Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 195

Four things retirees must know about shares

Australian retirees have a love affair with shares, but not all share portfolios are created equal when it comes to providing sustainable income. This article focusses on the four things that pension-phase investors need to consider when investing in equities: tax, income, growth and regulations.

1. Tax matters – but not in the way you think

Retirees have different needs to accumulation phase investors, and tax is one of the big differences. In particular, the role of franking credits is crucial, while capital gains tax is not an issue at all.

One failure of the Australian investment industry is that franking is largely invisible, with investment returns conventionally reported pre-tax, excluding franking. For a pension-phase investor, the difference is significant.

Chart 1 highlights the tax differences between pension, super and the highest individual tax rate. For the pension investor, $1 of pre-tax capital gain (short or long term) or unfranked income (interest, rental, overseas dividend, unfranked dividend) is worth $1. However, $1 of fully franked dividend is worth $1.43 since the pension investor gets a $0.43 franking credit refund. Franked dividends are also worth the most for super investors at $1.21, with long-term capital gains worth $0.90 whilst the other two returns are worth $0.85.

This clearly highlights why taxed investors would prefer low turnover strategies to reduce the time value of capital gains tax (CGT). However, for pension investors there is no cost to realising or delaying realising a capital gain, as they pay no CGT. So the common perception that low turnover strategies are tax efficient is not correct for pension investors.

Chart 1. The after-tax value of $1 of pre-tax return

Source: Plato, ATO using current tax rates, including Medicare and Federal Deficit Levies

2. Income matters – and so do franking credits

Retirees have different needs to accumulation phase investors. They need income to live off, are likely to be less risk tolerant than working investors, and their pension income is tax free.

This should be reflected in both the design of retirement-phase products, and in the way they’re measured. Generally, income returns are calculated without regard to tax or franking credits, while observations that Australian shares have suffered from a ‘lost decade’ of poor returns don’t give sufficient credence to the income generated.

On its own, price growth of Australian shares is underwhelming. Over the 10 years to the end of 2016, the ASX/S&P200 price index has tracked predominantly sideways, as highlighted in Chart 2. In price terms, it still hasn’t returned to its pre-GFC highs recorded on 1 November 2007.

Chart 2. Australian shares over the past 10 years to 31 December 2016

But equity investing is not all about capital growth. When dividend income is added, the Australian ASX/S&P200 has actually returned 4.5% p.a. over the 10 years to 31 December 2016. Not a great return, in our opinion, but certainly better than the capital growth suggests. The official overnight cash rate averaged 3.8% p.a., whilst the average 1 year term deposit interest rate averaged the same 4.5% p.a. as the dividend yield over the same 10-year period.

However, the 4.5% p.a. term deposit income didn’t include franking credits, which the dividend income stream did. Australian pension phase superannuation investors get a full refund of franking credits, so franking credits represent extra income.

Using the S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt), the total return for tax-exempt investors like pension-phase super, charities and low income Australian investors increased by 1.6% p.a., giving a tax exempt total return of 6.1% p.a., over the 10 years.

Chart 3 highlights the differences in index returns including franking for tax exempt investors.

Chart 3: Australian S&P/ASX200 cumulative returns with and without dividends and franking credits – 10 years to 31 Dec 2016 based on investment of AUD$10,000.

Source: S&P. Price = return on Australian S&P/ASX200 Index; Accumulation – return on S&P/ASX200 Accumulation Index; Tax Exempt = return on S&P/ASX200 Franking Credit Adjusted Annual Total Return Index (Tax Exempt).

Dividend income and franking credits are an important part of the total return for share investments. For the 10 years to 31 December 2016, income has represented all the return from Australian S&P/ASX200 Index.

Many investment products aren’t structured to distribute regular income, and in the current low interest rate environment we believe many traditional cash, bond or annuity based products are unlikely to be able to deliver the minimum 5% p.a. income stream that a 65-74 year-old retiree requires.

3. Growth matters – even in retirement

Ultimately income has to be generated from underlying capital, so most pension-phase investors need to protect - and even grow - their nest egg. This total return focus is key to managing longevity risk and when done well, it’s why shares play an important role in retirement portfolios.

Even as an income-focused investor, we believe in building portfolios that generate capital growth over longer time periods despite the subdued capital growth of the Australian market over the past decade. For instance since the start of 1980 to the end of December 2016 Australian shares have risen approximately 10 fold in capital value, with dividend income growth generally keeping pace with that capital growth. Shares enable both income and capital potential to be captured over the longer term.

4. Regulation matters – pension asset tests have moved the goalposts

The last 12 months have presented a number of challenges for self-funded retirees. The government’s asset test changes have crimped part-pensions for many people in addition to the raft of new superannuation rules set to take effect on 1 July 2017.

We estimate that a home-owning couple with $800,000 in other assets had (until 2017) received $567.15 per fortnight in part pension and we expect this will fall to just $47.70 per fortnight, a reduction of over $500 per fortnight or $13,500 per annum. Similarly a single home-owner part pensioner with $550,000 in assets will miss out completely on a part pension, losing some $365 per fortnight or nearly $10,000 per annum.

What can pensioners do to offset the pension changes? The government suggested that part pensioners can make up for the loss of income by drawing down on their assets. For instance in the $800,000 couple example, the pension reduction can be offset by drawing down 1.7% of that $800,000 in assets each year.

Alternatively, if the $800,000 in assets earns 7.8% p.a., then based on our calculation the pensioner can offset the loss in part pension without drawing down. We think this is a better option, and is more consistent with the way pensioners behave.

Can a 7.8% p.a. return be achieved in the current low yield environment with Australian official cash rates currently at 1.5% and 10-year Australian Government Bonds currently yielding less than 3%?

It will certainly be difficult, particularly for conservative strategies with large weightings to cash and bonds.

Thankfully Australian equities provide some of the strongest income opportunities available in the world today. For an Australian pension-phase investor who gets a full refund of franking credits, we’ve shown that the S&P/ASX200 yielded approximately 6% p.a. in income in the decade to end 2016, with about a quarter of this due to franking credits.

But high yield Australian equities have potential to earn even higher rates of income. For instance, Australian banks currently yield around 8-10% p.a. on a grossed-up basis for franking.

However, pension investors need to balance risk and return, and so putting all their eggs in the Australian banking sector may not be a wise strategy. Pensioners investing at least part of their assets in well-diversified equity products (both Australian and global) that produce the required returns should help preserve their capital base over a long-term investment horizon.

 

Dr Don Hamson is Managing Director at Plato Investment Management Limited. This article is for general information only and does not take account of any person’s financial circumstances. On 9 March 2017, Plato opened its first LIC to investors, providing the opportunity to invest in an actively managed, diversified portfolio of Australian shares with an income focus.

 

11 Comments
David Tanner
April 03, 2017

How long has that been in place?

Graham Hand
April 03, 2017

Since the year 2000. Many investors such as pension funds and charities with nil tax liability receive large refunds of franking credits.

Graham Hand
April 02, 2017

Hi David, there is an entitlement to have dividend imputation tax credits refunded in cash when your tax liability is less than your franking credits (after taking into account any other tax offsets you are entitled to). So they are of use if below the tax-free threshold.

David Tanner
April 02, 2017

Franking credits are no use if your income is below the tax free threshhold. As well as that, if you are not paying any tax, you are not making a lot of money.

SMSF Trustee
April 03, 2017

Or you are older than 60 and receiving tax free pension income from your super. If you are doing your accounts right you should get a refund from the ATO for your franking credits.

Or you are a charity that is tax exempt and has some investment funds earning franked dividends.

Knowing things like this is one of the reasons everyone should have a financial adviser.

Anthony Saliba
March 27, 2017

Thanks for the article Don.

Just wanted to point out that the return provided by an annuity is made up of both investment returns and mortality credits which, if you live long enough, generally outperform any asset you can find in the financial markets (which makes it a very good alternative for managing longevity risk).

Shylock
March 25, 2017

Should the government reduce the corporate tax rate, then will this not lead to a reduction of franking credit income/tax refund for shareholders ??

So all shareholders especially the retired SMSF in pension mode will partly be funding the corporate tax cuts as the government will not have to refund as much in franking credits.

They giveth with one hand and taketh with the other. Now you see it, now you don't.

Warren Bird
March 27, 2017

As Ross Gittins has pointed out in his latest piece of wisdom http://www.smh.com.au/business/comment-and-analysis/company-tax-cut-has-a-notsodirty-little-secret-20170325-gv6d6v.html

b0b555
August 05, 2017

But companies will have more after tax funds to payout as dividends. I expect the gross amount of dividends to remain much the same.

Jerome Lander
March 23, 2017

I would add that retirees should also know that shares don't always go up and can fall very substantially in value, making whatever income they are making from them a lesser concern for some people than the potential capital losses.

If retirees don't have a very long time frame when investing - and can't stomach a big fall in prices - and shares are expensive and at risk of large losses, it may not make sense to have long only share portfolios alone, whether these are biased to harness dividends or not.

There are many other strategies out there which mitigate the risk of large losses, and these are worth considering in great detail. Ask your adviser what the worst possible case is from owning a share portfolio alone, as downside risk management is critical if your portfolio, particularly if your portfolio is limited in size.

John Parker
March 23, 2017

An excellent piece, thanks Don.

 

Leave a Comment:

     

RELATED ARTICLES

Easy money: download Robinhood, buy stonks, bro down

banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.