Keeping an eye on the way ahead

Whatever the coming years hold, investors might be wise to expect less of the same. BRENT SHEATHER looks at what low returns mean for retirement plans.

Anyone investing for the future has probably heard the news that the new era of low inflation means investment returns will probably be low too - 5 or 6 per cent a year for bonds, with shares struggling to beat 7 per cent.

But what does this new world mean if you are saving for retirement? Is your target of "$200,000 by the time I'm 50" realistic? Is $200,000 enough anyway?

Don't expect too much in the way of intelligent comment on the subject from the local savings industry, as many participants have huge vested interests and desperately cling to the fantasy of double-digit returns (hedge funds being just the latest manifestation of this sort of wishful thinking).

While research in the US and UK shows that funds with high management fees generally achieve lower returns after fees, the reality in New Zealand is that the higher the fees your financial adviser charges, the higher their "forecast" returns are likely to be too, so as to project a worthwhile result after those fees are paid. To acknowledge the reality of low returns is usually to admit that one's fees are far too high.

For this reason - and because the marketing department says "if the savings task looks too hopeless, many individuals will ignore the issue" - fund managers and financial planners are loath to embrace the new era of low inflation, low return investing.

The sole voices of reason in the debate about forecast returns seem to come from disinterested parties such as the Financial Times, the Economist, and veteran investors such as John Bogle, Warren Buffet and Robert D. Arnott.

It's no surprise then that most of the calculators available from financial planners and on fund managers' websites use growth rate assumptions that are well ahead of commercial reality. Many appear to be based on the euphoric and unsustainable 1981-2000 period, rather than the more austere conditions likely to prevail in the next 20 years.

So what does "low inflation, low returns" mean if you are saving for retirement? How much should you save and how much income will your portfolio generate once you retire?

Below we put some numbers on various savings scenarios based on realistic return assumptions and actual costs and taxes. That should give you a feel for the numbers as they relate to your own situation.

But first, let's define "low returns". For the foreseeable future, our return assumptions look like this:

* New Zealand Bonds: average yield about 6.5 per cent.

* Overseas bonds: average yield around 5 per cent.

* New Zealand shares: about 8.5 per cent (6 per cent a year from dividends, growing at about 2.5 per cent a year).

* Overseas shares: about 7 per cent (2 per cent a year from dividends, growing at about 5 per cent a year).

* Property: about the same return as New Zealand shares.

A balanced portfolio, like those used by pension funds and balanced unit trusts, is typically made up like this: 40 per cent bonds, 10 per cent property, 50 per cent shares - with half the bonds and two-thirds of the shares invested overseas.

If your portfolio looks like that, and our expected returns hold good, then the overall return will be about 6.9 per cent a year - before taxes, fees and inflation.

It's pretty easy to redo the sums for your own portfolio once you know your asset allocation. If you don't know your asset allocation, maybe it's time to get serious.

The next step is to deduct fees. If you are a do-it-yourselfer, with direct investments in New Zealand bonds and using low-cost products for the rest of your investments, the average annual management fee on your portfolio is likely to be around 0.5 per cent. If, on the other hand, you invest via a portfolio of unit trusts which a financial planner monitors for you, total fees will average about 3 per cent a year.

So, after deducting fees, your 6.9 per cent return will be somewhere between 3.9 per cent and 6.4 per cent a year.

Calculating tax is the next step. Most NZ investors who use balanced unit trusts and super funds are unwittingly paying capital gains tax, but today's low returns mean that is not nearly as big a deal as it once was.

If your fees are around the 3 per cent a year level and your portfolio is subject to capital gains tax, deduct 1.3 per cent for tax. If you get hit with income tax only, deduct 1 per cent. If you don't know your investments' tax status, ask your adviser.

Those are the return assumptions. Now let's see how they apply to three different savings scenarios:

Scenario A: A couple aged 45, planning to retire at 65, have investment assets of $50,000 (not counting their house) and save $500 a month through a portfolio of managed funds which are monitored by a financial planner and which are subject to capital gains tax.

The expected return on their investments is 3.9 per cent a year. Deduct 1.3 per cent for tax and 2 per cent for inflation and their "real" return is just 0.6 per cent a year.

By retirement, they will have the equivalent of $181,000, in today's dollars. Incidentally, total management fees on this option add up to $76,000.

Scenario B: The same as above, but with total annual fees of 0.5 per cent and no capital gains tax, to yield a real return, after taxes, fees and inflation, of 3.4 per cent a year. Now the couple can expect to retire with the equivalent of $267,000 in 2002 dollars.

Scenario C: A 25-year-old saves $100 a week through a company superannuation fund with total annual fees of 1 per cent a year, no initial fees and subject to capital gains tax. The total real return after tax, fees and inflation is 2 per cent a year. After 40 years the total saved will be the equivalent of $295,000 in 2002 dollars.

Note how sensitive the final amount is to changes in the rate of return. Einstein is supposed to have said that the greatest force in the universe was compound interest. Perhaps that's not quite so true in a low inflation world; under the new rules, what you retire with is a lot closer to what you have saved.

So much for guesstimating the terminal sum. Next we need to forecast what return a portfolio will generate for us once we retire.

One major source of disappointment with financial plans, apart from overstating returns, concerns the failure of advisers and their computer models to differentiate between cash income and capital gain.

More often than not, the spreadsheet forecast of one's retirement income lumps together capital gain and income, thus assuming a similar level of volatility.

As we know, more than two years into the current bear market, interest and dividend payments, although not guaranteed, are a lot more reliable than capital gains. Thus we should separate income and capital growth.

Another issue is how you divide up your investments once you retire. The conventional wisdom seems to be that, unless you have millions to invest, on retirement you will sell all your shares and put all your money into high income bonds.

In real life, that's not the way things are. More realistically, let's assume that during retirement your assets are divided up like this: 50 per cent bonds, 40 per cent shares and 10 per cent property.

Annual fees could conceivably range from 1 per cent to 3 per cent a year, which implies that your portfolio will produce a cash income of between 2.1 per cent and 4.1 per cent. In other words, every $100,000 of savings will produce something between $2100 and $4100 a year in cash - before tax - plus $1600 a year in capital gains, which may or may not be taxable, depending how you invest.



Cynics might observe that, with assumed returns of 6.9 per cent before fees, they would be better off leaving their funds on term deposit at 6 per cent or whatever. Certainly, with a high fee structure this is a fair enough comment but it is also a risky strategy.

With returns on overseas bonds and equities so low, the days of 6 per cent bank deposits look numbered. As well, the managed portfolio has the advantage that the income it produces can be expected to grow at around the rate of inflation.

Before all this makes you too despondent, spare a thought for the average US defined benefit pension fund which last year was still forecasting long-term returns of 9.4 per cent a year. The actual return last year was minus 7 per cent.

What rate, you might ask, does that doyen of the investment markets, Warren Buffet, use for the pension fund of his own company, Berkshire Hathaway? Apparently the man from Omaha is counting on 6.5 per cent which, if fees are 0.5 per cent, is remarkably close to our 6.9 per cent figure.

* Brent Sheather is a Whakatane investment adviser.

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