New hurdles in the 'chase for yield'

PORTFOLIO POINT: The Australian government will be watching the impact of estate planning changes in the US. You should too, as they could affect your retirement nest egg.

Buried in all the rhetoric that surrounded the 2012 American election campaign was a very serious attack on share owners and in particular retirees.

Interestingly, we saw similar forces in Australia emanating from Canberra looking to take to the Australian superannuation movement with an axe. Thanks to the work of Eureka Report, Business Spectator and great help from Bill Kelty, that movement was at least mothballed.

But we will need to be on the alert. I don’t think many analysts really appreciated the viciousness of the attack on the US sharemarket and retirees that is now imbedded into the so-called fiscal cliff. We are looking at a possible sharp rise on the tax on US dividends, which will simply reduce the value of American shares. Just how big the rise is will depend on the negotiations between the Democrats and the Republicans. There is also a massive hike in death duties and a lowering of the cut-off rate for those eligible for death duties from $10 million to $1 million.

And in the United States, for savings and assets over $1 million – half the money is going to end up in the pockets of the tax man rather than descendants and family.

This will cause some angst in America, just as it did in Australia. We will need to be very alert in this country because if the final negotiations between the Republicans and Democrats leave the estate duty as it is now planned to be, it will represent a tax source that the bloated Canberra public service will look to tap.

Because Australian estates for the most part are not taxable I certainly have not gone into any elaborate estate planning exercises. In years gone by I have seen friends involve their family members in such asset protection moves, often with disastrous results, particularly when the family member becomes divorced/separated from their spouse or partner .

But in the US they look set to go down that journey – yet another lawyers’ picnic.

When the Republicans finally realised that they had lost the election there was considerable anger, because it was an election that should never have been lost given the high levels of US unemployment.

They were not able to focus their attack on retiree America in the way it would be done in Australia, partly because they played a role in these special taxes as part of their Boston Tea Party exercises. And, of course, in America large segments of the Hispanic and black populations are struggling and did not relate to the Romney rhetoric – a danger for right wing parties.

While Australian retirees are not under direct attack as they are in the US, they are under indirect attack. Indeed those who depend on investment income to live are starting to feel the pinch, and many are going to require lifestyle changes. Whether it be in Australia, the US or Europe, central bankers have lowered interest rates to the point where those borrowing money are substantial beneficiaries, while those saving money suffer.

The idea is that by having interest rates low it will stimulate economic activity and maintain bank profits. This strategy has to a limited extent worked in the US, but it is not working in Europe. Again in Australia it shows signs of working, but there is no clear recovery. In essence we are transferring wealth from the savers to the borrowers in our attempt to stimulate the economy. Because there are inherent problems in the US, Europe and Australia this wealth transfer process may take some time, so it presents a real problem for retirees.

The Reserve Bank is suggesting to retirees and investors that maybe they need to consider taking greater risks to achieve their required income. Effectively that means investing in Australian bank shares, Telstra and other high-income areas, but of course once an investor does that they are taking a market risk. And we have seen this week, with the fall on Wall Street, that such a strategy does carry real risk. So retirees have to weigh up the risks involved in share investment to gain higher income against the now much lower returns that are available without risk. There is no easy solution to this.

There are a number of strategies that can be adopted to maximise income in the equity market, but none of them avoid the equity risk. Last week I canvassed asset allocation strategies for self-managed superannuation funds looking to duplicate the strategies adopted by the Future Fund. I would not encourage investors who are comfortable with say a 33% equity content to suddenly double that equity content as they seek higher yields. Even more dangerous is to seek higher interest rate debentures and other lending securities.

For the last 50 years we have had countless numbers of finance companies go broke, which paid higher rates of interest and took higher risks. The latest collapse of Banksia here simply follows a trend that I first saw in the 1950s, that no doubt goes back even further. The rewards from interest-bearing securities, even though they are offering say 7%, are simply not high enough to justify risking all your capital. At least with equity you have the chance of a much higher rate of return from capital appreciation, so there is a potential reward for the risks you take.

I hope that in the next five years the governments will begin to understand how the infrastructure market works, and will offer to markets and particularly to self-managed funds a great many more infrastructure assets that will carry yields without the sort of market risks we are now experiencing.

It is very important that if you are investing for yield that you make an assessment on whether the income is able to be maintained, and be particularly wary of companies or trusts that get their income in part by high leveraging. In an ideal world there would be very limited leveraging of infrastructure assets, and investors would gain the benefit of surplus income generated without carrying the liability of risk.

It is very important in Australia that investors watch very carefully that we don’t follow the Americans and throw out our franking credits and other attractions to investment—it’s the only way we are going to maintain a substantial number of people who are able to fund their own retirement.

Reports this week indicate that a large number of people are in fact borrowing, and basically relying on their superannuation savings to come through as a lump sum soon after retirement. And then that lump sum is used to repay debts that have been built up in property investment, household investment and even credit card debt. This, of course, goes completely against the traditional superannuation plan, which is an excellent form of funding retirement because all returns are tax free once it is in pension mode.

But people are choosing a different strategy, and so there’s quite a lot of education to be done on the attractions of superannuation that has not been helped by the government’s chopping and changing and the very high fees that many superannuation funds charge.