Investing for income
We often speak to investors at or near retirement age who are looking for consistent income streams on which they can live. There are a number of strategies that they are employing to achieve this objective including playing the share market, buying bonds and or investing in term deposits. Unfortunately, we often find a common misconception by investors that income-based investment is inherently without risk.
This April edition of Investment eNews will explore some of the risks inherent in the most common income investment strategies. After all, it is critical that investors understand all the risks, as well of the benefits, of each of the investments that they are choosing.
Cash & term deposit investments
Cash and term deposit investments have traditionally been seen as providing two key benefits: capital security and regular income streams. And, from a capital security point of view, cash has long delivered for Australian investors.
The real issue is whether these investments are delivering the size and rate of regular income streams that today’s investors increasingly require in this very low inflation environment. Two of the biggest risks that investors face are inflation adjusted nil returns and longevity risk – the latter risk is that the investor will outlive their retirement savings. These risks are both real and potentially massive – life expectancies are increasing and retirement costs are skyrocketing. A significant cohort of investors face a very real prospect of exhausting their retirement savings just when they are at their most vulnerable, in a low interest rate world.
Against this context, the sad reality is that interest just ain’t what it used to be. A baby boomer who remembers paying almost 20% per annum on their home loan in the late 1980s and early 1990s is now faced with getting at best, a miserly 3.10% per annum on a five year term deposit. This is simply not enough to live on, let alone to protect or grow their investment corpus. Take for example the following chart which outlines the best rates of return for average Bank term deposits as at March 2019 over different maturity lengths.
The second income strategy that investors talk about is bond investment. Traditionally, it has been difficult for individual investors to access bonds because of the high minimum investment required (often up to $500,000). However, some bonds are targeted at individual investors and have lower minimum investments required. Additionally, bond funds allow individual investors to access the asset class.
Whilst bonds in themselves are a well-respected part of the investment universe, any investment decision in bonds needs to be informed by a sophisticated understanding of the specific risks of each bond investment. Recent media reports have covered the bond-holders of Mackay Sugar. They were originally offered an apparently attractive 7.75% per annum yield. Now they are being offered 50c in the dollar by an opportunistic investor or risk seeing the company fall into administration. Similarly, ASX-listed finance company Axsess filed for voluntary administration just weeks after raising money from retail investors via a “simple” corporate bond. Did the average retail investor realise that they were the last priority in a long list of more senior funders?
The frank reality is that bond investment is a highly specialised craft. A deep understanding is required of a company’s capital structure and debt obligations, as well as its prospects and challenges as a business. For many retail investors, it is simply asking too much to expect such a rigorous analysis in order to make an informed investment decision with respect to bonds.
A popular alternative to bond investments in some circles is hybrid bank notes. These are difficult to assess as a class, because their merits are so dependent on the detail of each individual hybrid issue. The ideal hybrid seeks to deliver higher returns (like shares) with lower risk (like bonds/fixed interest investments).
Unfortunately for investors, the opposite is all too often true. Investors are exposed to fixed interest returns, in compensation for running risks more commonly associated with shares.
The difficulty most investors face with hybrids is separating the ‘wheat from the chaff’. The standard hybrid offer document typically runs into hundreds of pages and is full of highly technical terms and conditions. Frequently – and particularly with bank hybrids – a detailed understanding of the legal and regulatory issues associated with these investments is required, such as the banking capital requirements, along with APRA’s regulatory requirements.
The complexity of individual hybrids might make the investment decision simply too onerous for individual investors. As Warren Buffett once said “...Investing is not like Olympic diving – you don’t get bonus points for degree of difficulty.” And if bonds present some complexity risk, hybrids double it down.
The final income strategy that we will consider is investing in shares, or equities. Since 2011, many investors have been investing in equities for the dividend yield. There is little doubt that this strategy has been successful over this period. There have been some very strong dividend yields on offer, often boosted significantly by franking credits.
However, it is important that investors do not forget the fundamental characteristics of equity investment. As we all know, fixed interest investments typically do not deliver returns as high as equity investments, but, in exchange, investors get greater certainty of return.
Equity investments expose investors to capital risk. The S&P/ASX 200 dropped nearly 50% during the GFC and – twelve years later - is still down by about 10% on its pre-GFC high. For SMSF investors who need to sell down portfolios for living expenses, this is a very significant capital hit. Importantly, whilst fixed interest yields derive from legal obligations (the ‘borrower’ has a legal obligation to make repayments), a dividend is by its very nature discretionary. It might look solid right now, but if circumstances for the company in question change, the dividend is the first thing to be dropped. Underlying capital and income risks is the fundamental equity risk of volatility. Equity markets and individual equities are prone to volatility and – as we’ve already seen – this volatility can result in multi-year or even decade-long periods of underperformance.
This discussion becomes yet more pointed in the context of the current Federal election. As has been widely discussed, a key ALP policy commitment is to axe cash refunds for excess imputation credits paid to individuals and in superannuation funds. Politics aside, the inarguable effect of this policy is a significant hit to the income of thousands of retirees. According to SMSF Association Chair, Deborah Ralston, in 2014-15 more than half of the 1,132,380 people receiving refunds had taxable incomes below the $18,201 tax-free threshold and 95% had taxable incomes of less than $65,000. Around half of the refunds go to people over the age of 65. Net effect – a serious hit to the ‘equities for income’ retirement strategy.
Investing for income is here to stay and it is always appropriate for investors to consider which strategies suit their individual needs and objectives. However, no strategy is foolproof and each has its own profile of benefits and risks. Investors need to assess these in detail to ensure that their strategy matches the investor’s individual risk profile.
What’s more, there are often better risk return yield-generating alternatives beyond these ‘usual suspects’.
At La Trobe Financial, we target the generation of income through mortgage-backed investment. Our ‘peer to peer’ investment options allow investors to choose individual loans from our Investment Shopping List in order to satisfy their own needs and objectives.Click here to view our latest Peer-to-Peer Investment Shopping List.
Our Peer to Peer Option offers a truly national, diversified portfolio of income-generating loans. Since its inception in 2002, the Peer to Peer Option has produced a powerful income return for its investors. Its capital stability (zero investor capital losses) and liquidity profile (full capital return on investment maturity) has been coupled with monthly income returns that have been strong both in absolute terms and relative to peers.
Our flagship 12 Month Term Account (recognised by reputable finance journal Money magazine as Australia’s “Best of the Best” for the past 10 consecutive years), adopts a capital preservation focus, with low-LVR, registered first mortgages backing each and every loan selected for the portfolio. The objective of this investment term aims to provide investors with a reasonably stable and predictable income based on a monthly variable rate of return.
The demand for this type of performance profile has been substantial in recent years. Obviously, it has proven to be a popular investment alternative for investors. As you can also see from the below chart, it has delivered regular, capital stable returns from inception and in every economic cycle since inception, even during the GFC.
12 Month Term Account annual performance comparison
The chart below shows the 12 Month Term Account’s annual returns against those of the other key asset classes since the 12 Month Term Account’s inception in 2002. The low volatility of the 12 Month Term Account returns is notable. In particular, we can see that the GFC did not affect the 12 Month Term Account in any significant way. Whilst the rate of return is variable, we manage on the basis of predictability, sustainability and consistency.
Whatever market you’re in... we hope it’s profitable.
As Warren Buffett once said “...Investing is not like Olympic diving – you don’t get bonus points for degree of difficulty.”
The Private Wealth Management Team at La Trobe Financial
About La Trobe Financial
This publication does not constitute financial advice and should not be relied upon as such. It is intended only to provide a summary and a general overview on matters of interest and it is not intended to be comprehensive. You should seek your own financial or other professional advice before acting or relying on any of the content. Copyright 2019 La Trobe Financial Services Pty Ltd ACN 006 479 527. All rights reserved. No portion of this may be reproduced, copied, or in any way reused without written permission from La Trobe Financial.
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