By Mary Holm
Money Matters
Q: I am semi-retired, not working at present, and my wife has a small income.
Until last year, our savings had, at 9 per cent, been giving us an income of around $30,000. Now it's about $12,000!
I am on the bottom tax rate of 19.5 per cent. I
am interested in investing to get as close to 9 per cent as possible, and property funds and managed funds all seem to have paid 33 per cent tax.
I would describe us as moderate risk, seeking security, good income and some growth.
Is there any way we can invest in either, or other investments that have not paid 33 per cent, and are likely to return the higher income that we are needing? We intend to draw against whichever managed fund we go into for income.
If there is an alternative investment where we wouldn't have to pay the hefty entry and management fees that funds demand, we would rather do it. Do you have any suggestions?
A: I've got a couple. But I'm afraid you'll have to take on more risk than you did a year or so ago, when term deposits were paying an extraordinarily high margin above inflation.
Even in riskier investments, such as shares and property, you might not get 9 per cent.
Their returns are volatile. In some years they are negative. And, if you can average as high as 9 per cent in the years to come, you'll be pretty lucky.
Nobody knows what returns will be, but experts predict they'll be lower over the next decade or so than in the recent past, partly because inflation is lower.
Still, given that your income has certainly been whacked, you might be prepared to take a bit of a gamble with some of your savings.
You seem pretty concerned about tax. Many advisers would say you're "too tax-driven", and point out that 10 per cent taxed is better than 5 per cent untaxed.
But, when considering managed funds, there are some tax-favoured ones that do at least as well, on average, as those without a tax advantage, so you might as well go with the former.
There are two types of funds that get a tax break: index funds and British investment trusts. Neither type pays tax on capital gains, which considerably cuts their tax bills.
What's more, their ongoing fees tend to be lower than on other managed funds.
Another alternative is to invest directly in shares or property. As long as you don't trade frequently, you shouldn't have to pay tax on capital gains on these either.
The trouble is, even though it sounds as if you have about $330,000 in savings, that's not really enough to get broad diversification in direct investments.
You'll keep your risk down by sticking with a managed fund.
A good sharebroker or financial adviser can tell you which index funds and investment trusts are available.
And ask around about entry fees. They vary widely. Some brokers and advisers charge zero entry fees on some funds. They're satisfied with the portion of ongoing fees that goes to advisers.
For more on index funds, see the next letter.
You might also consider corporate bonds, which pay higher interest than term deposits. They are, however, riskier.
Or you could buy an annuity - as described in the third letter. Annuities are available for couples as well as individuals.
Q: You mention in Weekend Money of 26-27 June that you favour index funds. What are index funds?
Who and how does one manage such funds, as I am unsure what you mean by "in which nobody selects the shares".
Why is it much cheaper to have index shares?
And could you elaborate more on why you favour index funds?
A: I've had several letters like this lately.
Another, for example, simply says, "With reference to your July 10 Money Matters, what are passive (or index) funds, and in what way do they get favourable tax treatment?"
Because I like index funds, I've mentioned them quite often in this column. I don't want to go into detail about them every time. But I guess it's time for an explanation.
An index fund is a type of managed fund - pooling lots of investors' money. It holds the shares in a sharemarket index - such as the NZSE40 index of the 40 biggest companies on the stock exchange - in the same proportion as the shares' weightings in the index.
The fund changes its holding only when the index changes. That's why it's called passive. Unlike "active" managed funds, index funds have no managers hired to decide which shares to buy and sell.
Because of this, and because index funds usually trade less frequently, which keeps brokerage costs down, they are cheaper to run. So their fees are lower than on active funds.
How do index funds perform, compared with active funds?
An NZSE40 index fund, for example, performs as well as that index.
Active funds that also invest in some or all of the biggest 40 companies will hold the shares in different proportions from the index.
Some active funds will be clever or lucky enough to hold the better performing shares, and so "outperform" the index. Others will "underperform" the index.
Over time, though, the same ones don't tend to outperform every year. If you look over 10 years, usually only a small proportion of active funds will have done better than a similar index fund, especially when you take into account their higher fees.
It would be great if we knew in advance which these long-term star performers would be. But we don't. So index funds are a better bet.
As I said in the first answer in today's column, index funds also have a tax advantage - another point in their favour.
A common criticism of the several index funds based on the NZSE10 or NZSE40 is that they are too heavily invested in Telecom - giant of the New Zealand share market.
I suggest, therefore, that you consider also investing in funds based on other indexes, covering property companies or medium-sized companies. I also recommend putting a sizeable portion of your money in one of the funds based on worldwide share indexes. The two New Zealand-based ones are AMP's WiNZ and Tower's TORTIS-International.
Q: I will be retiring in one to three years and I have a minor dilemma as to what to select from my super options.
I am 60 years old and belong to an old-fashioned company super scheme where the payout is basically x 60ths of my salary, where x is the number of years in the scheme.
That will provide a guaranteed annual income of about $40,000 tax free, with some adjustment for inflation.
My near-new home will be mortgage-free by the time I retire. I have only minor investments apart from the super. I do not expect to have any major purchases to make after I retire.
I am fit and in good health and I expect a retirement of up to at least 25 years, although I realise the actual situation could be much different.
The choice I have to make is whether to take the full pension [guaranteed for life] or take a reduced pension of about $30,000 tax-free, plus a lump sum of over $100,000.
Are there reasonable investment options that could persuade me to take the lump sum option?
A: No.
You'd need to get a return on your $100,000 of more than $10,000 a year, after tax, to be better off with the lump sum.
You might see investments offering more than 10 per cent, but they will inevitably be quite risky - which is not what you need if you're looking for steady retirement income.
We should, though, take into account one advantage of going with the lump sum.
If you don't touch the capital, but just live off the returns it brings in, you'll still have the $100,000 when you die. With the full pension, there won't be anything left at death.
That could affect your decision if you want to leave money to others. Then again, you've already got your home as an inheritance.
Alternatively, you could gradually use up the $100,000.
In your first year, for instance, you might get a return of $7000 after tax and take $3000 of capital, bringing your total to $10,000.
The trouble is, as the $100,000 dwindles, your return on it will fall.
And you don't know how fast to use up the capital, because you don't know how long you'll live.
Another alternative would be to buy an annuity with the $100,000. This is a do-it-yourself pension. It will give you guaranteed payments until you die, regardless of when that is.
You could, for instance, buy a $100,000 annuity, at age 62, that will rise by 2 per cent a year to take inflation into account.
At today's rates, it will pay you about $7000, tax-paid, in the first year, says Darrell Colmore-Williams of Aon Benefits Services.
That's pretty good. But clearly not as good a proposition as your super scheme.
All in all, I would go with the $40,000 option. It gives you a worry-free retirement income at a much higher level than most New Zealanders.
You're sitting pretty. Enjoy it.
* Got a question about money? Send it to Money Matters, Business Herald, PO Box 32, Auckland; fax: (09) 480-2054; or e-mail: maryh@journalist.com. Letters should not exceed 200 words. We won't publish your name, but please provide it and a (preferably daytime) phone number in case we need more information. We cannot answer all questions or correspond directly with readers.