5. RETIREMENT WEALTH
The pre-eminent savings vehicle for retirement is superannuation. However, there will soon be more limited caps on how much you can contribute. For example, the concessional (before tax) cap will be restricted to $25,000 a year for everyone from July 1.
I now encourage even younger clients to consider salary sacrificing to super earlier rather than later. It is now harder to catch up with later contributions. Another limit is that non-concessional (after-tax) contributions will be limited to $100,000pa from July 1.
Yes, it may take a little longer to pay off your home loan but the tax benefits in super will outweigh that. Also there is a real chance that many people simply won’t have enough to retire on if they focus too much on their home loan and not enough on super growth.
Our taxation system and the benefit of leverage from borrowing to invest in an investment property means that many people (including me) have benefited from the growth in residential real estate. But new investors need to be aware that negative gearing could well be removed by a new government, and this could affect your property’s value, at least in the short run.
Growth assets such as shares should be part of most portfolios. One of the great risks for clients is living too long – longevity risk – and if you don’t have enough growth assets your retirement wealth may run out before you do. This goes for money held in super as well as outside it. When you’re about to retire, your time frame should not be the two or three years to retirement but the next 20 or so years that you or your spouse will be living.
So where are we going to put your extra $200pw? We believe in “evidence-based investing”. And that has led us to an investment company called Dimensional Fund Advisors (DFA). Originating in the US but in Australia now for many years, DFA bases itself on academic research. Indeed, its advisory board had been chock-full of Nobel Laureates (in economics, of course!). When I got my master of applied finance in 1993, the core of our studies was based on the work of these academics.
DFA focuses on things such as:
Smaller companies over larger companies. Value over growth companies.
More profitable companies.
This has led to excellent returns over time, in both shares and bonds. DFA doesn’t pick stocks per se, though – if shares meet its criteria, it will simply pick the cheapest one on the day or wait until a stock that meets its needs becomes available at a better price.
To invest with DFA you will need to find a DFA adviser – DFA understands the benefits that good advice can add for an investor. By the same token, it is picky about the advisers it works with. For example, it has never worked with advisers who charge commissions on their investments. Advisers need to be trained at DFA seminars before they are allowed to use DFA products.
If you have a “balanced” risk profile you might be invested in the World Allocation 70/30 Trust (70% in growth assets and 30% in defensive assets). At the end of February, it had an average return of 10.57%pa (before tax) over five years.
However, we will use a more conservative assumption of 7.63% because that is the return we would assume for a balanced investment over time and the five-year return doesn’t include the GFC. Assuming this return was replicated in the next five years (we would be more conservative with an actual client about the future return), this would mean that your $200 could accrue to $63,055 (assuming an average return of 7.63% and no tax. There are 260 periods in my graph – 52 weeks for five years).
Super alternatives
From July 1 there will be new limits on how much you can add to super. And there will be a $1.6 million cap on how much you can have in an income stream. So where can you invest for retirement if you are in excess of this cap?
One possibility is using an investment bond. These instruments are taxed normally at the company rate (currently 30%) but the effective rate can be lower thanks to things such as franking credits.
Franking or imputation credits (where the government gives you a credit for the Australian income tax a company has paid) can make a big difference to a retired investor, so have your adviser look at that option too. The only problem is you will be limited to Australian shares and our market is dominated by the banks, BHP and Telstra. No exposure to Facebook or Apple there.
If you decide to sell an investment property, consider doing it in your first full financial year of retirement. This will limit your taxable income and you may be able to offset the capital gains tax liability with an unsupported contribution to super.
As always seek advice from qualified tax and financial advisers before acting – they’ll save you money in many cases.