Money: Nest-eggs look fragile

By Brent Sheather

A large part of my time is spent calculating what retired clients' investment portfolios can reasonably earn after tax and fees.

While this might seem fairly straightforward, it is not. In fact, if one was to go to four different advisers and ask: "What income can you generate from a balanced portfolio worth $200,000?" you would likely be given very different answers.

If you assumed the $200,000 was invested in a similar proportion to the average pension fund - 40 per cent bonds, 10 per cent property, 50 per cent shares - if you forgot about fees and tax, and if you took it that returns over the past five years were indicative, forecast annual income could be as high as $29,000 a year.

Alternatively, if you were to base the answer on longer-term historic performance and did deduct fees and tax, annual income would be around just $6000.

You can bet your boots that somewhere on any given day, someone is being advised that their funds will produce income on the basis of extreme scenarios such as these.

For Mum and Dad Battler, aged 55 years and 60 years respectively and who are nearing retirement with $150,000 in savings, it makes the decisions they need to make even tougher.

How much can they reasonably expect to earn after tax and fees from their nest egg? Should Dad Battler retire next year or stay working for another five years? Can they afford a trip to Britain to see their grandchildren?

But first a few definitions: Income: Is it being used in the sense of "dividends and interest, after tax and all costs" or is it equal to total return? The difference is very, very important, particularly if you don't have a heck of a lot of money.

Put very simply the difference between the first and second definition is that the latter includes capital gains. In other words, the second definition assumes that you sell some investments each year to turn capital gains into spending money.

This strategy poses a couple of problems.

First, it assumes that stock and property markets increase by a certain amount each year, whereas in reality stockmarkets go up lots for a few years, fall dramatically once in a while, and go nowhere for a good deal of the time.

The second problem is that many people who have saved religiously for years do not easily embrace the idea of living on their capital, particularly in a bad year or two when there are no gains to realise.

This discomfort can ultimately persuade people to move their money into higher-yielding, riskier investments, usually at the worst possible time.

Returns: Rightly or wrongly, attitudes towards stockmarket investment are invariably a reflection of the returns achieved over the past five or so years.

Over the past 10 years the average compound return of the United States stockmarket has been 19 per cent a year, some 71 per cent higher than the 11.2 per cent average since 1926. (Some academics have even noted that the 1926-1998 average US return of 11.2 per cent overstates the long term expected equity return because US returns since 1802 have averaged only 8.4 per cent and American returns have been higher than those achieved elsewhere in the world.)

So no wonder that per capita share investment is at its highest ever level in the US, Americans are spending like there is no tomorrow and sharemarket volumes are setting records.

The extraordinary returns of the recent past have been primarily due to falling interest rates. In the 1989-1998 period yields on long-term US bonds have fallen from 8 per cent to 5 per cent.

The reason for lower interest rates? That's easy. Lower inflation rates. The US Federal Reserve has shown that a 1 per cent fall in inflation translates to a 20 per cent increase in share prices.

But inflation cannot fall forever. Indeed, when it goes negative, as has happened in Japan in the past decade, it is bad news for share prices. More ominously, experts are warning that even long-term historic returns may not be achievable over the next five to 10 years.

Let's says the expected return will be unlikely to exceed 8.2 per cent over the next 10 years or so. A recent report in the London Financial Times was even more pessimistic with a 7 per cent forecast. I'm feeling lucky - we will stick with 8.2 per cent.

Similarly, the bond market is likely to enjoy much lower returns as the potential for interest rates to drop further is obviously less (given they have fallen as much as they have over the past 10 years), so a long-term return of 6 per cent seems reasonable.

This may be a little high as it is some 0.7 per cent greater than the 5.3 per cent average recorded over 1926-1998 yet inflation is likely to be well under the 3 per cent averaged since 1926.

Of course, in the bond sector the Battlers can currently achieve higher returns than our assumptions. Some corporate bonds yield 9 per cent and more.

But the higher return offered by these corporates reflects the higher premium the companies must pay to attract funds. Over the short term the risk with them may seem slight, but over 30 years even corporate giants can become shadows of their former selves.

Forming a view on property is more difficult. It is more risky than bonds and less so than shares. A return midway between bonds and shares, at 7.1 per cent, seems reasonable.

Putting all this together within the balanced portfolio gives a pre-tax, pre-fee average return of 7.2 per cent a year.

Fees and taxes: Fees and taxes can vary considerably in the financial planning industry. Some advisers set a big initial fee and little or no monitoring charge. Annual fees (management expense ratios) payable to fund managers for actually managing the portfolio can range from 0.2 per cent to more than 2 per cent. Monitoring fees payable to advisers range from zero to 1.5 per cent.

For individuals who invest in unit trusts, possibly through a mastertrust structure., annual fees are typically upward of 1.75 per cent covering the fund management and administrative features with a 1 per cent annual monitoring fee going to the adviser.

Most managed funds pay tax on capital as well as income returns. Thus a further 1.5 per cent needs to be deducted from the 7.2 per cent pre-tax, pre-fee return, to give a net return after tax and fees of around 3 per cent.

Back to work, Dad: Once you have agreed the income, tax and cost assumptions with your adviser, he or she usually loads that information into a computer model to see what sort of level of annual drawings is sustainable.

If Mum and Dad Battler invest $150,000 and assume an annual drawdown of $10,00, all the money will be gone by the time Dad is 76.

The Department of Statistics tells us that women aged 65 can on average expect to live to 84 years of age. Even if drawdown is reduced to $8000 a year, the funds will still be gone by the time Mum reaches the age of 87.

This is too much of a risk to take, particularly with the high likelihood of some "bad" stockmarket years in the next two decades and the degree of reliance on capital gains for income.

Note that over the period the proportion of the Battlers' income that results from actual dividends or interest decreases from 12 per cent in the first year to 6 per cent after 10 years.

The conclusion is straightforward: Back to work, Dad!

Anecdotal evidence suggests many advisers' expectations are still too high with the result that many savings plans will be underfunded.

A recent BT Funds Management's research document, How Long Will Your Money Last, assumed long-term investment returns would average 7 per cent after tax and fees. That is more than twice our assumed level of returns.

It is essential that the savings industry as a whole is realistic when advising individuals on retirement strategies.

Make sure your retirement plans are based on realistic assumptions. As they say, it's your retirement.

* Brent Sheather is a stockbroker in Whakatane.