Should under 40's salary sacrifice to superannuation?

It's a question that I'm often asked off the cuff by younger people, "Should I be contributing extra to superannuation?"

The question comes about because they want to set themselves up for retirement and they know starting early is the key to that. There is basically one major pro and one major con - the pro is tax savings and the con is that it is locked up for a long time. That con however could also be seen as a pro, as it can be a method of 'forced savings' similar to a mortgage.

There is never an answer that fits everyone, hence this being just general advice, but lets have a look at it to help you make the decision.

There is 2 types of contributions you can make:

Non concessional - a contribution to superannuation using after tax money. ie. money you have already paid income tax on and is in your bank account. A non concessional contribution incurs no contribution tax on entry to superannuation as you've already paid income tax on it.

Concessional - this refers to contributions your employer makes as well as salary sacrifice contributions or a contribution that a self employed person makes which they claim a tax deduction for. It is essentially contributions made using pre tax money. Money in which income tax hasn't been paid yet. Concessional contributions incur 15% tax on entry to superannuation.

For most people under 40, they probably shouldn't be making any non concessional contributions, unless they are a low income earner and can access the government co contribution. In which case, they should only be making up to $1,000. For details on the thresholds for this, you can visit the ATO Website here. For some lucky few who have managed to accumulate significant wealth prior to the age of 40, they may start looking to make some larger non concessional contributions but this would definitely be in very rare circumstances.

For someone making extra concessional contribution (above the employer contributions), such as requesting your employer to salary sacrifice contributions, the benefit may just be worthwhile. The tax savings on salary sacrificing to superannuation depends on your marginal tax rate. If you are on the top marginal tax rate (and earning less than $300,000), you will save 34% in tax after taking into account the 15% tax on superannuation. It essentially means that by giving up $1 of after tax income (money in the bank) you would have $1.67 in superannuation. 67% more money just by having it in superannuation and if you are on the top marginal tax rate, you probably have reasonable cash flow to afford to give up a few $.

As you earn less, the savings become less, and the less likely that you have surplus cash flow lying around but that definitely doesn't mean people on lower marginal tax rates shouldn't salary sacrifice.

Looking at the maths, however, doesn't really answer the questions - there is other factors at play. For anyone under the age of 40, their preservation age currently 60, and we'd probably be kidding ourselves if we didn't think it will be more like 65 by the time we get there. So, what do you do?

Well, as I said earlier, there is no right or wrong answer but what I will say is that I talk to people all the time about their finances, it's what I do, and I'm yet to meet a person that has said "I really regret putting away that extra money into superannuation" but I do meet people all the time who aren't adequately prepared financially for retirement and I also meet plenty of younger people (myself included) that spends money on things that they could probably do without.

For most people (earning between $37,000 and $80,000) they are on the 34.5% marginal tax rate. Why don't you think about requesting salary sacrificing say $50/week. It'll mean you'll have $32.75/week less in you bank account. Maybe increase it over time? Your future self will thank you for it.

Note: it is important to remain under your concessional contribution cap of $30,000 per annum for those under the age of 50. This includes what you employer contributes for you. This is general advice only and does not take into account your personal circumstances. We recommend you seek professional personal advice.

Author: Glenn Hilber is the Senior Financial Adviser for Precision Wealth Management. He can be contacted on 1300 200 012 or enquiries@precisionwm.com.au

The biggest investment crash ever

Every time the RBA cuts interest rates, the news will run a little segment on how this is great for borrowers and bad for retirees as their income on their cash investments has reduced.

The goal for a retiree would be to invest to ensure they have adequate income to live on for their entire retirement. If a retiree with $1,000,000 in the late 80's (they would have been considered a very wealthy retiree at that time) had invested in cash, they would have been enjoying income of about $140,000 per annum at the start of their retirement. By 2008 that would have been down to about $50,000 per annum and now they would be struggling to get $30,000 per annum. A fall of over 75% in income!!

Is that not the biggest crash ever? To have your income fall by 75% in a period where living expenses have more than doubled.

Not to mention, inflation has halved the real value of your capital over that time.

And cash is meant to be the safe investment, and shares are the risky investment, right?

If that retiree had invested their full retirement savings in the ASX 200 at the time and just left it there, living off the dividends each year, their retirement savings would be about $10M today and they would have income of about $500,000 per annum. HALF A MILLION $ PER ANNUM! As opposed to the guy who took the safe option now receiving $30,000.

Sure the first few years they would have received less income but I'm sure anyone looking at these numbers would choose less income for a few years.

Retirees really need to change their thinking when it comes to investing in retirement. They really need to invest less of their savings into the risky cash and allocate a large portion of their wealth to the safe shares.

QSuper have changed their default investments to the lifetime investments options. This now means anyone over 58 (who hasn't made an election) now has between 50 - 75% of their retirement savings in CASH!!! A 58 year old could have 40 years of investing ahead of them. The example above, back to the late 80's, is less than 30 years. I think you get my drift on what I think of this.

In other news, the government has already come out ahead of the budget to announce the Age Pension asset test will be tightening. I've been saying this for a long time. And expect to see the principle residence included in some way at some point in the future. What does this mean? Simply, if you want a comfortable retirement, you need to take control and plan to be completely self funded. The Age Pension will be only for those people on very limited income in retirement.

If you would like to discuss your retirement plans and investments with an independently owned and licensed, fee for service, financial planner, contact me on 1300 200 012 or www.precisionwm.com.au

Should we invest based on managed fund star ratings

There is a big industry out there to review all the managed funds available and give them star ratings to try help people choose the right fund that will 'do well' but the problem is, they really have no idea. They are like the fortune telling/horoscope industry, the only difference is there is billions of dollars at play and people base fairly large financial decisions on them.

The data shows that people follow the star ratings - just look at the following graph. It shows cumulative cash flows of 4 and 5 star funds are positive (meaning more people added money to these funds than withdrew month) and negative for 1, 2 and 3 star funds (meaning there is more withdrawals than additions to these funds).

Data provided by Morningstar and adapted by Vanguard

But, how do you the star ratings actually perform? Surely it must be a reasonably decent guide?

The following graph shows the performance (relative to their benchmark) of the different star rating funds for the 36 months following their star rating.

Data provided by Morningstar and adapted by Vanguard

The graph shows that after funds have been awarded their higher star ratings, which is generally based on past performance, they then demonstrate the most under performance. Quite a classic case of a statistical term - mean reversion.

I'll note at this point that on aggregate, all funds collectively under perform the index and that is a fact of life, the index has no costs in it but there will always be costs involved when investing. The collective under performance is usually around the 1% mark which is roughly the average cost of actively managed funds.

So what do we do? Go through and pick the lowest star rating funds? They should under perform the least?

No!

We simply ignore the star ratings and take a passive approach to investing. Don't try pick the top or bottom fund of the year before. Simply have low cost exposure to the asset classes that are appropriate for you. Don't take speculative risks and remain diversified. Over the long term, you will end up with a successful investing experience which results in greater lifestyle outcomes, as that is really what it is all about.

We all want greater lifestyle outcomes and that's what I'll award 5 stars to!

Sequencing risk - What can retirees do to minimise it?

Sequencing risk is the risk that you experience negative returns early in your retirement.  Because you are drawing on your capital, the sequence of returns matter even if the long term returns work out to be the same.

It is a really difficult risk as we don't know what order of returns you will get. Over the long term, we can be pretty confident on the returns a portfolio will deliver within a couple %, but over the next 12 months, they can be very varying.

Retirees who went through the GFC were told to not panic, markets come back etc etc. and those who stayed invested are definitely better off than those who switched to cash at or near the bottom of the market. But the fact you have been drawing on your money, means it won't bounce all the way back as you might be expecting and it is an issue.

So, how serious is sequencing risk? Let's relate it to Russian roulette. The chances of getting the bullet is pretty small (1 in 6 I think, not too familiar with guns), and once it goes click - no bullet, you're fine. What was the issue? But, there is that 1 in 6 where it becomes a serious issue. So, what can we do to keep you alive if you are that 1 in 6 (I'm not saying there is a 1 in 6 chance of a major negative return for retirees, I'm just keeping with the Russian roulette odds).

Have a look at the following graph. It shows 2 retirees with the exact same portfolio and returns. One uses the returns from January 1990 through to end of Feb 2009 (bottom of the GFC), and the second person is reversed. ie. they got the bad returns of the GFC first up. This is for a retiree with $500,000 and drawing $30,000 per annum increasing at 3% p.a. On paper, these 2 people had the exact same annualised return for almost 20 years but in reality, have a very different outcome. If they had retired at age 60, they would be 80 now and with possibly another 10 - 20 years left in retirement - you wouldn't want to have just $264,500 remaining and drawing over $50,000 per annum (as that what it now would be after inflation for 20 years). It isn't going to last long, even if you get better than average returns over the next few years.

So, what can you do to avoid this/limit the risk? Well, there is a few things you can do. One would be to return to work for a couple more years if you were to experience bad returns first up, however, for a person who retirees just prior to a GFC type situation, it can be very difficult. They are unlikely to be able to re-enter the workforce due to their age and unemployment has possibly just increased.

So, better planning and going into retirement with a greater asset base. This first example started drawing 6% of their asset base, increasing with inflation. Although that looks fine in the scenario with returns from 1990 going forward, that was a particularly good time through the 90's and 00's. Having a greater asset base at retirement and drawing a smaller proportion reduces the issues around sequencing risk.  The following graph shows the same 2 sets of returns, same annual income, but they start off with $1,000,000 rather than $500,000. As you can see, the negative returns early had less of an impact on their overall retirement.

Another option is to reduce the amount you are drawing as soon as you start having poor returns for a while to reduce the negative impact of the downturn. The following graph shows the 2 scenarios from the original example, but a 3rd scenario of reducing the annual draw down to $12,000, after the first 2 months of negative returns, increasing with inflation for 3 years, then reverting to the original draw down.

Another thing you can do is to have a more conservative asset allocation. With a lower allocation to growth assets, sequencing risk becomes a smaller problem. But, that then opens up to a greater risk of outliving your money because you didn't achieve high enough returns though out retirement. Alternatively, if you are faced with poor returns early, you could take an aggressive approach to get out of the situation, by increasing your allocation to growth assets during the down turn (this approach would work well when combined with reducing your draw downs as well), but again, it isn't a free lunch because you are increasing the risk of your portfolio.

What about those people who retired in 2006,07,08. They are now quite a few years on and can now see that they are faced with a lack of capital for a potentially long retirement. What can they do?

Well, there is no magic bullet. You could reduce what you are drawing (almost indefinitely) to allow your portfolio life to extend as long as possible. Take a more aggressive investment allocation but that comes with increased risk. But ideally, return to work, even in a part time role just to supplement your income to minimise the draw down on your portfolio so it can recover.

At any point in time, getting good quality advice will be the best way for you to navigate your entire retirement financing issues.

If you would like advice on your retirement planning, contact Glenn Hilber on 1300 200 012 or enquiries@precisionwm.com.au. Or visit the Precision Wealth Management website at www.precisionwm.com.au

Annuities - Are they really good?

I was watching TV the other night and they had an ad for annuities. Annuities provide a guaranteed income for a defined period of time, some of which are for your lifetime, however long that may be. I must admit, the ad looked quite good and I imagine would work quite well for someone approaching retirement who might be a bit worried about investing in the stock market or for whatever reason really likes this idea of "security".

But how good are they?

Well, I thought I would have a look into it and do some calculations for a comparison.

Right now, you can get an annuity (for a 65 year old male) that will pay $4,268.77 per annum for the rest of your life guaranteed. I stress to clients or prospective clients that longevity is a big risk for retirees, we are living so long in retirement that you need to be prepared. So the idea of an income stream that could potentially last for 30+ years sounds pretty good, right?

Well, maybe not so. Lets assume our 65 year old male purchases his lifetime annuity for $100,000 and gets his $4,268.77 and he lives quite a good life and lives to 100 years old, so he receives his annuity payments for 35 years. His original capital investment of $100,000 has returned $149,406.95 in annuity payments, so it's really only earned him $49,406.95 as the lifetime annuity in this example has no residual value if death is after the first 15 years.

So, lets take another person who decides to invest it in a reasonably conservative, diversified portfolio which can expect to earn 6% per annum with growth and dividends/interest. This person also takes $4,268.77 per annum from his investment until he reaches 100 years of age. He has also taken his $149,406.95 in payments over the 35 years, but the original investment still remains and with the growth after all his payments, has a residual value of $264,378.

So the annuity person received $149,406.95 and the person who invested and achieved 6% per annum has a total of $413,784.95 (the income they've taken plus the remaining capital value).  Or to look at the annuity another way, a $100,000 investment, drawn down to $0 after 35 years with an annual payment of $4,268.77 works out to an equivalent interest rate of 2.42%. Do you really want to lock yourself into an investment which is going to give you an equivalent rate of 2.42% over 35 years?

If you are still thinking "ohhh...but with the global financial crisis I just don't know, I might not get a very good return anywhere else", the example I gave was a 6% return. My model portfolio with 50% growth assets and 50% defensive assets has returned 7.08% over the last 10 years - The GFC was right in the middle of that.

Do you want to take a very very small chance that you might not achieve the investment return you wanted over 35 years? Or do you want to guarantee the investment return over 35 years is not very good (ie. the annuity).

In fairness to annuities, they can provide Centrelink benefits with favourable income and asset assessment so there can be a benefit there.

We just can't go without

Can you imagine always leaving home without a mobile phone. The moment you leave the house, you are un-contactable for the whole day until you get back home? You can't just give someone a quick update with an SMS? The idea is just unfathomable.

What about going without air conditioning on those really hot summers days? Or without the internet or TV? The idea to go back to life without these things just seem impossible.

Well, this is the issue that our governments have at the moment in trying to repair a serious budget black hole. The government needs to save money but taking something away that we've become so accustomed to is met by fierce objection.

"Everyone in the last 10 years got a baby bonus or paid parental leave and I pay taxes so I should get it too."

Well no. If the government takes away some sort of benefit or welfare, there comes a point in time were someone doesn't get it.

It's just like queuing up for tickets to a sports game or concert and they sell out. Somewhere in the line, the person in front got tickets and you didn't and this needs to happen for government hand outs.

Baby bonus/paid parental leave, Family tax benefit, HECS and government assisted tertiary education, free* health care, age pension, any welfare for that matter.

I'm not saying all of these are bad and should be scrapped altogether, but something needs to change and as I said earlier, taking something away that we've had is very difficult to accept.

Look at the backlash and resistance to the proposal to increase the age pension age to 70. The outcries of the government making everyone work so long.  When the age pension was introduced, the qualifying age was 65 (for males) and our life expectancy was 63.  So living long enough to claim it was a good outcome. Now, it is seen as a right to get the age pension, and not just get it, but get it for 20 years.  The age pension age being 70 is not the retirement age. The retirement age is any age you want if you have enough money so the onus is on you if you want to retire earlier.

So, all that I ask is that before you just jump up and down at a proposal to remove some benefit to help repair the government budget and before you start sharing the hate photos on Facebook about how they have no right to take this or that away, just have a think about it and maybe share this blog instead (shameless plug). Sure, it would be nice if we could just have everything but unfortunately the world doesn't work like that. Politicians don't work on a bonus structure on savings they make and they don't have some psychiatric problem where they just want to see us suffer. Sometimes taking something away is for the countries long term benefit.

*Health care isn't free. It's just not on a user pays system so it 'seems' free.

The big risk for retirees and it's a good thing

So what could possibly be a big risk for retirees and be a good thing? Stock market crashes aren't a good thing. Reducing government assistance in retirement isn't a good thing. Inflation devaluing your assets isn't a good thing.  Well, the big risk for retirees is living too long. Advancements in modern medicine and better health is resulting in increasing life expediencies which means you need more money to support your retirement plans.

Having a life after you finish work, especially in good enough physical health to travel and enjoy yourself, is a relatively new concept and it is growing more and more. By that I mean, our life expectancy is growing rapidly, yet there is a large reluctance to work past peoples preconceived retirement age, just see the uproar when the government recently announced plans to increase the age pension age to 70 (from 67); Pension Plan Backlash. So what does this mean?

Well, lets just assume someone retires at age 65, even though some retire later and there are plenty that retire earlier, well they want to. At 65, the life expectancy for a male is 19.2 years and a female is 22.1 years. So, for a couple and working on round figures, we could work on 20 years, calculate an assumed rate of return, inflation and how much they want to spend each year and presto, we can work out how much money they need.

But that's the problem with a simple calculation like that, and that is, there are many many people living beyond their life expectancy, although not exactly, we'll say roughly half do. On top of that, the continual advancements of medicine and healthcare means we don't know what life expectancy is like in 10 or 20 years time. So, I'd put my money on well over 50% of 65 years olds will outlive their currently life expectancy.

So, therein lies the problem. If you have enough money for 20 years, are you then unlucky to live a healthy retirement past what your life expectancy was at age 65?

So, what do we plan for? Well, my opinion, longevity risk is a big risk for retirees these days. By the time you realise you are going to live too long for your assets to support, it's too late. There will be very little opportunity to go back to work and the Age Pension is borderline poverty at best and likely to get worse. So, I suggest when approaching retirement to plan on living to 95. Sure, you might spend less in the last 10 or 15 years of retirement than you do in the first 10 or 15 years, but that can be included in the calculations.

So, lets take a couple wanting to retire at age 65 and base a calculation on living to 95 and they are going to spend $58,188 for a comfortable retirement for a Queenslander (according to ASFA Retirement Standard) . That's 30 years. Assuming they achieve a rate of return of 7% and inflation of 3%, They would require just over $1,000,000 outside of their family home. Unfortunately, very few have that. But they can; engage a financial planner that is working in your best interest, that puts a plan together to get you to where you need to be and start early. The longer the plan is in place, the easier it is to achieve.

My name is Glenn Hilber and I am the owner and Senior Financial Adviser at Precision Wealth Management, an independently owned and licensed financial planning firm operating on a true fee for service basis. If you would like to discuss your retirement plans, contact me on 1300 200 012 or glenn@precisionwm.com.au