When it's time to get out

By BRENT SHEATHER

The investing public's love affair with international shares was always going to be a precarious relationship, given the average mum and dad's need for enough cash to sustain them in retirement and, on the other hand, the small amount of cash that overseas shares typically produce.

While many financial planners' spreadsheets showed that income could be taken from consistent capital gains of 7 per cent a year, in practice sharemarkets could fall for three years in a row, occasionally longer, implying long waits for cashflow in the real world.

The way the investment advisory industry works, however, means that intermediaries and fund managers alike get paid more for selling shares than they do for selling bonds.

So it's no surprise that, at the tail end of the biggest bull market of all time, some New Zealanders are finding that their retirement plan is not delivering on the promises made a few years ago.

The story of Mr and Mrs Farmer - real people, though that isn't their real name - captures some of the excesses of the local financial planning scene and the cult of equity, but it is by no means a worst-case scenario.

The Farmers' story may be indicative of the experience of many New Zealanders who took professional investment advice during 1999-2001, when international shares were the flavour of the month and concerns about cash income were assuaged by the wonders of modern portfolio theory and the promises of active funds management.

Their investment advice came not from some fly-by-night organisation but a leading company with a significant market share, via an adviser who was both experienced and qualified as an Associate Financial Planner and a member of the Financial Planners and Insurance Advisers Association.

The Farmers thought they had done everything right: the financial planning firm came highly recommended by their accountant and trustee of their family trust, their portfolio was fully monitored, they dollar cost averaged the purchase, and according to the brochure their adviser had met them "to gain a clear understanding of your lifestyle and financial needs".

Yet today, after months of worry and sleepless nights, they have sold their portfolio, feel betrayed, and are staring at a total loss of around $200,000 on an initial portfolio of $1 million. What went wrong?

The Farmers ran their 100ha dairy property for 48 years. They went to see the financial planning firm in May 2001, reasonably confident that they got a good price for the farm and with plans to pursue some interests and travel, things they had put off for the last 50 years.

Their prime objectives for the $1 million were documented in the original plan as follows:

1. "There is a strong need to protect your capital and achieve growth without undue risk."

2. "Provide security and income in retirement" (although it was noted no income was needed in the first year).

3. "You consider that you need to protect the real value of funds that are now available for investment, with an emphasis on achieving capital growth compounded within your portfolio rather than investing for just income, which even if reinvested, is likely to produce a smaller sum."

4. "We understand that you wish to have a portfolio of investments which have the potential to generate income and capital growth in excess of inflation over the medium to long term (5 plus years). You therefore are willing to place reasonable emphasis on growth investments which will fluctuate in value."

This is where the problems began: objective 3 partly contradicts objective 2, and neither the amount of annual cash income required by the Farmers nor the sum of the interest and dividends the portfolio would produce was ever quantified.

Lesson one: define how much income you will need in retirement and double-check how much cash your portfolio will produce after tax and fees.

The next step was to choose an appropriate asset allocation, based on the objectives above. The financial planning firm assessed the Farmers' risk profile as moderate and came up with the following portfolio:

* Cash: 8.5 per cent.

* Bonds: 15.5 per cent.

* Property: 7 per cent.

* Shares: 69 per cent.

The Farmers' plan then said that "based on the past performance of similar portfolios an average pre-tax return of 10.5 per cent per annum should be achievable over time".

Oh, oh! Many commentators have written on the extreme likelihood - indeed, virtual certainty - of lower returns in future than those enjoyed in the last 10 years.

This column has rehearsed the arguments for 6 or 7 per cent annual returns from shares (before tax and fees) many times, firstly in July 2000 when I drew readers' attention to the low future returns projected by the UK Institute of Actuaries.

The actuaries believe long-term returns on shares will be about 7 per cent a year, with bonds producing 5 per cent.

It is inconceivable that the financial planning firm was not aware of the likelihood of lower future returns. Advising new investors that a 10.5 per cent annual return "should be achievable over time" from a "moderate" risk portfolio is extraordinary.

Lesson two: make sure that your adviser's expectations of returns are realistic. If they are too high there might be a good reason for this: a high annual fee structure.

The basis of any financial plan is the asset allocation decision, which itself depends on the clients' risk profile and how much income they need.

Too many advisers waste too much time trying to discern the former to the nth degree when an individual's tolerance for risk is in part dependent on how recently they had their last cup of coffee, and in any case can easily be manipulated by graphs with the right starting points and a polished sales technique.

Individual investors and advisers who don't have a clue could (and usually do) do a lot worse than just copying the asset allocation profile of the average New Zealand pension fund (about 40 per cent bonds, 10 per cent property and 50 per cent shares), and simply increase the property and bond sectors by 5 per cent each if the clients don't have a lot of money and need income.

What the textbooks don't say is that asset allocation can also be a matter of timing: two years ago the historic data for international shares looked fantastic, so if you walked into your local stockbrokers - no matter what your particular circumstance - you probably walked out with a bunch of Cisco, Tyco and WorldCom shares.

Today the fashion is corporate bonds, a la Vector, GPG and Powerco. The Farmers' adviser had been seduced by shares, so they finished up with 69 per cent of their farm proceeds in shares, a much higher proportion than the average local pension fund has, even though the Farmers undoubtedly have a shorter investment horizon than the average pension fund member and see themselves as "average risk" investors.

What of the Farmers' decision to sell up? Isn't this exactly what we are told not to do - often by fund managers and advisers whose livelihood depends on us staying invested in equities, mind.

The main issues leading the Farmers to this decision were:

* Their asset allocation was clearly inappropriate - far too much in shares and not enough in bonds and property. It was far too volatile and the worry affected their health.

* The fee structure implicit in the plan was way too high, especially for a more appropriate lower risk portfolio.

* The Farmers no longer had any faith in their adviser, the spreadsheet, the graphs and active fund management. His answer was always the same: hang in there, it will get better.

* The Farmers could now see that the income from their portfolio, upon which they depended to live, itself depended on buoyant stockmarkets. When the markets slumped the income stopped.

While seeing their capital plummet was bad enough, what really upset them and underlined their decision to sell was the fact that they received little or no cash income from their $1 million investment.

* Brent Sheather is a Whakatane investment adviser.