Boosting income poser for elderly

By BRENT SHEATHER

A lot of the debate over personal finance concentrates on how to save for retirement and what the growth prospects are for particular investments.

While it's an open question whether anyone really benefits from that sort of speculation, what is certain is that most clients of financial planners and retail stockbrokers are already retired.

Their main question is how to invest in retirement, where the focus is on how much cash income their savings can generate.

Fifteen years ago investing for income was rather more straightforward. New Zealand had particularly high interest rates: 90-day bills yielded 13.8 per cent and longer-term bonds paid 13.4 per cent.

Today interest rates in New Zealand are still high compared with many countries but are much lower than they were in the late 1980s.

Mum and Dad investing their modest retirement savings in 2004 are likely therefore to increasingly be looking further afield, past the bank and bonds, to generate enough cash for their living expenses.

A few years ago, when international sharemarkets were booming, investors and their advisers could cheerfully assume that their share portfolios would steadily rise in value, so high dividends were not a priority. Quite the reverse in fact, because capital gains were often tax free but income was usually taxable.

However, the 2001-02 bear market bought home the fact that consistent capital growth could not be relied on, so fund managers and financial planners have had to come up with new products.

The potential solutions are many and varied, including collateralised debt obligations (CDOs), finance company debentures, high-yield share portfolios and hedge funds.

Some experts tell us that focusing on stockmarket floats will solve our investment problems while others nominate residential property as the best option.

While the search for income might seem a simple enough exercise the investment world is full of traps for the unwary - fees, advisers who mix capital returns with income and assume both occur consistently, and judging just how risky that finance company offering 9 per cent is compared with a bank deposit or property portfolio.

Below we review these issues and seek to answer the big question: how much income can you realistically expect in retirement, after tax and fees, from a balanced portfolio?

Let's look at a real-life example:

Mrs A, aged 70, has sold her house in a small North Island town and gone to live in Auckland to be closer to her children. She will receive $200,000 from the house sale and has decided to rent in Auckland at $260 a week. Are her plans feasible? What are her options?

Mrs A, like most retired people, has noticed those advertisements for finance company debentures offering 10 per cent, which sound great, and would certainly produce enough income to pay the $260 rent each week.

However Mrs A's son-in-law, who has reluctantly taken on the job of being her financial adviser, says this option is too risky; it took Mrs A and her late husband 30 years to save this money and any investment that runs the chance of losing some of it is a non-starter, unless that risk can be reduced through diversification.

"But aren't shares and property risky too?" protests Mrs A. Son-in-law agrees but adds that, by investing in low-cost managed property and share funds, most of the risk of capital loss can be diversified away (apart from a major breakdown such as a depression).

Higher-yielding debentures from finance companies can't be diversified easily or adequately so they are out of the picture. Besides, if son-in-law manages to lose Mum's money he will have the whole family on his back and maybe even mother-in-law will end up living with them. No, there is no place for high-risk heroics in this plan.

Mrs A can't afford to buy a house to live in, so residential property as an investment isn't an option. Investing in company floats was also rejected after the stockbroker conceded that, while some floats had offered big profits, before they listed he wasn't able to distinguish between successes such as Freightways and disasters such as 42 Below.

Neither Mrs A, nor son-in-law, nor any of their advisers knew how CDOs actually worked so they were crossed off as an option, too, with hedge funds which offered the "hope" of high returns but almost nothing in the way of the required reliable cash earnings.

Son-in-law decides to approach the problem in a disciplined manner: Mrs A has managed to live on National Super ($286 a week before tax) for the past 10 years so her savings will need only to cover the $260 weekly rent, less the insurance, rates and maintenance costs on her home which she no longer has to pay.

Son-in-law estimates those costs at around $1500 a year so the after-tax income required in a year is: ($260 x 52) - $1500 = $12,020.

To produce that much by investing $200,000 requires an after-tax, after-fees yield of 6 per cent. Mrs A pays tax at 19.5 cents in the dollar so, if total management/monitoring fees are 0.8 per cent, she needs to achieve a before-tax, before-fees yield of 8.2 per cent.

Son-in-law knows that pension funds and balanced unit trusts invest in a mix of bonds, property and shares.

With A-rated bonds yielding 6.2 per cent, property 8 per cent and shares 4 to 6 per cent, it doesn't take him long to see that not even a fund manager of the year would be able to produce the required cash income from a properly diversified, lower-risk portfolio.

The harsh reality is that, even tilting the portfolio heavily toward high-yielding sectors (property) and away from low-yielding ones (international shares) Mrs A will still need to dip into her capital to live.

This is a worldwide problem faced by individuals, pension funds and institutional investors.

People are living longer and, in many cases, achieving a reasonable standard of living in retirement means either working for longer, making their savings work harder (taking more risk) or living on their capital. Mrs A faces the last option but it's not the end of the world.

Son-in-law enlists the help of his financial adviser's computer model which calculates the extent to which Mrs A needs to eat into her capital each year to "top up" her after-tax investment income.

Given a realistic estimate of cash income from an appropriate diversified portfolio (45 per cent bonds, 30 per cent listed property trusts, 25 per cent shares), the adviser reckons that the $200,000 will produce an after-tax, after-fee income of $9200 - a shortfall of about $3800 a year.

Using the model, the financial adviser calculates that Mrs A's capital will run out in 22 years time, when she is aged 92.

This means that if she lives to be 85 or so there will probably be little or nothing left over for the children but she has discussed this with them and they agree that having Mum in Auckland is the best option - it's just unfortunate that house prices and rents in their suburb have risen so much faster than in her home town.

The diversified portfolio will produce a cash yield of about 4.6 per cent a year after fees and tax, with capital growth of around 2 per cent a year, but the financial adviser suggests using the model to look at alternative strategies.

For example, the lowest volatility option - putting everything into bonds - will produce a yield of 6.2 per cent but no capital growth, so Mum's nest-egg will disappear sooner.

Even that "safe" option has additional risks, firstly that interest rates could fall, blowing Mum's budget and secondly, the value of her capital and income might quickly be eroded by inflation.

Fees are also critical - if the portfolio were subject to the financial planning industry's typical 2 per cent annual management and monitoring fee, Mum's money would be gone around three years earlier.

Putting everything into international shares, on the other hand, would imply a higher overall return of 8 per cent but much of that would be by way of capital growth.

And, if we had a repeat of 2001-02, Mrs A would have been staring at a big hole in her savings and she and son-in-law might have lost their nerve and switched to bonds like so many other people.

In the back of his mind son-in-law fears that a loss of that scale could well mean mother-in-law moving in permanently. The balanced portfolio with a bias to property gets the go-ahead as the lowest-risk option from both Mum and son-in-law's perspective.

* Brent Sheather is a Whakatane investment adviser