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Funding retirement in a low-income world

Photo of Don Hamson By Don Hamson

min read

Australian shares still a good option for income, but consider using a fund.

Many baby-boomers are reaching retirement, with self-funded retirees transitioning from a salary-funded lifestyle to one funded from retirement income streams generated from their superannuation and investments.

Retirees need to live off their income and by law are required to draw down a minimum from their superannuation each year. For those aged between 65 and 74 it is 5 per cent.

Unfortunately for today’s retirees, traditional income-generating assets such as cash or term deposits are yielding returns that are at all-time lows, and well below the 5 per cent minimum super drawdown rate.

Luckily for retirees, there is still one asset class generating reasonable levels of income – Australian shares.

Figure 1, below, plots yields on bank bills and one-year term deposits (RBA Indicator Rate). As can be seen, cash is generating the lowest returns for the past 35 years. Low interest rates might be good for someone with a mortgage, but not for a retiree hoping to live off income generated from term deposits.

The graph does, however, highlight some good news. Although interest rates are very low, the dividend yield from Australian shares is still around 6 per cent when one includes the value of franking credits, which are refundable in full to pension-phase superannuation funds.
Figure 1 also highlights that the yield on Australian shares has been remarkably stable over the past 25 years, much more so than the yield on bank bills or term deposits.

Figure 1. Bank bills, 1-year term deposits and the All Ordinaries gross yield, December 1980 to June 2015
 

Souce: Iress, RBA, Plato

Managed funds or direct shares?

Investors can access the relatively high income from Australian shares by buying shares directly or investing in a managed fund, mFund or Exchange Traded Fund (ETF).

(Editor’s Note: Plato Investment Management is a foundation member of ASX’s mFund service).

Direct share ownership provides flexibility, transparency and generally lower costs than investing via a managed fund.  However, do not underestimate the work required to build and maintain a diversified portfolio of shares.

Managed funds and mFunds give an investor access to a well-diversified portfolio actively managed by experienced investment professionals.

ETFs provide cheaper access to a diversified portfolio of shares, but normally are not actively managed. Rather, they provide access to a passive index portfolio of shares.

Investing via funds can take much of the hassle out of investing in shares, looking after corporate actions such as takeovers and share plans, collecting income and summarising taxation in a single annual tax summary. For these services, funds charge a management fee, which reduces the level of income generated from an Australian share investment.

The importance of tax

Tax is an important consideration for most investors and can be quite complex. Different investors are taxed at different rates, long-term capital gains are taxed at different rates to short-term capital gains and normal income, and franked dividends have valuable tax credits that can be used to offset tax payable or even be refunded for low-tax investors.

Direct share ownership can allow an investor to optimise after-tax returns from their own tax perspective. This flexibility is not available in a fund, which has to take some sort of average, “one size fits all” approach to tax management.

Poor tax management is one disadvantage of using funds. However, some managed funds are providing solutions, for example, being managed for a particular tax clientele – optimising for the zero tax pension-phase superannuation perspective.

High-yield investing

Figure 1, above, shows that an Australian equity index fund can deliver around 6 per cent in gross yield, made up of approximately 4.5 per cent cash yield and 1.5 per cent franking credit yield, before fees.

However, it is possible to build a much higher-yielding portfolio of Australian shares. Some high-yield funds can deliver 9 per cent or more income after fees by tilting toward high-yield stocks or adopting other active high-yield strategies.

Investing for high yield is certainly not riskless. Besides taking on normal sharemarket risk, investing in high-yield stocks can bring other risks. They tend to be concentrated in certain industries, such as the high-yield banks in the financial sector.

As seen in the past few months, sometimes the bank sector can be sold off because of concerns about rising interest rates or tighter capital requirements. Investing in high-yield stocks also carries the risk of investing in “dividend traps”. These are stocks that trade on high historic yields but have a high risk of cutting their dividends.

Beware dividend traps

A recent example best illustrates the concept of dividend traps. In the year to May 2015, Metcash paid fully franked dividends of 15.5 cents. On a gross-of-franking basis this equates to more than 22 cents per share in income. During May, Metcash was trading on an historic gross yield of more than 17 per cent on some days, which is a very high yield in the current environment.

The problem with buying Metcash on a 17 per cent yield was that its dividend was not certain. Unlike interest payments, companies can easily cut dividends, and indeed this is what Metcash did. On 4 June Metcash announced asset writedowns of $640 million and stated: “The board will not be declaring a final dividend for FY15 and intends to suspend dividend payments in FY16.”

Not surprisingly, Metcash’s share price fell 18 per cent. Investing in Metcash for that possible 17 per cent yield in May might not only have resulted in no income, but also a sizeable capital loss.

In summary, Australian shares can provide good levels of income in today’s low-income environment. High-yield Australian shares strategies can provide even higher levels of income, but investors need to be aware of risks such as high sector concentrations and dividend traps. Some actively managed strategies have developed processes to help mitigate these risks.

About the author

Dr Don Hamson has over 20 years of investment experience and is founder and CEO of Plato Investment Management, a specialist in managing money for pension phase superannuation (SMSFs).  Subscribe to the Plato monthly newsletter. To learn more about Plato Investment Management visit www.plato.com.au

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