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Financial Happenings Blog
Wednesday, November 26 2008

The latest edition of our fortnightly email newsletter was sent to subscribers Tuesday 25th November. 

In this edition we consider the basics of income planning, take a look at CommSec's iPod Index, provide a summary of the movements in markets over the past fortnight and look at the link between the economic cycle and share market returns.


We are also pleased to continue with the new section looking at case studies this week looking at a couple with $1 million to invest.

If you would like to be added to the mailing list please click the following link to be taken to the sign up page - The Financial Fortnight That Was Sign Up Page.

The following is the lead article for the latest newsletter:

Financial Topic Demystified - Income Planning

Earlier this week we sent out an email to all of our clients.  In it we made some brief comments about the current market conditions.  Included with this email was our rationale for continuing to hold equities within an investment portfolio.  In our conclusion we reminded clients of what we consider an absolute key consideration when building investment portfolios - holding enough cash and fixed interest assets to cover income needs for the medium term while still exposing portfolios to growth assets to take advantage of the long term returns from these assets.   We call this income planning and wanted to take the time to remind readers of this concept by providing an extract from our book "A Clear Direction - Being a Successful CEO of Your Life" covering this topic.


Once you are retired (whether this be 40 for some or a little later for others), the aim is to replace your 'personal exertion income' (i.e. your income from your job) with your investments - possibly supported by some Centrelink benefits such as the age pension.
A great way to look at this process is using 'income planning'.  This involves construction of your investment portfolio with your income needs being a critical part of this process.
Let us consider 'income planning' by looking at a case study.
The couple in question are 65 years of age, retired, with $600,000 in superannuation and a further $50,000 in 'lifestyle assets' that Centrelink assess for the sake of the assets test (things like their furniture and car).  They own their own home.
As a couple they are eligible for approximately $7,500 of the age pension (based on pension levels at September 2008). 
Clearly this is not enough to live on, so they decide to draw on their superannuation portfolio at the rate of approximately 5% a year, or $30,000 a year.
So the couple needs to plan for an income of $30,000 a year to be provided from their $600,000 superannuation portfolio.
In the investment world there are two key types of investments.  The first are often referred to as 'Defensive' investments, such as cash accounts and term deposits - as well as other high quality fixed interest investments like bonds.  These offer very reliable short term returns, usually with easy access to the money.  Their downside is that they don't offer very good long term returns compared to shares and property (average defensive returns over a period might be 6% a year; where shares and property might be 12% a year).
The other investments are 'growth' investments, such as shares and property.  In the short term they offer volatile returns - however in the long run (7 to 10 years) they offer returns higher than defensive investments.
A reasonable conclusion to draw from this is that defensive investments offer a great short term option, and growth investments offer a great long term option.
This hardly sounds profound, yet sits as the basis for 'income planning'.
The couple in the case study, with $600,000 in superannuation and looking to draw on this at the rate of $30,000 a year, can plan to keep the money that they need in the short term in defensive investments, with the remainder in growth assets.
They might set aside 5 years ($150,000) in cash and fixed interest investments - to be sure that they have at least 5 years of living costs set aside.  This should allow them to sleep soundly at night - they know where their next 5 years of income comes from.
The remainder is invested in growth assets - such as shares and property investments - which benefit from the higher returns that growth assets provide that cash.  These assets are volatile (may rise and fall in value) - however the couple don't have to be concerned with that because they know that they have the money to fund their next 5 years of living costs.
Over the 5 years, there will also be interest received from the cash and fixed interest investments, dividends from the shares, distributions from the property and so on.  In fact, it is not unreasonable to think that a well put together portfolio of $600,000 will pay gross income (including the tax benefits of franking credits) of at least 5% a year - so there is a further $30,000 a year being received by the portfolio.  Because some of this income comes from share and property investments, it will grow over time, helping the portfolio provide an income that will keep up with inflation.
Given that 5 years of living costs are set aside in cash and fixed interest investments, and the portfolio is generating a growing income stream of at least $30,000 a year, then the couple seem to be in a really strong position to fund their retirement - using defensive investments to provide short term certainty and growth assets (shares and property) to provide the higher long term returns.


How Do We Apply This?


We use income planning in conjunction with risk profiling to come to a conclusion on the ideal amount of cash and fixed interest assets a client should hold or aim to hold when they commence drawing income from their investments.  In times like now it provides a deal of re-assurance that you can ride out down turns in growth asset prices without needing to sell investments to pay for your cost of living.
Posted by: Scott Keefer AT 08:11 am   |  Permalink   |  Email
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