Chasing income can be chasing added risk

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The goal of many retirees is to have a stable and consistent income flow so they can spend with confidence. The concept used to be that if enough money was in an investment portfolio, then it would generate enough income to be able to live on and keep the capital intact. This worked well when New Zealand enjoyed high interest rates and over a generation, a psyche developed of expecting a 10% income return from one’s investment portfolio.
What many forgot was tax had to be removed (and in days gone by, this was at a significantly higher rate than the relatively low tax rates of today) and inflation ate up the earning power of one’s investment return. In other words, the gross income return was higher than what many can achieve today but it actually went less distance over time due to the ravages of inflation.
We then hit the late 1990s and the first decade of the new millennium where finance companies, structured credit investments and syndicated property all flooded the New Zealand market to meet the insatiable desire for retirees to achieve this mystical investment return of 10% before tax. These investments all worked well for a few years and we all know what happened after that.
Age and experience are wonderful things but only if we learn along the way from our mistakes. What New Zealanders should have all learned was:
  • All that glitters is not gold
  • A high interest rate probably signifies a high risk
  • Diversification into different finance companies or diversification into similar income producing investments in the same asset class does not effectively reduce the risk of a portfolio
  • There is a difference between speculation and investing.
At Milestone, we are still seeing potential new clients asking to achieve a $25,000 pa before tax return from a $300,000 or smaller portfolio and not consume the capital and not take much risk ie: they don’t want to see the portfolio have a negative year. The hardest discussion we will ever have with those people is the one telling them this is not achievable . Let’s explore why. A quick calculation shows a return of 8.3% before tax is required. This might seem possible in good years but it needs to be averaged out over the length of the retirement span. Achieving that sort of return means the investor needs to have an aggressive risk profile and be prepared to accept lots of ups and downs in capital value. Then comes tax which (depending upon individual tax rates) could be as high as a third so the after tax return may now be down around 6%. A 6% after tax and fees return only provides $18,000 per annum- well short of the original expectation of $25,000.
But wait, it gets worse! Realistically, a retiree who only wants to take ‘average risk’ would be a ‘balanced investor’ and using the Morningstar expected long term return forecast, a balanced investment portfolio is only projected to average 7.0% and that is before tax and fees. Such a portfolio is certainly not without risk and Morningstar calculates a ‘balanced portfolio’ would have a variable return where over a 10 year period, returns could range from 1.6 to 12.5% before tax and fees. If we took off the gross earning rate an average of 1% for fees then a maximum of 28% for tax then the average gross return of 7.0% now becomes only 4.3%. This sort of return only provides $12,900 per annum from a $300,000 portfolio – a figure even further from the $25,000 expectation.
But wait- there is even more bad news!  It’s like the reverse of those infomercials where the longer you watch, the cheaper the product becomes. All the returns quoted above are not based on money in the hand. They are total returns based upon a mixture of income (be it interest or dividends) and capital growth. The only way an investor can get the full value of this return is to sell down some of the increased value of the investment.
What is happening?
Advisers are being regularly asked to produce ‘income portfolios’ which have a high exposure to income producing assets. This might sound fine in theory but what it creates is a portfolio skewed towards commercial property, infrastructure assets, high yielding cash, corporate bonds and possibly some higher risk alternative assets. Individually, these investments are not bad but when they are all combined together to provide the much needed income and the client is expecting consistent income with little or no risk, then mismatching of expectations with reality starts to occur and people get angry when the portfolio starts to suffer lurches. In 2013 and possibly in 2014, fixed interest investments such as bonds (which are traditionally regarded as being low risk if good investment grade) are showing negative total returns or close to zero returns. Therefore we now have a double whammy. The lower the risk of the client, the poorer the return they are possibly going to achieve in today’s interest rate cycle.
What is the solution?
New Zealanders need to realise we are part of the world wide economy and interest rates are low at present and not likely to shoot back to historical levels in the short term. Therefore, retirees and their advisers should be talking less about generating income and more about ‘capital draw down ratios’. This is where the portfolio is structured so it is nicely diversified and designed to meet the risk profile of the client. The client identifies what amount of money they need each year from the portfolio and the adviser calculates how many years the portfolio will last at that rate. If the portfolio is going to last longer than the lifespan of the client, then there is not an issue. If the portfolio is likely to be run down to zero prior to death then a discussion needs to be held around changing client goals, taking a higher risk with the portfolio or selling the house at some stage and investing the proceeds into the portfolio. This is the sort of discussion that occurs in most western nations – but not on a regular enough basis here in New Zealand.
Let’s go back and look at our retiree with $300,000 and wanting $25,000 pa. This would be a capital drawdown ratio of 8.3%. This 8.3% would be achieved by paying out the income flow plus selling down a small portion of the capital value. If we assumed the client took a balanced risk or slightly less and received an after tax and fee return of 4% pa, then deducting $25,000 pa would result in the portfolio reaching zero around year 15-16. The good news is the investor could have enjoyed retirement knowing the adviser was going to deliver a constant $25,000 after tax each year.
Talk to a Milestone adviser about how consistent an income flow you require each year. The adviser can model solutions to meet your particular needs.