Financial Planning Archives - the patient investor

November 30, 2015

The Trouble With Chasing Hot Strategies | Josh Brown

This should be blindingly obvious, but amazing how often it is ignored. Great post from Josh Brown at Reformed Broker:

How do most investors (and many advisors) select funds or strategies to allocate to? They look at what’s been working, learn the story and get long…….
And then mean reversion shows up – outperforming managers subsequently underperform, hot themes become over-loved, winning strategies become too crowded to offer excess returns. “No problem,” says the advisor, I’ve got six new ideas to replace the six ideas that are no longer working!”

It’s sad to say, but this is exactly how it works. I’ve been watching this for almost 20 years…….

Research Affiliates has an interesting pair of charts demonstrating this phenomenon in a new note from Rob Arnott, Jason Hsu and Co. They illustrate that increasing fund flows are a decent predictor of subsequent underperformance and that performance-chasing is destructive to returns across all types of investment products:

Research Affiliates

November 3, 2014

Is Mathias Cormann acting in investors’ best interest — or the banks?

Chris Joye from the AFR comments on Finance Minister Mathias Cormann’s final Future of Financial Advice (FoFA) bill:

Cormann seeks to assure consumers that a commission “is banned if it is made solely because a product . . . has been sold”.

This is part of his new definition of a commission, which lawyers say bears no resemblance to the real legal meaning of commissions under precedent laws.

The word “solely” makes the definition a farce. Cormann’s explanatory statement says: “If an employee [had] to meet a reasonable target – [like] selling 1000 products – as well as a compliance target . . . the payment would not be made solely because of general advice [and] . . . would be permitted.” In every other universe, these payments are a “commission” and/or “conflicted remuneration”.

I do not have a problem with the Coalition’s changes to the laws on “general advice”. Companies should be free to motivate sales staff, as is the case across the rest of the economy.

My main concern is with Cormann’s modifications to the “personal advice” laws, which allow planners to earn up to 10 per cent of their total remuneration in sales bonuses partly determined by how many products they sell to customers relying on personal advice.

Cormann’s logic is because he has exempted these “performance bonuses” – which planners do not support – from the ban on conflicted remuneration, they are not conflicted remuneration: “With personal advice the requirements are very stringent, so all remuneration that would conflict the advice given is banned, and the overarching requirement for the adviser to act in the best interests of the client remains in place.”

Conflicts of interest are rife in the provision of financial advice. Removal of the overriding requirement that an adviser act ‘in the best interest’ of their client leaves the door open to an array of abuses. The argument that advisers are already obliged to act in the client’s best interest is not an argument against removal of the provision. If the obligation is already implied, making it an express obligation would simply reinforce this by removing any doubt.

In my view, advisers offering personal advice should not receive any (material) incentive for recommending specific products. That would limit the potential for any conflict of interest and improve public perception of adviser integrity. And where general advice is offered, the adviser should be required to (prominently) notify readers or listeners that they (the adviser) receive incentive payments based on the products they recommend. After all, the primary concern of the industry should be to protect the consumer. In doing so, advisers will benefit from an enhanced reputation and trust from the community.

July 11, 2014April 16, 2018

Growth or income?

Most investors face a decision as to how much of their portfolio to allocate to growth investments and how much to income investments. The mind-set of many income investors is that they cannot afford the volatility of growth investments. The following example illustrates how income investors can use growth investments to protect their portfolio against inflation and enhance overall returns.

Growth investments, historically, have outperformed income investments, but at the expense of greater volatility. They are typically favored pre-retirement by investors with long time horizons who seek to maximise their capital on retirement. Other than improved performance, growth investments also generally receive more favourable tax treatment than fixed income, further enhancing after-tax returns. Income investments historically exhibit lower volatility and are favored by retirees for their consistent income, also by risk-averse pre-retirees who wish to reduce the volatility of their overall portfolio.

Historic Returns

These historic returns to Australian investors from 1981 to 2009 illustrate the differences in returns and volatility. Data was originally provided by AXA:

Asset class:	Australian stocks	Australian fixed interest	International stocks	Australian REITS	Australian cash
Annualized return (%)	11.38	10.41	10.81	10.49	9.18
Inflation (%)	4.41	4.41	4.41	4.41	4.41
Real return (%)	6.97	6.00	6.40	6.08	4.77
Standard deviation	23.32	7.60	21.41	18.75	4.95

Not all investment strategies are likely to match the broad asset classes, but they are a good starting point for developing a broad investment strategy.

What the future holds

One thing about the future is certain: it is not going to match the past. It also is not going to match our projections. Without a magic crystal ball, the best we can do is adjust past performance for expected changes and hope we are not too far off course.

My own expectations are that we are entering a low inflation environment. Central banks, after the global financial crisis, are likely to be far more vigilant about rapid credit expansion and asset bubbles. I have therefore adjusted my inflation expectation down to 2.0%. I also expect that low inflation will have greater impact on fixed interest and cash and have adjusted their returns accordingly.

Asset class:	Australian stocks	Australian fixed interest	International stocks	Australian REITS	Australian cash
Annual return (%)	9.00	7.00	9.00	8.00	5.00
Inflation (%)	2.00	2.00	2.00	2.00	2.00
Real return (%)	7.00	5.00	7.00	6.00	3.00
Standard deviation	25	10	25	20	5

These projections are no more than an educated guess and are used for illustration purposes only. Make your own projections, but understand that unrealistic projections will yield unrealistic results.

Investing for Income

We can now determine how much to allocate to income investments and how much to growth investments.

Take a retired investor whose objective is to earn $60,000 per year (after tax) from investments while protecting capital from inflation.

If he/she earns an average return of 7.0% p.a. on income investments at an average tax rate of 15%, with 2.0% inflation, we arrive at a net return of 3.95% and a required investment of $1.519 million:

Average return:	7.00%
Less tax at:	15%
After tax:	5.95%
Deduct inflation:	2.00%
Net return:	3.95%
Required income after tax and inflation:	$60,000
Required capital (60,000 x 100/3.95):	$1.519 million

Adding growth investments

If we recognize hedging against inflation as a long-term goal and not an immediate cash flow need, we can consider funding the inflation element of the portfolio with higher-yielding growth investments.

Income Component

First we calculate the capital required to meet current income needs:

Average return on income investments:	7.00%
Less tax at:	15%
After tax:	5.95%
Required income after tax:	$60,000
Required income investment:	$1.009 million

Growth component

Growth investments typically enjoy higher after-tax returns because of improved performance as well as a lower tax component — through capital gains concessions and franking credits on dividends (for Australian investors).

Average return on growth investments:	9.00%
Less tax at:	10%
After tax:	8.10%
Deduct inflation:	2.00%
Net return:	6.10%
Required income from growth investments ($1.009m x 2.0%):	$20,180
Required growth investment ($20,180 x 100/6.1):	$0.331 million
Total required capital:	$1.340 million

Using growth investments to fund the inflation component reduces required capital to $1.340 million, a reduction of $179,000. Alternatively, if we invest the previously determined capital amount of $1.519 million, we should average close to $11,000 of additional income (after tax and inflation) each year. With higher inflation rates, the difference is even greater.

Remember that this example does not take into consideration your personal needs and circumstances. Also, taxation and investing for retirement are complex subjects and we recommend that you consult a professional adviser before making any decisions.

June 22, 2014

“Highly unlikely to ever see a Storm again”

Andrew Starke welcomes the latest proposed changes to Future of Financial Advice (FoFA) legislation in FINSIA News:

Changes… outlined by the government on Friday have generally been well received, with many in the industry now hoping for final clarity on a process that has been running since the Labor Government revealed the proposed reform package in April 2011…..First and foremost, the changes outlined by the government on Friday ensure a clear ban on commissions after it had previously left the door open via the so-called ‘Wolf of Wall Street’ clause within general advice. Any possibility of a return to commissions on investments or superannuation products has now been ended.“This response removes all doubt that commissions will be introduced in the provision of general advice. The government will define and ban commissions in black letter law” said John Brogden, CEO of the Financial Services Council FSC. “The changes outlined by the government also maintain a detailed and comprehensive best interest duty requiring a financial adviser to act in the best interests of their client.”

Best interest clarified
While the perceived watering down of the best interest duty has attracted a great deal of attention in the mainstream press, Brogden said this should be put in perspective. Prior to FoFA, financial advisers simply had to offer ‘appropriate advice’ while they now need to comply with a raft of regulation. “There are six separate duties in the Corporations Act that require a financial adviser to act in the best interests of their client. In addition, there are six specific steps that must be met by an adviser when providing advice that codifies the best interest duty,” Brogden said. “The government has made one minor change to the best interest duty by removing an unnecessary ‘catch all’ provision. This change will actually clarify the best interest duty and remove any ambiguity for a financial adviser to always act in a client’s best interests.” The FSC has legal advice from leading commercial counsels Ian Jackman SC and Gregory Drew which it said confirms that the removal of ambiguous ‘catch-all’ phrase will not dilute the obligation of an adviser to act in the best interest of their client……The Australian Bankers’ Association ABA also welcomed the announcement and said the amendments would preserve the original intent of the law while correcting the current overreach and broader uncertainties.

What puzzles me is:

How an overriding provision — that advisers act in the best interests of their clients — can be “ambiguous”?
How removal of the overriding provision helps to clarify the situation? and
Why, if legal advice confirms that removal of the ‘catch-all’ phrase “will not dilute the obligation of an adviser to act in the best interest of their client”, should it be removed?

Major banks have spent billions of dollars buying up financial planning firms in order to secure distribution of their investment products. Christopher Joye at AFR puts it in a nutshell:

The big vertically integrated institutions (mainly the four majors and AMP), which now control 70 per cent of planners, want these tied distributors to have the freedom to recommend in-house platforms, super funds and investments without being hampered by a catch-all best interests duty.

An overriding provision would certainly not be in the banks’ best interests.

October 4, 2013

Consumption biggest SMSF risk

Last week the consulting group Deloitte ……. analysis of how long after retirement retirees’ nest eggs would last that was the most profound aspect …..it showed that retirees living “comfortable” retirement lifestyles would run out of superannuation money after just 11 years compared to those that opt for a “modest” retirement lifestyle who would see their superannuation last 30 years.

August 12, 2013

Superannuation is inequitable and unsustainable | | MacroBusiness

I agree with Leith van Onselen that Australia’s aged pension/superannuation regime will be sorely tested over the next 30 years as the number of workers per retiree falls to below 2.5 to 1:

Workers per Retiree

But I don’t agree with his proposed solution:

…The flat 15% tax on superannuation contributions should also be axed in favour of a flat 15% concession. As illustrated above, under the current 15% flat tax arrangement, the amount of super concessions rises as one moves up the income tax scale, resulting in a system whereby higher income earners receive the most super tax benefit, despite being the very people that are the least likely to rely on the aged pension in retirement. A flat 15% concession, by comparison, would improve the equity and sustainability of the system by: 1) providing all taxpayers with the same taxation concession; 2) boosting lower income earners’ super savings and thus reducing reliance on the aged pension; and 3) reducing costs to the budget.

Argument that the flat tax on superannuation contributions is inequitable is based on the presumption that the present system of progressive tax rates is equitable. No doubt high income-earners benefit more from the flat tax than low income-earners, but the proposal ignores the fact that they pay more income tax in the first place. And even after the larger tax savings on their super contributions, the high income-earner will pay a significantly higher average tax rate.

April 7, 2013

Australia: Unsuspecting super investors are being sold a pup

David Potts at the Sydney Morning Herald writes:

Retirees with far less than $2 million in superannuation face extra tax bills…… the new tax will apply to all earnings above $100,000 a year from 2014, no matter the size of the nest egg.

The tax net is far broader than the 16,000, or 0.4 percent of retirees, mentioned in the recent announcement. Treasury estimates cited are based on a projected 5 per cent rate of return on investment and ignore the fact that returns can fluctuate widely, from 30% in a good year to -30% in a really bad year. Super funds with as little as $200,000 or $300,000 are affected if they earn more than $100,000 in any given year.

The problem is further exacerbated by capital gains, especially for self-managed funds that are not widely diversified. If a super fund sells a property or large block of shares, the asset may have been held for many years but the entire capital gain is recognized in the year in which the asset is sold. Despite some phase-in concessions, lumpy capital gains could lift a retiree over the $100,000 income threshold.

This is a deliberate tax grab that affects ordinary Australians while being sold to them under the smokescreen of “taxing the rich”.

Hat tip to Ody for bringing this to my attention on Incredible Charts forum.

March 26, 2013

Conflict of interest: Will Wall Street put their interests ahead of their clients?

You bet they will. Here Cullen Roche explains why he quit Wall Street to become an independent advisor:

One of the reasons Roche transitioned to becoming an independent advisor was because of [the] perceived conflict of interest that exists at big Wall Street firms. “Those big firms are revenue-driven – they’re fee generators. They’re not able to do what’s in their clients’ best interest – a lot of the time the best interest of the client is to reduce fees,” he notes. According to Roche, the financial advisor model needs to change, with more and more advisors needing to act as independent consultants or fee-only advisors. “I think the conflict comes mostly from the big wirehouses: public companies that need to maximize profits – profits largely derived from generating fees from clients,” he concludes.

March 10, 2013

Australia: SMSF – a matter of self-interest

Reece Agland, senior policy adviser at the Institute of Public Accountants, compares the performance of self-managed super funds to retail and industry funds:

Let’s look at the facts. For the three most recent years where performance has been measured SMSFs out performed both retail and industry funds. The average operating cost of an SMSF fell from 0.72% of assets in 2007 down to 0.57% in 2009 – less than average costs for either industry or retail funds1. With average assets of over $888,000 in 2009/10 (up from $475,000 in 2003/4) they exceed the average assets per member compared to other types of funds. Their rate of non-compliance at 2% is at around the same for other superannuation funds and the number of funds that fail in any one year is very small.

June 6, 2012

SMSF Education: So…how much can I contribute?

SMSF Education is a free online education resource for SMSF trustees and their advisers.

SO…HOW MUCH CAN I CONTRIBUTE?

There are two types of contributions that can be made to superannuation. These are known as Concessional (pre-tax) contributions and Non-Concessional (post-tax) contributions. There are contribution caps that determine the maximum amount that can be contributed in any one year for each type of contribution.

A Concessional contribution is a contribution made to superannuation where a tax deduction has been claimed. This includes contributions such as the Superannuation Guarantee Charge (SGC), salary sacrifice and personal deductible contributions. Concessional contributions incur contributions tax of 15% upon entering superannuation. From 1 July 2012, this contributions tax increases to 30% on Concessional contributions for individuals with an income greater than $300,000.

The maximum Concessional contribution that can be made into the account of a superannuation member is dependant on their age. Currently, a member under the age of 50 is able to have contributions of up to $25,000 made to their account as a Concessional contribution in any one year. For those over age 50, the cap is $50,000. However, as of 1 July 2012, the Concessional contribution cap will be a universal $25,000 for all members regardless of age. In saying this, the Government has announced that members over age 50 will be able to have up to $50,000 (potentially $55,000 due to indexation) contributed to their accounts as a Concessional contribution from 1 July 2014 if their superannuation member balance is below $500,000.

A ‘non-concessional’ contribution is a contribution made to superannuation with after-tax dollars – where income tax has already been paid. No tax is incurred on this type of contribution upon entering superannuation.

The maximum Non-Concessional contribution that can be made in any one year is $150,000. However, members under the age of 65 have the ability to ‘bring forward’ two years’ worth of the Non-Concessional cap. This means that up to $450,000 may be contributed in any one year, with no further Non-Concessional contributions being made for the following two years. The ‘bring forward’ rule is triggered in a financial year if more than $150,000 is contributed as a Non-Concessional contribution.

Exceeding the Cap

Where a member receives Concessional contributions in excess of their relevant cap, the excess amount is subject to excess contributions tax of 31.5% and the amount in excess will then count towards their Non-Concessional cap.

For various reasons, many individuals have been incurring excess contributions tax as a result of circumstances out of their control. From the 2012 financial year, new measures in place provide certain individuals with the ability to have excess contributions refunded to them and taxed at their marginal tax rate, so as not to incur excess contributions tax. However, this is only available in limited circumstances where the excess contributions equal less than $10,000 and there are no excess contributions for an earlier financial year (excluding years prior to 2012). This option for a refund is only available once for each individual’s lifetime. It is not available in the years subsequent to a refund being claimed.

In cases where the Non-Concessional contributions cap is exceeded, excess contributions tax of 46.5% is incurred. This is after income tax has already been paid on the amount contributed.

There are some instances where 93% in tax on contributions could be payable. This occurs when the Non-Concessional contribution cap has been reached and a Concessional contribution is made, which causes the Concessional contribution cap to be exceeded. In this case, the concessional contribution will incur contributions tax of 15% and then excess contributions tax of 31.5% for exceeding the Concessional contribution cap. Because the contribution has exceeded the Concessional cap, it will count towards the Non-Concessional cap. However, because the Non-Concessional cap had already been reached, excess contributions tax of 46.5% will be payable for exceeding the Non-Concessional cap – totalling 93% in excess contributions tax.

Contribution caps for relevant years (excluding indexation):
SMSF Contributions

Ideally, all contributions should be made to your superannuation account a couple of weeks prior to the end of the financial year. The end of the tax year is a hectic time for superannuation funds. By getting your contributions in early, it should ensure that any delays in transaction or processing time will not affect your ability to claim a tax deduction in the current financial year.

Warrick Hanley
For more information, please go to www.smsfeducation.com.au