Boys Own Financial Plan

The boys (DS1 and DS2) net worth decreased slightly this month, taking hits on their small, undiversified stock portfolios. DS1 suffered the worst performance, with his investments in ANZ and QBE both doing badly. DS2 did slightly better, with CSL and CPU in his portfolio.

The long term financial plan for the boys aims for each of them to have a net worth somewhere north of $100K when they turn 18 - providing a sound base for them to save for a house and fund their retirement accounts without too much stress.

There actual and projected net worths are plotted against age below:



The projection is based on the following assumptions:
Savings accounts.....1.2% real return
RSA account..........4.7% real return
stock portfolio......8.8% real return
superannuation.......8.8% real return
(invested in stock/geared stock funds)

savings:

• $1,200 pa contribution each (by me) into their superannuation accounts
  
• $1,500 pa government co-contribution each into their superannuation accounts
  
• $50 per month saved from their odd jobs/busking/pocket money etc.
  

The recent dip in DS1's graph shows how unlikely it is that the actual outcomes will be anything like the smooth projection.

Copyright Enough Wealth 2007

Swings and Roundabouts

With the market recovery in the past couple of days it looks like this month's net worth figure will just manage to break even. My stock investments are still down around 5% for the month but this was offset by a jump in the estimated values for my home and investment property. Unfortunately I already have the raw data for calculating next month's house price estimates and about half of this month's real estate gain will be given back next month. Perhaps the market has bottomed out and next month will gain enough for net worth to stay relatively constant. If nothing else this is proof of the value of having an diversified allocation of uncorrelated assets.

Of course it won't always be the case that one asset class is doing well when others are struggling - I'm sure there will be periods when everything in my portfolio is doing badly, and the rare 'perfect storm' when everything is going gang-busters. In the inevitable bad times an asset allocation on the efficient frontier isn't enough to see you through, you also need to take the long term view and stick to your plan. So it's especially important to have a plan that is based on realistic expected returns (historic returns over 20, 50 or 100 years may not be replicated over your 10-20+ year investment time frame, but it's the best guess available), and which has a risk (volatility) level that matches your risk tolerance. When I get bored and want to plan around with my investment plan I take my current asset allocation, grab some historic annual returns for the past 20 or 50 years, and use a spreadsheet to simulate my portfolio using randomly selected returns. This sort of "Monte Carlo" simulation will show you what the most likely outcome of your plan is. But of more interest is to see how your portfolio might perform in particularly good or bad periods. If you translate the bad patches into prospective dollar losses you can get an idea of how hard it will be to stick with your plan in those trying times. Looking at the worst performing runs of your simulation will also give you an idea of how comfortable you would be in retirement in a likely worst case scenario. This might help motivate you to live frugally and up your savings rate a notch or two. I always figure it's better to live frugally by choice while I'm working than to have an impoverished lifestyle when I'm retired.

Copyright Enough Wealth 2007

How to Halve the Amount of Tax you Pay

Although most readers will know that gearing can be used to increase returns (and risk) of an investment, some may not be as familiar with the benefits of gearing as a tax reduction* tool. This aspects of gearing means that even when rising interest rates make gearing facilities such as margin lending appear unattractive, in reality they can still be a core component of your financial plan. The fact that long term capital gains (ie. a capital gains tax event occurs more than twelve months after an asset is purchased) are taxed at half your marginal tax rate is the key to understanding how this works.

Take, as a example an ungeared investment of $100,000 in a share fund (returning 3% dividend income and 5% capital growth) vs. the same investment increased through the use of a margin loan for the same amount, with an interest rate of, say 6%. Marginal tax rate is assumed to be 30% and dividends fully franked. Net value is calculated at the end of a "typical" year:

            Ungeared      Geared
Equity      $100,000.00   $100,000.00
Loan              $0.00   $100,000.00
Total       $100,000.00   $200,000.00
Dividend      $3,000.00     $6,000.00
Franking Cr   $1,285.71     $2,571.42
Cap Gain      $5,000.00    $10,000.00
Interest          $0.00    -$6,000.00
Inc Tax      -$1,285.71      -$771.42
CG Tax         -$750.00    -$1,500.00
Net Value   $107,250.00   $110,300.00

As expected, where the margin loan interest rate (6%) is less than the total return (8%) from the investment, gearing increases your gains.

What is interesting though, is that gearing is still beneficial when the interest rate on the loan is as much as the total return on the investment (8%):

            Ungeared      Geared
Equity      $100,000.00   $100,000.00
Loan              $0.00   $100,000.00
Total       $100,000.00   $200,000.00
Dividend      $3,000.00     $6,000.00
Franking Cr   $1,285.71     $2,571.42
Cap Gain      $5,000.00    $10,000.00
Interest          $0.00    -$8,000.00
Inc Tax      -$1,285.71      -$171.42
CG Tax         -$750.00    -$1,500.00
Net Value   $107,250.00   $108,900.00

This happens because the use of gearing is effectively 'converting' taxable income into taxable capital gains, which provides a superior after tax return.

Of course gearing also magnifies any losses, so this "tax effect" is only a consideration if you are reasonably sure the total return on your investment will be at least match the cost of funds borrowed over the long term. For this reason I prefer to use margin lending to fund a diversified share portfolio, preferably with a core holding of an index fund.

It's also important to be reasonably conservative in your gearing levels so that normal market volatility and 'corrections' won't trigger margin calls. Although it's hard to correctly 'time' the market, it's probably also prudent to reduce gearing levels when the market is well above it's long term trend line, and thereby have some spare borrowing power available to add to your investments at the end of a bear market if the index is well below it's long term trend. It's also worth shopping around to find the best interest rate available for a margin loan, as there can be a significant difference between lenders. It's also worth reading the fine print, as you may be able to negotiate a reduced rate on large loan balances. For example, I get a slight discount on the standard margin loan rate from St George margin lending as we have a large home and investment property loan with them and thus qualify as 'gold' customers.

* I use the term 'tax reduction' as it seems to be the most acceptable terminology to use these days in regards to tax planning. Although tax evasion is illegal and tax avoidance/tax minimisation is, by definition, legal, there has been a trend towards vilifying and legislating against "tax minimisation schemes" and "tax avoiders". On the other hand, politicians on both sides revel in passing laws to facilitate 'tax reduction' through reduced tax rates, increased thresholds or expanded deductions, so it seems to be the PC term to use in relation to paying as little tax as possible.

Copyright Enough Wealth 2007

Make Hay While the Sun Shines

Besieged by the non-stop promotion of the consumer life-style everywhere we look and everywhere we go, many people are struggling to cope with consumer debt and the pressure to live a lifestyle that is, to be honest, beyond the means of their available income. However, if you look back at how our grandparents are earlier generations lived, we are currently living in a "golden age". To quote an article in the SMH:

"A couple of decades ago, the language of prosperity was almost like a foreign language ... Now, phrases like full employment, stock market highs and the commodities boom roll off the tongue.

Across the board, jobs are plentiful, wages are high and individual wealth continues to rise. There's no doubt this is a golden age of prosperity - possibly the best of economic times Australia has experienced.

And there's no doubt, either, that the economy is surging. The latest figures for the June quarter showed annual growth of 4.4 per cent, the highest for three years. Non-farm GDP growth, which removes the impact of the drought, was at its fastest in almost 13 years at 5.2 per cent."

At the same time, looking forward there are problems with "the limits to growth" that could quite possibly make living conditions much more difficult for our descendants. The apocalyptic prophesies of Malthus and, much more recently, the "club of Rome" turned out to be wrong (or at least premature). But the more recent concerns about climate change (whether or not they are caused by human activity) could mean we run into problems supplying food and water at reasonable cost to everyone. And the commodity boom has some chance of turning out to be a supercycle (or a "peak" in production of many commodities, not just oil) which could lead to ongoing real price increases in resources.

Therefore, there is a least some chance the our current economic situation is just about "as good as it gets". If so, we'd better make the most of this opportunity to build up of families wealth so we have some store of wealth put aside to tide us, or our kids and grandkids, over where the hard times come again. Make hay while the sun shines, for there may be some hard winters ahead for our descendants.

Copyright Enough Wealth 2007

Diploma of Financial Service (Financial Planning)

I saw an ad for a financial planning course and decided to visit ps146.com.au to see what was available. The Diploma course takes 8 days to complete (not quite the years of study I had to do for my Graduate Diplomas in IT and chemistry, but hey, it's probably a stretch for most insurance and investment salespeople to stay awake for 8 days of coursework!) and costs $4,360, or can be done by distance education over 4 months, for a reduced fee of $2,360.

Under the Australian Financial Services Reform Act 2001, all individuals who provide incidental personal or general financial product advice to retail customers must meet the minimum training standards as outlined in ASIC Policy Statement 146. (Hence the catchy website domain name ps146). I'm not planning on becoming a professional financial planner or investment advisor (I'm already doing a Graduate Diploma of Education in case I want to become a high school science teacher as a form of early retirement), but the subject matter looks quite interesting, and I like collecting bits of "continuing education" paper to stick on my home office wall ;) So I decided to enrol in the course by distance education. I'll let you know if I learn anything interesting in the next four months. The subjects in the course are:

Subject                         Topics

Financial Planning (DFS 1)      Generic Knowledge (GK) 
                                Financial Planning Skills (FPS)  

Insurance (DFS 2)               Insurance (term, TPD, trauma & income protection insurance)  
                                General insurance  
                                Business overheads insurance 
                                Consumer credit insurance 
                                Travel insurance 
                                Health Insurance 

Superannuation (DFS 3)          Personal superannuation 
                                Retirement income stream products, pensions, roll-overs and annuities 
                                Property ownership structures 
                                Business superannuation 

Investment (DFS 4)              Managed investments (listed property trusts, primary production) 
                                Securities (shares) 
                                Foreign exchange 
                                Derivatives 
                                Fixed-interest products 

Enough Wealth

What to do when you save too much

The times has an article covering the contrarian view of some academics that Americans are saving too much for their retirement, and risk squandering their youth rather than their money. The theory being that a middle-income couple could trade off $400,000 less in retirement money for an extra $3,000 a year disposble income during prime working years to spend on education or home improvement.

On the other hand, I've seen advice that if you are "on track" to meet your retirement or investment target you should adjust your asset allocation to attain the amount of return required for the least possible risk.

I don't find either of these options terribly attractive - just because my retirement fund is on track to meet my retirement income needs doesn't mean that I want to start spending more or wish to adjust my asset allocations to a mix with lower "risk" and a lower expected rate of return. I'm happy with my current budget, so I intend to add any future pay rises (that exceed increases in my cost of living) to my savings plan. Similarly I'm quite content with the current risk level of my investment portfolio, so it is likely to achieve a higher rate of return than I really require to achieve a comfortable retirement. Even if I adjusted the risk level of my retirement account investments down in order to "guarantee" that I'd have enough money in retirement, I'd still aim for the same overall level of risk in my entire investment portfolio that I'm comfortable with, so I'd likely accept an increased level of risk with my non-retirement investments as my retirement account got load up with "safe" assets.

So, my preferred option for when you find yourself ahead of target for your investment goals is just to keep on accumulating "excess" wealth. You can always leave it to charity in your will if you're so inclined, or else leave a larger estate to your heirs.

Plus there's always the risk that advances in medical technology might mean that you live a lot longer than you currently expect. Or else the world could go to "hell in a handbasket" due to global warming, WMD terrorism, etc. etc. and you could find yourself "retired" earlier than you expect, or else needing a lot more income in your retirement than seems likely assuming "status quo".

Kicking around some investment scenarios

I've been doing some research on Self-Managed Superannuation (Retirement) Funds with a view to setting one up for myself, DW, DS1 and DS2 (luckily the maximum number of members in a SMSF is a perfect fit to my "nuclear" family).

The potential benefits of a SMSF compared to my company-selected superannuation fund are:
* can invest in any "suitable" investment (eg. direct shares, index funds) rather than picking from the list of 20 or so managed funds available via my current Super Account.
* saving money on fees - although our employer has arranged for a "rebate" of part of the standard admin fee charged by the Super Fund (so it ends up being around 0.4% instead of 0.95%, plus the managed fund management fees of around 1-1.5%), this is still higher than the $500 pa "flat fee" available from eSuperFund.com.au for a SMSF (eg. on my current Super Account balance of $315K this equates to an admin fee of 0.16% pa)

There are some possible drawbacks though:
* I currently have life insurance via my Super Fund. If I changed funds I'd have to apply for cover again, and, for the amount of cover I currently have ($400K) I'd probably have to pass a medical exam
* As a member of a SMSF I'd have to be a trustee and be responsible for setting an investment policy and abiding by the rules regarding running a SMSF, otherwise the SMSF can lose it's tax-advantaged status. This shouldn't be too onerous though, as I previously acted as an employee-appointed Superannuation Fund trustee at my previous job.

The other thing I have to consider is shifting some of my assets that are currently held outside of Superannuation (ie. my geared investments in Australian shares) into a Superannuation account to save tax. Basically an undeducted contribution of up to $1M can be made before Sep 2007 (due to recent changes in the Superannuation rules) and there won't be any contribution tax. Once held by a Superannuation Fund, the assets income is only taxed at 15% (rather than my personal marginal tax rate of around 30%+) and capital gains are taxed at 10% (rather than half my personal marginal tax rate). Also, once I reach retirement age (65) all withdrawals from the Superannuation account are not taxable under the new rules.

The disadvantages of putting these assets into a SMSF are:
* Can't "borrow" for a Superannuation investment, so gearing is out. However, this isn't a big issue as I'm thinking of eliminating my gearing this year anyhow as the stock market has had a good run for 3 years and will eventually have a "correction" of 10%-30%, not a good time to be geared up. Also, Superannuation Funds can invest in "warrants" which give you similar effects as margin loans, but without the risk of margin calls (but the effective "interest rate" built into warrants is higher).
* You can't "roll" existing stock investments into a Superannuation account without triggering a CGT "event" - so I'd have to pay Capital Gains Tax on the currently unrealised gains in my stock portfolio. If I was just selling off enough of my stocks to pay off my margin loans I could probably offset a large part of the realised gains by selling off all the "losers" in my portfolio.
* I'll have to get all my CGT records up to date in Quicken so I can work out how much capital gains tax I'd be liable for (I have old records up to 1998 in my old Quicken backups, but need to trawl though the past 8 years of transactions to get my CGT records up to date! It's amazing how little time I've had "spare" to do my financial records in Quicken since I got married and started a family!). I wouldn't want to do the transfer till after the end of the Australian tax year (30 June) as DW is on maternity leave this FY and may get some family assistance money if our combined income is not too high this FY. So the "window of opportunity" to make a large (up to $1M) undeducted contribution into Super for me is between 1 Jul and Sep this year. After Sep the max undeducted contribution each FY is going to be $50K, so it would then take 6 years to shift my current Australia Share investment into Super.
* Once assets are in a Super Fund they can't be "released" until retirement (except in exceptional circumstances). Thus, I'll be keeping some other assets outside of Super to act as my "Emergency Fund".

I'm also looking into DirectPortfolio.com.au which offers a managed direct share service, which can be done within a SMSF. I like the fact that they run individual stock holdings for each account, so you avoid some of the unintended tax effects that can arise when investing in managed funds. But their admin/management fee is quite high (around 2%) and you have to pay a $1000 setup fee when open an account with them. The setup fee covers recording all your CGT history if you transfer existing stock holdings to them, so it would be reasonable if I transferred my existing stocks without triggering a CGT event. But if I transfer my shares into a SMSF CGT will have been paid on the date of transfer, so there's no CGT history data required - so the $1000 setup fee seems a bit high in that case. Looking at DirectPortfolios results for their various "mandates" they have achieved around 2.3% above the ASX200 accumulation index for this period, which means they "outperform" by slightly (0.35%) more than the fees are costing. But, they don't provide data on the "beta" of their "mandates" so it's hard to tell if their risk-adjusted return actually outperforms enough to offset the management fee. So, if I decide to move my stock assets into a SMSF I'll probably just sell them off and deposit cash into the SMSF, then use it to buy a Vanguard Index Fund (perhaps their "High Growth" Fund).

Lots to research and think about in the next 5-6 months!