows: Which means low mortgage repayments, if you have them.
Outgoings can be low: If you’re healthy and handy, you can leverage your free time in retirement to save maintenance costs by doing your own property management and minor repairs.
Holiday ahoy: Many Australians choose to purchase investment properties in holiday locations. When leased, your tenants provide an income stream; when not, you have an instant holiday house for yourself or perhaps a short-term rental.
Cons of living off rental income
Ongoing costs can pile up: In addition to anticipated outlays – property management, insurance and rates – you risk unexpected costs like emergency repairs and oft-forgotten long-term appliance or structural replacements.
Income from your investment property may be subject to income tax: This will depend on the net amount per financial year – and the amount and type of any other income.
Liquidity is restricted: If you need funds unexpectedly e.g. for medical costs, to take a holiday, or for emergencies, you can’t sell a single room of your investment property as you can with shares of stock – the whole thing has to go, and it will take some time before you get the actual sale proceeds.
Your income isn’t guaranteed: the rental market can change, and it might mean that your property can be empty for periods of time.
Living off equity
This option essentially sees you paying-off as much as you can on your property while working (reducing the loan-to-value ratio) and then funding your retirement by borrowing against the equity (the value of your home, less any mortgage) if and when you need it. A number of strategies are available, including home reversion, reverse mortgage and home equity release.
Keep in mind that the amount of money you can access depends on your age, the value of your home and the type of equity release.
Pros of living off equity
It’s tax free: You don’t have to pay tax on this ‘income stream’ as it is effectively a loan.
You can tailor the amount of equity you borrow: Whether it’s regular payments, a lump sum, line of credit or a mix.
You don’t have to sell: If the equity is in your own home, you get to keep living there and you don’t have to make repayments while you do.
Negative equity protection: means you will never end up owing your lender more than your home is worth if you take out a new reverse mortgage.
Cons of living off equity
There are costs involved: Application, service and end-of-agreement fees may apply. Check with your lender as they may vary from lender to lender.
A volatile market: This strategy only works well if your property is increasing in value.
You are converting capital to debt, for yourself or your beneficiaries: Some dub this investment strategy “spending wealth, rather than cash flow.”
The amount you can ‘borrow’ is restricted: If you’re 60, you can only access 15-20% of the value of your home. As a guide, add 1% for each year over 60. Over time, your payback interest rates may be greater than an average home loan. With home reversion, you ‘sell’ a share of your home usually for well under market value.
Selling property to fund retirement
To sell or not to sell? It’s a question many Australian homeowners face as they enter retirement, regardless of whether it’s the family home or an investment property. If this is to be your major income through retirement, check that any profits you reap will equate to comfortable golden years. Also consider the effects of re-buying or renting in the same market if you’re downsizing.
Pros of selling property
Selling your property may mean you have an increased cash flow: You can use it to pay off debt or invest in shares or in managed superannuation funds, which may provide additional tax benefits and liquidity.
You may not have to pay capital gains tax: This may apply if your property is your primary residence, or you purchased it before September 1985.
Cons of selling property
Capital gains tax: When selling an investment property you’ve never lived in, you may be liable for capital gains tax on any profit.
All those costs of selling a property: Real estate agent fees, legal fees, moving costs and so on.
Timing: If you need to sell in a hurry to fund your retirement, you may not be selling into the best market. Liquidating during a market downturn can mean a significant hit to your retirement income.
On the other hand, selling at the top of the market could mean boosting your super balance with a large lump sum, but remember the pension transfer balance cap limits the amount you can invest in a tax effective retirement pension.
Your bank balance: Selling your home may impact the amount of Age Pension you receive.
No one-size-fits-all approach works when it comes to using property for retirement. With so many factors influencing your decisions, it’s wise to consider your options and speak to your financial adviser.
Source: AMP
How does your pension live on after you die?
By Robert Wright /February 18,2022/
Account-based pensions offer a flexible and tax-effective method of drawing a regular income stream from superannuation. They are an essential part of your overall retirement strategy and are usually used from retirement until death. But what happens to your tax-free account-based pension when you do die?
Superannuation does not automatically form part of your Will unless a Death Benefit Nomination is completed to that effect. In this article we examine the nomination of an individual beneficiary, where the nomination of a member’s estate and a reversionary beneficiary nomination is not in place.
What are your beneficiary’s options?
The short answer is it depends. To receive your account-based pension your nominated beneficiary may have two options:
- Commencing a death benefit pension; or
- Receiving a lump-sum payment.
Both options are subject to additional eligibility criteria. Let’s briefly explore both options with our focus being option 1, commencing a death benefit pension.
Option 1: Commencing a death benefit pension
Features of a death benefit pension
A death benefit pension can basically be considered as allowing your account-based pension to live on after you die, for the benefit of your eligible beneficiary. Features of this pension are much the same as those for an account-based pension. Arguably, the most attractive feature is the tax-free nature in which the assets will reside. Recipients are required to receive a minimum cash pension payment each year which is based on their age and pension balance as at the previous 30 June.
Death benefit pensions can also be rolled into another fund at any time, however, they retain their identity as a death benefit. Therefore, a death benefit pension cannot be combined with other pensions or rolled back to the accumulation phase.
Is your nominated beneficiary eligible?
Generally, only your spouse is eligible. Adult children and your legal personal representative (your estate) would have to receive the benefit as a lump-sum withdrawal, i.e., the assets are removed from the superannuation environment and subject to tax on the taxable component. A dependent child (or children) may also receive a death benefit pension in limited circumstances; if they are under age 18; under age 25 and financially dependent on you; or have a prescribed disability.
Transfer Balance Cap
Another important matter to consider is your eligible beneficiary’s Transfer Balance Cap (TBC). To reiterate, the TBC is a lifetime limit on the total amount of funds that can enter the tax-free pension phase, currently at $1.7 million. Where your beneficiary has already commenced an account-based pension and does not have a sufficient remaining TBC to receive the death benefit pension, they may roll back their existing account-based pension into the accumulation phase to create room for the death benefit pension.
Option 2: Receiving a lump-sum payment
The alternative is to receive the amount as a lump-sum payment. With this option, the funds exit the superannuation environment. The benefits may be cashed as either in-specie or cash depending on your fund’s governing rules.
Conclusion
The death benefit pension option presents an opportunity for your eligible beneficiary to maximise the total amount of funds held within superannuation. While there are limitations on who can exercise this option and matters complicated by TBC, it is still worth considering as the assets will reside in a concessional tax environment.
Source: Bell Potter
5 steps to better financial goals
By Robert Wright /December 02,2021/
Everyone has financial goals. Maybe you want to pay off your mortgage early, stop relying on your credit cards, or go on an amazing overseas holiday (once we’re allowed to travel again). Or you might want to set up good money habits, like investing regularly or look at ways to grow your super. Whatever you want to achieve, it’s possible – as long as you approach your goals with the right mindset.
There’s a lot of science behind what happens to your brain when you set goals. It can trigger new behaviours, increase your motivation and attention, and improve your self-confidence. What’s more, when you set goals that are ambitious, challenging and highly important to you, you’re much more likely to perform in a way that helps you achieve them.
So, in other words, the best way to set yourself up for success is to make sure you choose the right financial goals and support them with a solid plan. Here are five steps that will help you get started.
Step 1: Identify and write down your goals
Goals are meaningless if they’re just vague ideas in your mind. That’s why new year resolutions always fail. Writing them down will help you focus on what you want. To make you even more accountable, share your goals with someone and update them on your progress.
A 2015 study by psychologist Dr Gail Matthews showed that 76% of people who wrote down their goals and shared their progress were able to successfully achieve them, compared to a 42% success rate for people who didn’t write down or involve other people in their goals.
Make a list of all the things you want to achieve financially and then prioritise them in order of their importance to you and your loved ones. You’ll find that two or three goals will stand out – they’re the ones to focus on.
Step 2: Make them specific, measurable and realistic
Now that you’ve decided on your goals, you need to expand on them so you know what you’re working towards. The best goals are specific, measurable and realistic. Set yourself a challenge, but don’t make your goals impossible to achieve.
For example, consider this common financial goal:
I want to pay off my mortgage earlier.
That’s a great goal. But it doesn’t mean much if you don’t put parameters around it. Here’s a better example:
I’m going to pay off my mortgage by December 2028. I will do this by paying an extra $500 each month on top of my minimum payment.
This goal is much more specific, with a set deadline and regular actions you need to perform.
Step 3: Have a plan
Work out the actions you need to take to achieve your goals. Do you need to earn more? Spend less? Refinance your loan so you’re paying lower interest? Cut back on some non-essentials?
Let’s revisit our earlier goal. We know we can achieve it by paying an extra $500 each month. But where is that money coming from, and what will you do with those extra payments? This needs to be part of your plan. For example:
I’m going to pay off my mortgage by December 2028. I will do this by paying an extra $500 each month on top of my minimum payment and keeping that money in a mortgage offset account to reduce the amount of interest I pay. To ensure I have this money available each month, I will work to a monthly budget that minimises any unnecessary spending and I will increase my income by working two hours of overtime each week.
Everyone’s plan will be unique. The key is to make it relevant to your lifestyle to give yourself every chance of success. It’s also a good idea to allow for the occasional slip up in your plan. No-one is perfect.
Step 4: Track your progress
Big, long-term financial goals are great, but it’s easy to become overwhelmed by them. Breaking down bigger goals into smaller steps can help you track your progress and celebrate your success along the way.
If you have a goal with a five-year deadline, break it down into five one-year goals. Or even monthly goals. That way you’ll know how you’re going and whether you need to make any adjustments to your behaviour. Reward yourself when you reach certain milestones – this can help keep you motivated and avoid splurging.
Step 5: Revisit and refine your goals regularly
No matter how determined you are to reach your financial goals, things may get in the way. You may have unexpected major expenses, or your priorities may change. That’s okay. Once you have the right behaviours and mindset of working towards a financial goal, you can adjust the goalposts whenever you need to. The process is far more important than the outcome.
Along with tracking your progress and celebrating your small wins, revisit your larger financial goals regularly, Are they still your top priorities, and does your plan need to be updated? If you have a financial adviser, they can help you with this and let you know if you’re overreaching or if you could be striving for more.
What financial goals do you want to work towards?
Source: Colonial First State