KEY POINTS:
While the launching of KiwiSaver has seen a marked improvement in the public's awareness of saving for retirement, investors who actually bought into a balanced super scheme at the beginning of 2007 might be wondering what all the fuss is about.
With a few notable exceptions, returns have been hard to come by and most asset classes have underperformed simply leaving the money in the bank.
Of course that's not the natural order of things. In the real world risky assets like shares are supposed to produce higher returns to compensate for their higher risk.
But New Zealand's consistently high short-term interest rates have proved a pretty hard act to follow and, through a high dollar, depressed overseas returns as well.
The balanced portfolios of typical New Zealand superannuation funds, according to investment consultant Aon, have about 39 per cent of their assets in international shares. However, thanks in part to an unexpectedly strong dollar, year to date returns have been marginally negative.
Over one year things aren't any better and even with the benefit of a 10-year horizon returns are just 6.2 per cent a year. For comparison, in the latter period short-dated bank bills have averaged 6.6 per cent. These numbers are before the Fair Dividend tax and, of course, fees.
Local shares comprise about 16 per cent of a balanced portfolio and returns here have been reasonable, if uninspiring, at 5.6 per cent for the half year, again before fees and tax. The 5.6 per cent is the return from the broad market and some fund managers will have done better, some worse.
Fund managers with a bias to small and midcap funds are likely to have outperformed: midcap stocks returned 5.9 per cent and the small company index was up by 6.9 per cent.
If your fund manager was clever enough to have a decent weighting in Australian shares, performance is likely to have been considerably better. In the six months Australian shares returned about 11.8 per cent thanks to a more resilient Aussie dollar and the continued bull market in resource stocks.
The other big component of the typical balanced fund is NZ and overseas bonds but this sector had a particularly poor time of it as interest rates rose around the world so that the price of bonds fell. The logic of this process can be difficult to understand but it is worth getting to grips with the reality of investing in bonds as in more normal environments they form the steady backbone of a portfolio and are something of an insurance policy against recession.
But the last six months have not been good for bond enthusiasts: investors who bought low-risk 10-year NZ Government bonds at the beginning of the year have sustained a 6.5 per cent loss in six months. While Government bonds are pretty well free of default risk because they are long dated they have substantial interest rate risk.
By purchasing December 2017 Government bonds you lock in an interest rate for 10 years, thus you run the risk that market interest rates go up or down in that period. A change in interest rates will not affect your return if you hold until maturity in 2017, but it's important if you sell out early or you value your portfolio quarterly. If interest rates increase, the market price of the bond you bought will fall to ensure that the return on your bond to a purchaser will be the same as the market return. Conversely, if interest rates fall your bond will be worth more because you can look forward to another 10 years of interest at higher rates than the current market rate.
At the beginning of 2007 the interest rate on 2017 Governments was 5.85 per cent, today it is about 6.71 per cent, hence these bonds have dropped in price.
History gives us some perspective on current yields - since 1930 the 10-year NZ Government bond yield has averaged 6.5 per cent with a high of 18 per cent in 1986 and a low of 3 per cent in 1950.
There are short, medium and long bonds with the latter being most sensitive to changes in interest rates. You might wonder why anyone would be silly enough to risk their capital in a long bond? The answer is that although interest rates have been high in New Zealand for as long as anyone can remember they occasionally go down as well as up. If you are investing for the long term and leave all your money in short bonds you expose yourself to reinvestment risk.
Short-term interest rates could halve over five years, if we go into a recession for example, and investors with all their funds in short-term deposits might suddenly be unable to reconcile their net income with their gross habits.
Overall the NZ Government bond index was down by 0.5 per cent in the six months before fees and tax, a particularly poor performance given that their annual running yield is almost 8 per cent. Overseas bond markets were also weaker, falling by 10.7 per cent in NZ dollar terms. However, many local managers hedge their foreign exchange exposure thereby limiting their clients' losses to about 1.4 per cent.
Property and cash at 10 per cent and 9 per cent of total assets make up the balance of the average balanced pension fund and these sectors returned 5.6 per cent and 3.7 per cent respectively.
Put all these sectors together with the typical weightings of your average fund and, if your fund manager was able to do as well as the index in each sector, total returns for the six months ended June 30 would have been around 1 per cent, pre-fees, pre-tax, pre-inflation.
Over 12 months the return is just 5.3 per cent and even for the 10 years ended June 2007 a balanced portfolio has only managed around 7 per cent a year. Take off 3 per cent for inflation and given typical retail fee levels, real returns are being shared equally between the investor and their fund manager.
With the experts telling us that returns are likely to continue at 7 to 8 per cent a year for a balanced portfolio then over the long term fee levels will be one of the key determinants of performance.
It will be interesting to see whether any of the fund managers offering KiwiSaver actually deliver on their promises of providing savings plans with realistic annual fees.
* Brent Sheather is a Whakatane-based investment adviser.
