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www.reidconsultants.com.au

1st May 2008

The premise that you can earn sufficient income and save enough to generate a comfortable retirement income and still have a lifestyle during the earning years of 20 or so to 60 odd without enormous sacrifice is flawed. The theory is that you work hard, save harder and you will be rewarded in your retirement. It is a good theory, unfortunately the reality is that it just does not happen for the vast majority of people. Over 70% of retirees rely solely upon the government aged pension. Many of us, even those on very high incomes, are potentially three months away from bankruptcy. Would you survive financially if you suddenly lost the ability to earn income for three months?

Why is this? Why have we been misled? What is the reality?

The next two tables give a glimpse of what actually occurs.

• Although these are a couple of years old, they clearly indicate that the overwhelming portion of net assets per household is the house. In comparison, superannuation is a small component for most households’ total accumulated wealth.
• To bridge the chasm between what current superannuation balances are likely to provide from just contributions from the SGC (superannuation guarantee charge of 9%), people need to contribute to retirement age anywhere between another 8.8% to 15.3% per annum additional money into superannuation to bridge the retirement savings gap.
• Superannuation of $100k does not last long. If you retire at 60 with a super balance of $100k, normal life expectancy another 20 years say to 80, your super pension would be around $6k a year with the balance running out by the time you were 80. If you had access to the pension as a single at age 65, you will then have an annual income of about $19k per annum. If your previous wage was an average wage of about $50k pa, you would receive less than 40% of your previous wage. The aged pension for a single is about $550 per fortnight or about $14k pa. It is set at a subsistence level, being 25% of average workers income.

What can you do to improve your long term wealth position?

Superannuation had been advocated by many as the path to retirement wealth. Government offer generous tax incentives, where by using superannuation salary sacrifice (if available in your workplace) you can contribute pre-income tax dollars into your superfund, pay 15% contribution tax on the way in and the superfund earnings in accumulation phase are taxed at 15% as well. There are generous incentives for low income earners where the government will pay up to $1,500 pa co-contribution, but even with 30 years of co-contribution, you will not accumulate a large balance. Depending on which fund or type of fund and portfolio selection, you may get an average return of 6 to 9% pa after fees and taxes. With recent changes, superannuation is now more a vehicle to house wealth than accumulate.

As a rough rule of thumb, imagine what you would want to retire on as a net income in today’s dollars, multiply it by 15 and that is the value of income producing assets required to generate the retirement income to last for your normal life expectancy. A $50k net income per annum, you need $750k in assets. Are you saving enough? Can you save enough?

How do you accumulate sufficient wealth for your lifestyle choice?

The name of the game is leverage. It is the principle of borrowing other people’s money to purchase capital growth assets. The main assets classes to consider are shares (or the stock market) and property. Some of my other newsletters (Oct & Nov ’06) have discussed asset allocation and compared property to shares, but the most important factor of investment strategy is the finance component.

If I use an example, it may help clarify the rationale behind that statement. There are two distinct assets as shown below, both assets cost $400k. Which is the better investment?

On all counts, Asset #2 is. It has a higher capital growth and higher income (dividend or rent) yield to return an 18% gain compared to a 14% gain for Asset #1.

What if we now add in leverage or what can you borrow against the asset itself? Everything else remains the same.

If you can borrow 80% against Asset #1, meaning we need $80k of our own money and then borrow $320k, at an interest rate of 9% costing $28.8k, we have a net gain of $27.2k or a return on our own funds of 34%. Asset #2 at a 50% borrowing maximum, we borrow $200k and use $200k of our own funds, same interest rate, we generate a net gain of $54k, but the use of our own funds, we have a return of 27%. It is certainly nothing to be sneezed at and far better than a 6 to 9% growth on superannuation assets.

What if we can borrow at 95% for Asset #1? We use $20k of our own money and borrow $380k.

Our net gain reduces to $21.8k but the return on our own funds is 109%. Would this be acceptable? This is what leverage is about, using other people’s money to purchase capital growth assets. In a future newsletter I will talk more about and compare capital growth to income yield, but let us work on the premise that capital growth is the far more important component for wealth creation.

What is the strategy?

The asset class is residential property because the banks will lend up to 95% of the value of the property. It is a well understood asset, most people have purchased a home and many an investment property. What is needed to be understood is that one investment property is not sufficient to create long term wealth. It is better than none but you need a base of five to six properties and preferably ten properties to give you that wealth and income earning ability for a long retirement.

Jan Somers in an early book in 1992, talked about purchasing one investment property every two years to accumulate net equity of over $1m by year 10. This is possible and more people are starting to follow in her footsteps.

Why don't you know about this already? How many bankers do you know with investment properties, how many real estate salesmen, or accountants or financial planners or mortgage brokers? The reality is very few. Strategy and structure are key components, setting up finance properly and purchasing the right type of properties. Find the people who are investors and who can assist and support you.

With any investment, there comes the risk of loss as well as gain and with leverage, both the gain and the potential loss are magnified by a factor depending on the amount borrowed. In well published cases like ABC Learning and Opes Prime, margin lending blew out losses of those involved when the market fell. Besides the shares themselves having little value, the loans still needed to be repaid.

There are strategies to build in safety nets, to provide a high degree of protection, to ensure that certain risks are insured and covered, such as income protection, life and trauma insurance but more importantly, a safety net in terms of cash facilities available in case of unexpected circumstances.

There has been some interesting analysis of real property compared to other asset classes, Residex has produced some information comparing risk and return over a ten year period to 2006.

The graph above compares various asset classes, including the All Ordinaries Index as well as Treasury Notes and compares them in terms of risk to return against some real residential properties in the Sydney, Brisbane and Melbourne markets for both houses and units. Many respected property commentators have long advocated the fundamentals of the Melbourne and Brisbane markets due to demand and supply, demographics etc. This graph clearly supports that view where high returns year on year for low risk (or volatility) are demonstrated in Melbourne houses and units as well as Brisbane houses.

Give me a call to find out whether this type of strategy would work for you. We have access to a network of professionals who can assist in property selection, purchase and management as well as providing information needed to obtain appropriate tax deductions. We take the approach of looking at your long term goals and working to find a solution through finance for you. This appointment is at no-cost and is obligation free, call – 03 9397 7275