Westpac exits financial planning …

You may (or not) have noticed my Blog article output has reduced over the past 12 months. Having written about 180 articles over the last 10 years and with retirement imminent, it has become increasingly difficult to find new personal financial planning matters that compel me to “put pen to paper”.

Unlike the financial media, we have refrained from recycling our old articles. However, re-reading many of those articles gives me some pride that we have remained true to our original intent of 10 years ago to provide educative material that would stand the test of time. While often prompted by a topical matter, the articles always addressed the subject of interest in terms of our “Principles of successful wealth management”. There isn’t too much we would change if we were to write on the same topics today.

The catalyst for today’s article is Westpac’s recent announcement that it is quitting personal financial advice, the last of the “Big 4” banks to do so. The article is more commentary and personal opinion, rather than the usual educative piece. It is motivated by the irony that as I approach the end of my 20 plus year career in financial planning the institutions primarily responsible for making it increasingly difficult and costly for firms like ours to “help (more) people make better financial choices”[1] have finally decided to vacate the space that, in our view, they should never have been allowed to occupy.

…but the damage remains

Unfortunately, the “Big 4’s” departure will leave behind a lot of baggage, in the form of overkill regulation and bureaucracy that will not easily be dismantled. The vested interests of the regulators, lawyers and educators who benefit from the bloated edifice created to “protect” consumers from inappropriate financial planning practices will almost certainly replace the bank lobbyists in arguing for the status quo or even more draconian regulation.

Bank lobbyists were extremely successful over the past twenty years in persuading legislators that irreconcilable conflicts could be managed, through such contrivances as prescribed:

• Disclosure requirements;
• Client best-interests duty;
• Client servicing requirements; and, most recently;
• Education and ethical standards.

However, the resulting compliance burden placed on all participants in the personal financial planning industry increased to the point where the “Big 4” banks were unable to make money from financial advice (e.g. Westpac lost $53 million in 2017-18 from its financial advice businesses), while remaining exposed to huge actual and potential reputational risks.

The costs of providing financial advice to those consumers the regulators believed they were protecting have been pushed to a level where most people who need assistance can’t afford it. Unless the legislators and regulators consider that good personal financial advice has no value, their constant tinkering over the past 20 years has been an unmitigated disaster for most consumers. The “red tape” has pushed financial advice into the luxury good category.

The future of financial planning?

Before you can provide an adequate solution to eliminating the poor financial advice practices uncovered over recent years (particularly by the Financial Services Royal Commission[2]), that persist despite ballooning regulation, you need to acknowledge the core problem. In our very strong view, that core problem has not changed in the past 20 years. For us, it’s difficult to conceive how impartial financial advice in the clients’ best interest will be consistently provided if the adviser’s employment or business is linked to that of a financial product provider (e.g. through shareholdings, revenue sharing, referral payments, bonuses etc.).

The solution then appears obvious – to legislatively separate product from advice. Any incentivised link to a financial product provider should preclude the giving of financial advice. The Hayne Commission appeared to be heading down this path but backed off (for reasons that aren’t clear) in its final report, suggesting enforcement of existing legislation is sufficient to counter poor practice.

But now that all four major banks have indicated their intention to exit financial planning, perhaps the political will to tackle the obvious conflict of interest head-on will emerge. Some existing institutional resistance will remain (e.g. AMP, IOOF and Macquarie) but its lobbying power to protect the status quo will be weakened by the absence of the major banks (except to the extent those banks want to sell their financial advice businesses to institutions that continue to provide conflicted advice).

Also, the one-stop accounting/financial planning/legal/mortgage broking practices would strongly object to the separation of product and advice. But their “convenience” pitch should not be strong enough to counter the significant potential to place the interests of the business conglomerate ahead of that of the client.

With regard to one stop shops, it is interesting to note that the financial advice firm Westpac intends to transfer about 175 of its current financial advice personnel (with their clients) to, Viridian Advisory, is rife with conflicts of interest.

The Financial Services Guide covering the Viridian Group states:

“The Viridian Group includes VPW, IAM, Viridian Advisory and VFGL. VPW, IAM and VFGL provide financial services such as financial advice, funds management, insurance, superannuation, investment and administrative services.”

It would appear that the affected Westpac financial planning clients will be going from the “frying pan into the fire” when it comes to receiving conflicted personal financial advice.

Some final observations

So, the “Big 4” banks conflicted wealth management models have collapsed under the weight of regulation. That’s a good thing for those, like us, who believe that financial advice should not be tainted by product links. But is has occurred 10-15 years later than it should have and left a compliance driven, still largely conflicted, industry that can’t profitably help those who most need help.

If the legislators are serious about making impartial financial advice affordable to the majority, they should quickly remove the product / advice conflicts and dismantle most of the regulations that have been progressively put in place in the unsuccessful attempt to manage those conflicts.

Realistically, I will have left the industry before that happens. It will be interesting to watch how things evolve over the next 5 – 10 years. But the exit of the “Big 4” banks leaves me more optimistic than any time since I began my financial planning career that personal financial advice can become a true profession.

[1] “To help people make better financial choices” is Wealth Foundations’ guiding objective.

[2]  The Hayne Commission i.e. the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.

 

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Another one bites the dust … is a post from: Wealth Foundations Blog

The share market “news” you’re hearing may be misleading

The four months to 31 December 2018 saw a nasty fall in both Australian and global share markets. As measured by the S&P/ASX200 Price Index, the Australian share market fell 11.3% over this period. At an end December 2018 level of 5,646.40, financial commentators couldn’t help themselves adding to the gloom by noting that the index was 15.7% below the all-time high of 6,700.6, recorded on 26 October 2007.

The implication is that the Australian share market was still well below pre-Global Financial Crisis (“GFC”) levels, despite the passage of over 11 years. A further conclusion that might be implied is that the share market isn’t a great place to invest. While not claiming the past 11 years has been the best experience for investors, the focus on the 26 October 2007 S&P/ASX200 Price Index peak as a benchmark is potentially misleading, for at least two reasons:

1. The peak may have represented an extraordinary level, rather than what could be considered “normal”; and
2. The “Price” index doesn’t measure the total return from share investing, capturing only changes in the prices of shares and completely ignoring the impact of dividends.

With regard to the peak level of the Price index, the following chart shows that from about March 2003 to October 2007 the index grew well above the trend for the period examined (i.e. the dashed blue line). With the benefit of hindsight, the October 2007 pre-GFC peak appears the anomaly rather than the end December 2018 level, that was a little below trend.

However, Australian share market performance can’t begin to be assessed without taking into account the contribution of dividends to total return. The rest of the article examines the recent and longer term total return performance of the Australian share market, highlighting the historical importance of dividends.

Total share returns comprise dividends and changes in value

The total annual pre-tax return for an investment (e.g. share, investment property, term deposit) comprises any income provided by the investment (e.g. dividends, rent, interest) plus the change in its value over the year, less any associated holding costs. So, to measure the annual total return for the share market, ignoring any costs, requires adding the total dividends paid by all companies listed on the share market that year to the total changes in the prices of those shares over the year.

In order to create an index of total share market returns beyond a year, it is necessary to make an assumption regarding the investment of dividends paid. For the calculation of the S&P/ASX200 (Total Return) index, measuring the total return of the largest 200 companies on the Australian share market, it is assumed that each company’s dividends are reinvested in that company at the time the dividends are payable to shareholders.

The chart below shows the growth of an initial investment of $1 based both on the S&P/ASX200 Total Return and Price (as charted above) indices for the period from May 1992 to December 2018, together with trend lines for each index.

The Total Return chart story is very different to that of the Price chart. The end-December 2018 Total Return measure is 36% higher than the pre-GFC peak, rather than continuing to languish below as is the case for the Price Index. The Total Return Index gained all the ground it lost through the GFC by October 2013.

From the bottom of the GFC in February 2009, the Total Return Index increased by 264%, while the price index rose by 173%. These represent annualised growth rates of 10.4% and 5.7%, respectively, both indices’ performance roughly equating to their longer-term trends.

The importance of dividends as a component of return is highlighted by the difference in annualised returns for the indices for the entire period – 8.89% p.a. for the Total Return Index and 4.59% p.a. for the Price Index. The difference of 4.30% p.a. reflects dividends payments and the assumed reinvestment of those dividends.

The following chart reveals the annual contributions (i.e. dividends and price changes) to total return for the period May 1992 to December 2018:

Dividends contributed an average 4.1% to total annual return, with relatively little variation, while price change contributed a higher annual average of 6.4%, but with headline creating volatility (that significantly reduces compound annualised returns for the entire period).

There’s more to share market performance than changes in values

The message is that it is total returns that matter when assessing investment performance, rather than simply changes in value. In fact, to be more accurate, it is total returns, after taxes, costs and inflation, for risk taken, that you should be concerned about. But that is a considerably more complex story.

However, given the relatively high (e.g. compared with the US) levels of dividend payments made by Australian companies and the fact that over the past almost 30 years these dividend payments have accounted for about half of the Australian share market’s total return, it makes you wonder why any attention is paid to the Price Index at all. But, unfortunately, it is the most conveniently available measure of share market performance and makes for some good (but misleading) sound bites in the evening news. Boring, regular dividend payments don’t rate.

 

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A more complete view of share market performance is a post from: Wealth Foundations Blog

Your financial resources are the best predictor of a successful retirement …

As financial planners, we are heavily focused on our clients being financially well prepared for the retirement they desire. And, the psychological research[1] that we discuss in this article suggests that the adequacy of your financial resources is the most important indicator of a successful adjustment to retirement and to retirement satisfaction.

However, it’s probably fair to say that adequate financial resources are a necessary, but not sufficient, condition for a successful retirement experience. The research identifies five other resources’ domains that require assessment and, potentially, proactive interventions. These are, in order of importance after finances:

1. Physical;
2. Social;
3. Cognitive;
4. Emotional; and
5. Motivational.

A brief explanation of each of the domains is provided below.

…but the adequacy of other retirement resources can’t be ignored

“Financial” resources include whatever is available to support ongoing living expenses in retirement. This is the area that both we, and our clients, are most familiar. It is also the resources domain that gets the most attention. However, the retirement resources framework alerts us to the reality that your retirement experience isn’t pre-ordained by the amount or adequacy of your investment wealth.

Your “Physical” resources refer to your state of health. A high level of physical resources is evidenced by an absence of major physical illnesses and mental disorders and the energy to carry out daily activities and/or activities of interest.

“Social” resources reflect your access to support from friends and family, to both exchange information and receive emotional support. The more tangible and practical this support, the higher are your measured social resources.

“Cognitive” resources are assessed by such things as your ability to:

• remember where things are;
• learn new skills and acquire knowledge;
• process information quickly;
• solve problems; and
• make good decisions.

“Emotional” resources are evaluated based on responses to questionnaires that measure:

• demonstration of positive emotions;
• awareness of your own and others’ emotions;
• knowing how emotions affect behavior; and
• sense of personal worth.

Finally, “motivational” resources indicate such things as your ability and/or willingness to:

• increase effort in the face of difficulty;
• find new approaches; and
• set realistic goals.

Based on the above (admittedly, high level and simplistic) explanation of the retirement resources framework, the table below provides a simple tool to self-assess where you are placed on each of the domains.

Desirably, you rate yourself as medium to high on all domains. But the self-assessment may highlight areas that need attention in order to increase the chances of a successful adjustment to retirement or to increase retirement satisfaction. The research suggests that adding to your resources in any domain will improve your retirement experience.

Early intervention across all retirement resources is recommended

The retirement resources framework highlights that not only is a successful retirement experience likely to depend on having adequate financial resources but also on identifying and responding to any other resource weaknesses.

While we are well placed to assess the adequacy of financial resources, and to suggest changes to financial behaviours, as appropriate, our ultimate aim is for our clients to have a fulfilling retirement, in the broadest sense. Clearly, we don’t have expertise to assist across the other domains.

But should the self-assessment discussed above identify any potential issues of concern, we hope it’s a catalyst for clients (and other readers) to seek appropriate medical, psychological or other relevant professional assistance. As is usually the case with inadequate financial resources, the earlier a weakness is identified the more effective (and, potentially, less disruptive) any intervention is likely to be.

[1]  Much of this article is based on a video presentation, titled “The emotional side of retirement”, by Dr Joanne Earl of Macquarie University at the AFA National Practitioner Roadshow 2017.

 

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The keys to a successful retirement is a post from: Wealth Foundations Blog

Is history a reliable guide to future investment returns?

When doing long term cash flow projections for clients, it is necessary to make some “guesses” of future investment returns. Unfortunately, for the 50 year cash flow projections we do, the results are very sensitive to these guesses.

If they prove too high, without any adjustments along the way clients may end up in a considerably worse financial position than projected while, if too low, they may have led unduly financially constrained lifestyles. The antidote, of course, is to regularly review the projections, ideally annually, and make regular small adjustments rather than put an initial Plan in the drawer and see how things turn out in 50 years’ time.

For many years our key projected investment returns have essentially been 1% p.a. for cash and 5% p.a. for shares, both after-inflation and before-tax. A 4% p.a. risk premium for investing in shares is implied. The long term historical experience (from January 1926) of the US stock market shown in the chart below reveals an actual 0.4% p.a. return for cash, 7.0% p.a. for shares (i.e. equities) and a 6.6% p.a. risk premium, suggesting our share return and risk premium projections are “conservative”.

But as most investors probably know, at least intuitively, the last 20 years indicate that while long term historical returns may provide some useful information, you could be very disappointed if your financial plan was based on that history. The rest of the article examines actual cash and share returns, relative to our projections, since 1980.

Recent Australian investment returns don’t look at all like the long-term US experience

The chart below shows 20 year rolling after-inflation returns for shares[1] since December 1979. 20 years is used as an estimate of the length of time investors have available to seriously commit to accumulating investment wealth prior to retirement.

Clearly, the range of returns is large, with returns above (often, well above) our 5% p.a. projection until about the 20 years to September 2008. Beyond that, returns have oscillated around the 5% projection, with some significant undershoots (e.g. the 20 years to February 2009 at 3.78% p.a.).

The following chart reveals what this range of returns means in actual $ terms, showing the 20 year rolling returns converted to the after-inflation growth after 20 years of an initial investment of $1.

It indicates that a share investor who invested $1 million in March 1980 would have seen it grow to $8.7 million by March 2000, while someone who invested $1 million 9 years later, in February 1989, would have accumulated $2.1 million by February 2009. Needless to say, these are very large variations in investment wealth, with significant lifestyle implications, purely due to when the initial investment was made.

The following chart shows the 20 year rolling after-inflation returns to cash[1] since December 1979, compared with our cash projection.

The incredible 6% p.a. returns of those who invested for 20 years from December 1979 have since slid inexorably towards what we believe is a much more sustainable 1.0% p.a. and consistent with the long-term US experience. Many Australian retirees are still adjusting to the realisation that 3-4% p.a. returns above inflation for, essentially, a risk-free investment were more likely an anomaly rather than the norm.

The final chart below examines the rolling 20-year risk premium experience since December 1999 i.e. the additional return from investing in risky shares compared with risk-free cash.

It reveals that the risk premium has rarely been above our 4% p.a. projection and was consistently well below the long-term US experience of about 6.6% p.a. In fact, for the 20 years to March 2009, there was no premium for investing in shares in preference to cash – unsustainably high cash rates and the bottom of the Global Financial Crisis explain this rare occurrence. Share market recovery and falling cash rates have subsequently seen the risk premium increase but it remains below our projection of 4% p.a.

Don’t rely on investment returns to achieve your financial future

The analysis highlights that investment returns can vary significantly and for long periods of time. Even if the US long term experience proves to be a good guide to future long term investment returns, your lifetime investment return experience may bear no resemblance. That’s why our financial planning focus isn’t on investment returns – they are primarily market driven and out of your (and our) control.

The key to achieving the financial future you want is to focus on the things you can, to a greater or lesser extent, control, including:

• the amount of investment risk you are comfortable with;
• the efficient structuring of that risk;
• your investment market entry/exit strategy;
• your investment costs and personal spending; and
• your ability to generate income.

And, as your circumstances change and investment outcomes are revealed, make regular adjustments to your expectations to reflect the new reality.

[1]  An indexed share portfolio, comprising 50% Australian shares and 50% unhedged international shares.

[2] As measured by the Bloomberg AusBond BankBill Index

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What investment returns should you expect? is a post from: Wealth Foundations Blog

Making financial decisions based on what others are doing can be dangerous

My children and many of their friends are now at the age where they are making very important decisions regarding starting families and meeting housing needs. These decisions, of course, have a strong emotional element. But they also generally have massive financial implications that, once made, lock in commitments that will extend for many years into the future.

Entering into such commitments, without detailed consideration of your “best guess” capability to both meet them and continue to be able to enjoy a desired lifestyle, sets up a high likelihood of serious, unanticipated financial pain later in life. Anecdotes suggest that many young adults who borrowed to purchase in the Sydney housing market over the past three to four years are already finding this out.

A focus on the “here and now” and peer comparison when making financial decisions is fraught with danger. Young adults often wrongly presume because their friends are buying houses and starting families, they can and should do the same.

But young adults aren’t alone in basing their financial behavior on what people “like them” are doing. Often, for example, highly paid professionals (e.g. lawyers, accountants, doctors) in their early fifties are leading financially unsustainable lifestyles because they are too busy to look forward a few years and are comforted by their colleagues’ similar financial behaviors.

We encourage clients to make financial decisions based on their lifestyle objectives and financial expectations, rather than their life-stage or what friends or colleagues are doing. Particularly for those who are some years off intended retirement, a key metric we focus on is their expected “future capital” or “future savings”. This is calculated as expected accumulated savings, to a nominated retirement age, from after-tax employment (or business) earnings less lifestyle spending, including purchase of lifestyle assets (e.g. house purchase).

When added to current net investment wealth (“NIW”), future capital (“FC”) provides an estimate of investment wealth available to fund lifestyle when no longer working. We call this estimate Projected Lifetime Investment Wealth (“PLIW”). If you don’t have some reasonable expectation of what this number is and its adequacy in terms of financing a desired retirement lifestyle, you are setting yourself up for future financial surprises that may not be welcome.

A “back of the envelope” alternative to calculating future capital

However, the calculation of future capital is not a trivial exercise. It requires a detailed “best guess” of future earnings potential and desired lifestyle. For a 35 year old looking to retire at age 65, it’s a look forward for thirty years, a period of time over which things can change dramatically. And, as discussed in our previous article, this “visioning” is not something that most people naturally do.

An alternative simple, but potentially revealing, approach is to attempt to examine the long term implications of significant financial decisions in terms of more easily understood current dollar amounts. Let’s first consider an example of a 35-year old couple looking to purchase a $2 million residence, with a $500,000 deposit i.e. a financing requirement of $1.5 million. Their only investment wealth is $200,000, held as superannuation.

Using our “Rule of 25”, the couple can make an estimate of their required investment wealth at retirement by multiplying their desired level of retirement spending by 25. Based on current spending of $110,000 p.a. (with no children), they might estimate retirement spending of $125,000 p.a. at age 65, implying an investment wealth need of $3.125 million.

Assuming a 0% p.a. after-inflation[1], after tax return on investment (and cost of any borrowing), these basic assumptions imply a need to save $4.425 million over the next 30 years, for the couple to own their residence outright and accumulate $3.125 million of investment wealth. The simple calculation is shown below:

Accumulated savings of $4.425 million imply average savings of $147,500 p.a. over 30 years. Allowing for the additional costs of intended children, pre-retirement spending of $140,000 p.a. would be a reasonable starting point. Together the savings and spending requirement suggest an average after-tax household income of about $287,500 p.a. (or about $450,000 – $500,000 pre-tax income) for thirty years for the couple’s expectations to reasonably hold together.

The couple can then assess this “ball park” required average $450,000-$500,000 p.a. of pre-tax household income against both their current and expected future household income. While the conservative investment return assumption inflates the income requirement calculation, if there is a big discrepancy it should trigger a need to examine both the decision to purchase the proposed residence and/or lifestyle expectations in much more depth.

In a similar manner, let’s consider the situation of a 52-year old, high income, professional household with one income earner. Assume current investment wealth is $2 million, with a desire to spend $300,000 p.a. in retirement, from age 65. Again, using the “Rule of 25”, a retirement investment wealth need of $7.5 million is implied.

Based on a 0% p.a. after-inflation, after tax return on investment, accumulated savings of $5.5 million or $423,077 p.a., are indicated. If current spending is $350,000 p.a., after-tax income must average $773,077 p.a. (or about $1.4 million p.a. pre-tax) over the next 13 years for retirement plans to be achieved. This income requirement should be compared with current and expected income to judge whether adjustments to expectations may need to be made.

Some simple calculations could uncover major flaws in financial decision making

Some simple “back of the envelope” calculations will often highlight that basing your financial decisions on what those you consider most like you are doing is fraught with peril. Their circumstances may be very different and/or they may have you heading over the same financial cliff that they are.

In our view, there is no substitute for a detailed consideration of your financial future in order to make better financial decisions. However, application of the “Rule of 25” to give you a ball park retirement investment wealth requirement and some simple arithmetic mean there is no excuse for making current financial decisions without heed to your longer-term lifestyle expectations.

[1]  0% p.a. is a conservative assumption, but not an unrealistic one. It effectively assumes all investments are held as low risk defensive assets.

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“Back of the envelope” financial planning is a post from: Wealth Foundations Blog

Good financial health not measured purely by wealth

When we started Wealth Foundations in 2007, we embraced 20 principles of successful wealth management. These continue to underpin our approach to personal financial planning.

Principle 17 states that: “Money is a means to an end, not an end in itself”. Our original rationale for this principle was as explained below:

“Research indicates that a pursuit of wealth and its trappings for their own sake is unlikely to result in life satisfaction. Also, it is important to realise that maximising wealth may be a poor proxy for maximising life satisfaction.

Therefore, we believe that effective wealth management requires you to first examine and articulate what is important to you in life (i.e. your lifestyle objectives) and then consider what, if anything, may need to change financially for those objectives to be achieved. To blindly pursue increased wealth without first asking “what for?” is really putting the cart before the horse.”

In summary, we didn’t, and still don’t, believe that the state of your financial health is measured simply by the number of dollars you have. Nor does an increase in the number of those dollars necessarily mean that your financial health has improved. It may simply serve to feed a potentially unhealthy addiction.

A recent paper by Morningstar Behaviour Economist, Sarah Newcomb, titled “When More is Less; Rethinking Financial Health”, provides some research backed insights into the nature of “Financial Wellness”. Focus groups conducted with financial advisers for her study revealed numerous examples of apparent financial ill-health that we have also observed:

“There are the clients who fear not having enough, despite every indication to the contrary. There are those so fearful of making a wrong choice that they refuse to make any, leaving their wealth to slowly erode in cash accounts. Other clients, in contrast, spend too freely, choosing blissful ignorance about the damage to their bottom line.”

Newcomb’s observation is that financial wellness needs to incorporate both economic and emotional aspects of well-being. She suggests that, regardless of wealth, you can’t be considered financially healthy if your financial situation is an ongoing source of emotional stress.

Given this viewpoint, her paper examines the application of two principles of psychology to improve financial health – the first aimed at enhancing economic stability with the second directed at emotional well-being. These are examined in the remainder of the article.

Using psychology to improve financial health

With regard to improving economic stability, Morningstar research indicates that people who think further into the future (i.e. have a longer mental time horizon) tend to save more frequently and build larger retirement balances, as illustrated in the chart below:

This finding holds regardless of other potentially influencing factors such as age, income, gender and education. For example, the following chart from the Morningstar research reveals that those who thought further ahead (i.e. more than 10 years) on incomes of around $50-75,000 saved as much for retirement as those with shorter time horizons (i.e. less than 10 years) on incomes categorised as $150,000+.

Therefore, Newcomb concludes that to improve people’s economic stability an important prerequisite is for them to improve their ability to think longer term. One technique to achieve this is for them to regularly imagine how they would like their life to be one year hence and then extend the visioning out to 5, 10 and 20 years.

They should attempt to describe their ideal financial futures in as much detail as possible, rather than use vague descriptions such as “I want to be financially secure” or “I want to have peace of mind”. Corroborating research shows that the more people are able to identify with their future selves, the more emphasis they place now on securing their envisioned future, and not only from a financial perspective.

With regard to improving emotional well-being, Newcomb’s research indicates that people who feel empowered in their financial lives experience more joy, peace, satisfaction and pride with their financial circumstances than those who don’t. From a financial adviser’s perspective, Newcomb suggests that client empowerment is enhanced by ensuring clients are fully involved in decision making and given regular reminders of the progress they are making.

“Money is a great servant but a bad master” – Francis Bacon

Newcomb notes that money is the number one source of stress in US households, regardless of economic climate, according to The American Psychological Association. We would be surprised if the Australian experience is different.

But “more money” is not necessarily the antidote. In some cases (e.g. pursuing more wealth for its own sake), it may only reinforce an already poor emotional relationship with money.

Newcomb argues that sound financial health is characterised by high levels of economic stability and emotional well-being (around money). We regard this as consistent with our “Money is a means to an end, not an end in itself” principle, that suggests it is your concept of what is “a good life” that should drive your wealth needs, rather than any emotional issues you may have with money.

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What is good financial health? is a post from: Wealth Foundations Blog

Retirement readiness is low, both in Australia and internationally

Recently, the Aegon Center for Longevity and Retirement released its 2018 international Retirement Readiness Survey, a survey it has conducted annually since 2012. For each of the 15 nations surveyed, an Aegon Retirement Readiness Index (ARRI”) is calculated, ranking retirement readiness on a scale from 0 to 10.

A high index score is between 8-10, a medium score between 6 and 7.9, and, a low score being less than six. The results for workers in the fifteen surveyed nations (with a comparison with 2012 results, where available) are shown below:

In summary, internationally, the retirement readiness of those surveyed is regarded as at the low end of the scale, with Australia scoring a mid-range 5.9 despite our often-lauded “three-legged” approach to retirement (i.e. social security, employee/self-funded superannuation and other personal savings).

Inadequate financial literacy is identified as a significant factor contributing to this low level of retirement readiness. The survey report notes that:

To assess financial literacy internationally, the survey uses the “Big Three” financial literacy questions developed by Drs Annamaria Lusardi and Olivia Mitchell. The remainder of this article examines both these “Big Three” questions and some research findings based on the assumption that the responses to the questions serve as a reasonable proxy measure of financial literacy.

The “Big Three” financial literacy questions

The responses to the following three questions are often used as a basic, but well validated, guide to financial literacy:

1. Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow:

1. more than $102;
2. exactly $102;
3. less than $102;
4. do not know;
5. refuse to answer.

2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy with the money in this account:

1. more than today;
2. exactly the same as today;
3. less than today;
4. do not know;
5. refuse to answer.

3. Do you think that the following statement is true or false? Buying a single company share usually provides a safer return than a managed share fund:

1. true
2. false
3. do not know;
4. refuse to answer[1].

The three questions test for a rudimentary understanding of some key financial concepts i.e.:

• investment return compounding, for Question 1;

• maintaining real purchasing power, for Question 2; and

• investment risk reduction through diversification, for Question 3.

Question 3 also indirectly tests whether respondents know what a company share (or company stock in the USA) and a managed share fund (or stock mutual fund in the USA) are. If you can’t confidently and correctly answer the three questions, you have almost no chance of adequately planning for a financially secure retirement or even be in a position to assess the veracity of any financial advice received.

But as revealed in the chart below, the Retirement Readiness survey indicated that only about 30% of respondents answered all “Big Three” questions correctly:

For Australia, 28% answered all three correctly.

The chart below shows that the investment risk diversification question (i.e. Question 3) posed the greatest difficulty for respondents, in all countries:

Using the “Three Questions” responses as a measure of financial literacy, interesting research findings show, among other things, that:

• financial literacy varies with age, being low for young adults, rising through to about age 50 and then declining again with age. Unfortunately, peoples’ confidence in their financial decision making tends to increase with age, resulting in a potential gap between perceived and actual decision-making ability, leaving older people more exposed to unscrupulous practices;

• men tend to have higher levels of financial literacy than women. However, women show a greater awareness of their inadequacies when it comes to financial decision-making than do men;

• financial literacy is positively related to education. However, there remains wide variations in financial literacy among the more highly educated i.e. high cognitive ability does not imply high financial literacy; and

• those who are more financially literate are more likely to undertake financial planning and those who plan accumulate higher wealth than those who don’t. To date, there is no robust research to indicate that financially literate retirees are more successful in managing their financial resources in retirement although it would be surprising if they aren’t.

We all stand to bear the cost of low financial literacy

Unfortunately, there appears to be a vast gap between most people’s financial literacy (as measured by the “three questions”) and perception of their ability to make sound financial decisions. Although not measured directly, the Retirement Readiness Survey revealed that while only 30% of respondents could be regarded as having at least rudimentary financial literacy (i.e. answered all three questions correctly), 61% considered they were able to “understand financial matters when it comes to planning for your retirement” (i.e. rated themselves a 4 or 5, on a 5 point scale), as shown in the table below:

Low financial literacy, coupled with a lack of awareness, not only contributes to the revealed low level of retirement readiness but also to a high reluctance to seek financial advice and unwittingly imprudent investment risk taking, typified by the borrowing binge that fuelled the recent Melbourne and Sydney residential property booms.

Unfortunately, at some stage, the high cost of low financial literacy will almost certainly hurt us all.

[1] Correct answers: Question 1 – More than $102; Question 2 – Less than today; Question 3 – False.

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Low financial literacy: a serious threat to financial health is a post from: Wealth Foundations Blog

The usual suspects’ advice practices again under scrutiny …

The latter part of April saw the Financial Services Royal Commission[1] examine some poor financial advice practices that had been brought to its attention. The Big 4 banks and AMP came under intense scrutiny, with the following areas highlighted:

• Fees for no service, including continuing to charge the accounts of people who had been dead for some time;
• Investment platform fees;
• Inappropriate financial advice, that was allegedly in breach of the client best-interests duty that all planners must adhere to; and
• Improper conduct by advisers.

While the poor practices highlighted resulted in a lot of adverse publicity for the banks and AMP (and, since, a number of board and executive resignations), they didn’t surprise us or, I suspect, most in the financial planning industry.

The large, vertically integrated institutions are the original dinosaurs of the financial advice business.

Despite attempts to obfuscate, the primary reason they provide advice is so they can sell more of the financial products they manufacture and/or earn revenue from. Their “financial planners” are the financial products’ salesforce. An institutional planner that provides only advice and doesn’t recommend the institution’s products could be expected to have a very short career.

Legislative attempts to address the glaring product/advice conflict through disclosure, a best-interests requirement and, more recently, mandated ethical and education requirements for financial planners have failed and will continue to fail.

We believe a step in the right direction would be to require that the institutions’ sales emphasis is made more transparent for the customer e.g. for their “advice” providers to be called financial sales consultants, rather than planners or advisers; for customers to be told that they will only be offered bank products, even though better products may exist elsewhere; for products to be meet a “suitability” threshold, rather than be in the customer’s “best interests”.

The often used analogy that when you go into a Ford dealership, you don’t expect to be advised to buy a Volkswagen should apply. Customers of product manufacturers should clearly understand that their sales people are not under a duty and are unlikely to provide impartial financial advice.

… but Royal Commission reveals conflicts not the preserve of large institutions

With all the reputational damage, many of the institutional wealth managers are questioning whether the vertically integrated product/advice model is worth persevering with. Should the Royal Commission recommend changes that would further undermine its original rationale, it may be the last straw for some.

The major financial institutions are easy and obvious targets to uncover poor financial advice practices. However, the Royal Commission also revealed that conflicts leading to inappropriate advice don’t just apply to the large institutions.

A complaint regarding celebrity financial planner and 2016 AFA Planner of the Year, Sam Henderson, lifted the veil on another, less obvious source of dubious practice. Henderson is Chief Executive of financial planning firm, Henderson Maxwell Financial Planning. He also has an interest in Henderson Maxwell Accounting and, at the time of the complaint, held shares in the managed account service which managed over 80% of his clients’ funds.

Henderson had recommended to the complainant that she rollover her low cost, public service super fund to a Henderson Maxwell Accounting established and administered self-managed super fund. The funds were to be invested with the considerably more costly Henderson Maxwell managed account. This advice both failed to take account that rollover of the super fund would result in the complainant foregoing a $500,000 deferred benefit from her public service super fund and that she had no desire to establish a self-managed super fund.

The inappropriate advice that was clearly not in the complainant’s best interests was typical to that given to a high percentage of Henderson Maxwell’s clients i.e. establish a self-managed super fund (many of which were apparently administered by Henderson Maxwell Accounting) and invest the funds with the Henderson Maxwell managed account service. Although each clients’ circumstances would need to be examined before determining whether the advice was in their best interests, the apparent “cookie cutter” approach dovetailed nicely with the interests of Henderson’s financial planning and accounting businesses.

The Henderson case study draws attention to the inherent conflicts of interest of the one stop financial planning and accounting practices, which also often have attached loan broking and legal entities. Some also have residential property advisory arms. It would not surprise if on a disproportionate number of occasions, clients of such firms were advised to:

• Establish a self-managed super fund; and
• Arrange a non-recourse loan by the super fund to purchase a residential property.

Every entity of the financial advice conglomerate would get a slice of the action. But in our view, such advice is unlikely to ever be in clients’ best interest.

One-stop financial conglomerates may not be in your best interests

Financial advice conglomerates are fraught with conflicts of interest. If it is to make sense for the business owners, cross referrals between the various entities are essential.

While the benefits to a client of a one stop finance shop may seem obvious, there is a strong incentive to tailor advice to meet what suits the business structure rather than the client. The Royal Commission has exposed a potential “Jurassic Park” of financial advice.

The Royal Commission’s hearings suggest that to increase the chances that personal financial advice is in the client’s best interest a financial adviser should have no financial links to any other parties (e.g. through shareholdings, revenue sharing, referral payments). It will be interesting to see if the Royal Commission’s findings and recommendations head down this path.

[1] More formally, the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry

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The “Jurassic Park” of financial advice is a post from: Wealth Foundations Blog

Income yields are down, but should you worry?

The last few years have seen a fairly dramatic drop in the income yields obtained from typical balanced (i.e. roughly equal defensive and growth investments) investment portfolios. Reduced interest rates, lower rental yields on property and flat to declining dividend yields on shares mean that many retirees are no longer able to meet living expenses solely from the cash distributions (i.e. the income yield) generated by their portfolios.

There is often a reluctance to sell investments (i.e. draw down capital) to maintain desired spending. Rather, the apparent solution to the shortfall is often seen as higher yielding investments (e.g. higher risk fixed interest securities, including hybrids, high dividend paying shares and other structured products), with there being no shortage of financial product manufacturers happy to respond. However, yield enhancement always comes at the expense of a combination of increased credit risk, reduced diversification and/or increased taxation.

In our view, a focus on income yield results in less than optimal investment behavior. We explain to clients that it is the expected after-tax and inflation total return (i.e. both income and growth) from their portfolios that will determine whether they are able to finance their desired lifestyle. They should construct their investment portfolios to provide them with the highest expected after-tax and inflation total return, subject to the amount of risk they are willing to bear.

The rest of this article examines in some detail the potential tax inefficiency of yield enhancement, revealing that even when investment risk issues are ignored, it may have deleterious consequences for investment wealth. Unless investments are held in a zero tax environment (e.g. the pension phase of superannuation), the benefit of short term cash flow gains is offset by the cost of higher than necessary tax payments.

Unnecessary tax payments are detrimental to your long-term wealth

For purposes of our analysis, we assume a retired couple looking to finance a 30-year retirement, spending $100,000 p.a., growing with a 2.5% p.a. inflation rate, from a $2 million portfolio. The couple has a choice of three investments:

1. A fixed interest investment, paying 9% p.a. in income and with no growth, representing an extreme approach to income enhancement;
2. A fully franked, high dividend paying, Australian share portfolio paying a 4.5% p.a. cash dividend (i.e. grossed up yield of 6.43% p.a.) and growth of 2.57% p.a., implying a total pre-tax yield of 9% p.a. This typifies the growth portfolios of many self-managed super fund investors; and
3. A high growth portfolio, paying zero dividend and with growth of 9% p.a.

The three investment alternatives all have a 9% p.a. pre-tax return. For illustrative purposes, a tax rate of 30% is assumed on regular income, with a 50% discount applying to capital gains. The cost base, for calculation of capital gains tax, is equal to the initial value of the portfolio. Investment risk considerations are ignored.

The first-year cash flows for each investment are shown below:

After paying income tax, there is a cash flow surplus with the fixed interest investment, a small shortfall with the dividend paying shares and a $100,000 shortfall for the high growth portfolio. Cash flow surpluses after income tax are reinvested in the relevant investment. Cash flow shortfalls are met by selling sufficient investments to both meet the shortfall and any resulting capital gains tax.

It can be easily seen that investing focused on generating sufficient income to meet spending comes at the cost of considerably higher tax payments. Real (I.e. after-inflation) tax payments for the 30-year period for each investment are charted below:

The cost of the high tax expense, associated with the fixed interest investment, to long term real investment wealth is evident in the chart below:

For this scenario, the cost of an income focus is considerable. Now while lower tax structures (e.g. superannuation) will reduce the tax drag, as both wealth and desired spending increase, and superannuation’s share of total investment wealth holdings reduces, tax concerns generally favour selling assets rather than chasing income yield to finance cash flow deficits.

Your investment portfolio’s income yield is a low order priority

One of our investment mantras is that taxation issues should not take precedence over maintaining an appropriate risk exposure e.g. you shouldn’t continue to hold an overly large exposure to a single investment because sell down would result in crystallising capital gains and incurring capital gains tax.

However, we do rank tax concerns over income returns. Cash flow should be met from your total, appropriately structured, investment portfolio as tax efficiently as possible.

If the income distributions generated from this portfolio are insufficient to meet your desired spending, the solution is tax-aware asset sales rather than the addition of investments based purely on their expected income yield. Such investments inevitably come with additional risk (usually, not well understood) and tax concerns that are likely to reduce your chances of achieving your desired financial future.

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Is the search for higher income yield misguided? is a post from: Wealth Foundations Blog

Is a company tax reduction a second best solution?

The Government has proposed to reduce the large company tax rate from its current 30% to 25% by 2026-27. It argues that the reduction is necessary to keep Australia’s company tax rate internationally competitive and will create “jobs and growth”, ultimately leading to wages growth.

It’s been a hard sell, with those opposing the move citing, among other things, the budgetary cost and a lack of confidence in the reliability of so-called “trickle down” benefits to Australian workers.

We don’t propose to enter into the argument as to whether a drop in the company tax rate is a good or bad thing for the Australian economy. However, as a generalisation, we don’t think a tax on companies is a particularly efficient tax, given the scope for avoidance and that shareholders ultimately bear the tax burden. Most likely, it would be more effective to tax shareholders directly.

This article examines some aspects of what a company tax reduction may mean for the returns for investors in company shares. These returns come in two forms – either as dividends and/or capital gains. We use some extreme examples to highlight some of the considerations.

How a company tax reduction may affect investors’ returns

For simplicity, we initially look at the effect on shareholders of a company that pays out all of its profits as dividends and is 100% owned by Australians. We assume our shareholder pays tax at the top marginal tax rate (i.e. 47%, including Medicare levy). The table below shows how a $100 of this company’s profits and its shareholders are taxed under the Australian dividend imputation system, at both a 30% and a 25% company tax rate:

The Australian investor ends up with the same after-tax dividend, regardless of the company tax rate. The total tax payment of $47 remains unchanged but its distribution between the company and its shareholder changes.

Similarly, if we assume our shareholder has a 0% tax rate (e.g. a pension fund), the after-tax impact is no different. The tax rate reduction results in an after-tax dividend of $100, regardless of the company tax rate.

Given our assumption of a 100% payout of profits, there is no Government budgetary impact due to the reduction in the company tax rate – lower company tax receipts are exactly matched by higher personal income tax receipts. Also, because the company does not retain any of its increased after-tax profits, it’s hard to see how a change in the company tax rate would change share valuations.

So, in this admittedly unrealistic scenario, a reduction in the company tax rate is unlikely to have any impact on the total returns of Australian investors. But what happens when we change the assumptions, allowing for foreign investors and less than 100% dividend payout ratios.

Many foreign investors are unable to fully utilise Australian imputation or franking credits, in their respective tax jurisdictions. For those foreign investors who can’t use the credits, in the example above, the reduction in the company tax rate from 30% to 25% provides them with a windfall $5 increase in cash dividends for every $100 of company profits.

A higher cash dividend increases the return to foreign investors and, assuming nothing else changes, would be expected to result in an increase in the share price. The beneficiaries of the higher dividend will be foreign investors, while both foreign and Australian investors will benefit from the higher share price. The loser will be the Australian Government, as it will not receive the extra $5 in tax that the individual Australian investor pays in the example above.

The next issue to consider is the expected impact on returns when the company doesn’t pay out all its profits as dividends. Without any change in its (less than 100%) dividend payout ratio, a drop in the company tax rate will mean that the company retains more cash. For the example above, in the extreme case if the payout ratio is zero, the 5% reduction in the company tax rate will lead to the company retaining a further $5 for each $100 of profit.

Financial economics suggests that the value of a company is determined by the sum of its expected future after-tax cash flows discounted by an appropriate cost of capital (i.e. required investor return). On the face of it, a drop in the company tax rate would translate to an expectation of higher future after-tax cash flow and, therefore, an increase in value. But how much will depend on:

• The impact the lower company tax rate has on the cost of capital (e.g. the cost of capital could be expected to rise for a company with a high level of debt, as the after-tax cost of debt rises when the company tax rate falls); and
• the share market’s assessment of management’s ability to effectively use the additional funds.

Another potential implication of a company tax reduction is for shareholders to increasingly prefer that companies reduce dividend payout ratios (i.e. increase earnings retention). The rationale for this is clearest if a zero company tax rate is considered. In this case, a tax paying Australian shareholder is potentially better off not receiving regular dividends, leaving the funds in the company’s zero tax environment. Provided the company manages the increased funds responsibly, the investor would ultimately realise their return solely through capital gains and at a time of their choosing. Not only is tax deferral achieved, but capital gains currently receive valuable tax concessions.

In isolation, we expect a company tax reduction will increase shareholder returns

In summary, our analysis suggests the following potential implications for investors resulting from a reduction in the company tax rate:

• foreign investors are potentially the largest gainers, from higher cash dividends and, most likely, higher share prices;
• Australian investors’ after-tax dividends would be unchanged, but they would most likely benefit from higher share prices; and
• Personal tax considerations would increase investors’ preference for lower dividend payouts/higher earnings retention.

These conclusions are based on nothing else changing in share markets. Of course, the reality is that our expectations are likely to be swamped by unrelated, inevitable market gyrations, if and when the proposed tax changes are legislated.

 

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Will investors benefit from a reduction in the company tax rate? is a post from: Wealth Foundations Blog