Investing for Income Series: When you shouldn’t invest for income
Nevertheless, it’s always important to have the SMSF fund members’ long-term income needs in mind, no matter whether members are still working or if they have retired.
Self-managed super fund (SMSF) investors often trade off income for growth. That is, there is often a balance required between assets in the fund that produce a regular return versus those that have the potential for capital gain.
Most diversified SMSFs have a mix of assets that produce income and those whose underlying values will rise over time. The right split will depend on each investor’s needs. Sometimes, a bias for growth over income will be the right approach.
Damian Liddell is a financial adviser with Browell’s Financial Solutions. He says investing for income is often less important for wealth accumulators – people building their assets before they retire.
“Typically at that stage of your life you’re investing for long-term growth; that is, you’re investing for future needs and don’t need any immediate return on your investments,” he explains.
Nevertheless, it’s always important to have the fund members’ long-term income needs in mind, no matter whether members are still working or if they have retired.
“Trustees should focus on total returns. By that I mean, focus on income plus growth less fees and taxes,” advises Liddell.
“Most investments other than property are fairly liquid, which means you can easily buy and sell them. It should not matter greatly if trustees have to occasionally make a partial sale or redemption of an asset to realise some profit, to top up cash levels,” he adds.
In fact, focusing solely on one source of return and disregarding others can lead to traps. Relying too much on dividends for income is one example.
Retirees in particular tend to buy certain shares for their historically attractive dividend yield. The risk with this approach is that for whatever reason, the company’s share price could fall, and the dividend can also be reduced. There’s no guarantee just because a company has paid a solid dividend in the past it will continue to do so in the future.
Working out the trade off
Liddell uses the performance of the Australian share market compared to international shares since financial crisis of 2007/2008 to demonstrate why it’s important to focus on an investment’s total return. Since that the time the All Ordinaries has returned 3.5% a year, versus international equities, which has delivered 6.6% a year.
“In Australia we have a strong demand for income in the form of dividends. As such local companies have high payout ratios. The average dividend yield on Australian shares is 4% whereas it’s only 2% internationally.”
“Australia’s tax treatment of dividend imputation credits is part of the reason for this difference. This creates incentives for Australian companies to pay out high fully franked dividends to meet investor demand,” he explains.
However, by retaining most of the profits within the business, international companies have been able to grow their operations.
“Whereas in Australia, given they have relatively little retained earnings, companies have not performed as strongly as their overseas counterparts,” Liddell says.
A different perspective
Greg Einfeld a director of SMSF specialists Lime Super, has a unique approach to income.
“Many advisers recommend retirees invest for income rather than growth, so the income can meet their spending needs. Subject to risk and liquidity constraints, a better approach is to select a portfolio that will maximise expected return,” he argues.
For example, suppose an SMSF has $1 million in assets and members need $50,000 a year to meet their spending requirements. There are two assets available in the fund to achieve this.
Asset 1 yields 5% a year with no expected growth. Asset 2 yields zero, with expected growth of 8% per cent. Both investments have the same risk profile.
“Many advisers would recommend Asset 1which provides the required income. But the investor would be better off earning 8% with Asset 2, and selling 5% of their holdings each year to fund their lifestyle,” says Einfeld.
“In doing so they will end up 3% better off a year. What’s more, their tax position will be better with Asset 2, because capital gains are taxed less than income,” he adds.
So SMSF trustees have two important considerations with income: risk and liquidity. The overall risk of the portfolio should be in line with the investor’s risk tolerance, and the assets should be liquid enough so that a proportion can be sold each year to meet spending requirements.
It’s a good guideline for trustees to follow when making decisions about the right asset allocation for the fund.