By creating the right balance between guaranteed income, capital protection, and the promise of capital growth, a Perth-based couple managed to have their cake and eat it. Mark Story explains how.
In 2005, Perth-based diesel fitter, John Leeds, and wife Janice finally found themselves with enough surplus cash to fast track a diversified wealth accumulation strategy. With two grown-up daughters finally off their hands, the family home all but paid off – and a six-figure income burning a hole in John’s pocket – they decided to knock on the door of professional planner Gus Sadri.
Up until this point, John – who had little more than a couple of legacy Colonial funds and two small super funds – was a fairly dormant investor.
While Sadri had inherited John as a client some years earlier, following a company buy-out, they had had minimal dealings with each other.
Having been given the opportunity to conduct a full review of current and future financial needs, Sadri discovered that John and Janice wanted to live on an income of $40,000 (after tax) annually, supplemented by an additional $20,000 income from part-time employment.
‘John initially contemplated investing his lump sum within an SMSF’
WEALTH CREATION
Based on his initial review, Sadri was quick to recommend that the Leedses implement a three-pronged wealth creation strategy.
Firstly, he recommended borrowing $125,000 against the family home (valued at $400,000) and investing 40 per cent into direct shares and the rest into growth-oriented managed funds, under a Colonial First State platform.
Secondly, given the amount of surplus cash John was now accumulating, Sadri recommended significantly beefing-up his super through a salary-sacrifice strategy, thereby reducing his annual tax bill by 15 per cent.
To diversify risk, Sadri recommended share exposure through CommSec’s model portfolio comprising eight to 10 non-speculative, blue-chip domestic shares – covering resources, industrials, banking and media sectors – paying fully-franked dividends.
Following disappointing returns from the direct shares portfolio, relative to the managed funds, both Sadri and John concluded that direct shares provided insufficient diversification.
So the shares were sold within 12 months and the proceeds reinvested in numerous managed funds.
While they were enjoying double-digit returns, all managed funds were cashed-out in March 2007 – in the lead-up to the GFC – leaving the Leedses with a $69,000 return on the $125,000 they’d initially borrowed.
INCOME
With John having just turned 55, the third part of the strategy included transition-to-retirement through an allocated pension – with a growth risk profile – based on a maximum draw-down of 10 per cent. With interest rates low and managed funds continuing to perform well, Sadri recommended using the $69,000 from the sell-down to make a lump-sum undeducted contribution into his Colonial First State super fund.
John contemplated selling the shares he had acquired through an employee share plan to pay out the mortgage. But with interest rates still at historically low levels, and the outlook for shares continuing to improve, he decided to continue to service the remainder of the debt taken out against the family home, and to remain invested in his existing managed funds portfolio, which proved to be a useful strategy during the bull phase of the market 2003-07.
“Over the ensuing two years, John continued to salary-sacrifice into his employer super fund until his retirement in April 2009 – at which time his pre-retirement (non-commutable) pension was converted into a commutable allocated pension,” Sadri says.
“Now that John has turned 60 the fund is commutable and he can draw down lump sums tax-free.”
REINVESTING LUMP SUMS
John’s retirement brought with it the vexing issue of what to do with the $552,000 lump-sum payout from his Employee Defined Benefit Fund with BP. Owing to the nature of this fund, which offered a fixed-interest-style return – based on salary and years of employment – John had by default been safeguarded against the ravages of the GFC.
But with no option to take his retirement benefit as a regular pension, John was left with no choice but to reinvest elsewhere.
While John initially contemplated investing his lump sum within a self-managed super fund (SMSF) structure, he didn’t want the fiduciary and trustee responsibilities associated with maintaining it.
“Onerous compliance aside, a SMSF just wasn’t considered a cost-effective option, as substantial fees would gradually eat into the returns over the years,” John says.
“Given the extra costs they were incurring, none of my friends with SMSFs seemed to be forecasting demonstrably better returns than me.”
SAFETY NET
At face value, with the S&P/ASX All Ordinaries Index trading at 3800 points – still around 40 per cent down on its high of February 15, 2007 – the market was awash with value. Nevertheless, with John and Janice’s appetite for risk severely compromised, their brief to Sadri was simple: Replicate a level of security that John had within his defined benefit employer fund, with some upside for capital growth.
With long-term investment horizons still ahead of them, lack of capital growth meant term deposits didn’t appeal. And given the downside of zero accessibility to capital, the option of locking the entire amount into an annuity with a reputable life office was equally unappetising.
Out of the total $552,000 available, Sadri recommended that 45 per cent ($250,000) be invested in a CommInsure Guaranteed Index Track Annuity with a 15-year term.
What attracted Sadri to this annuity was the guaranteed income stream, combined with the potential to achieve compounded increases of up to 5 per cent per annum, in line with the movement in the S&P/ASX 200 Price Index.
“This $250,000 effectively offers $369,000 in fixed income over a 15-year period,” says Sadri.
GUARANTEED GROWTH
For the remaining $302,000, Sadri recommended AXA North Guarantee, an investment growth-style super asset, offering a “protected growth guarantee” for a term of 10 years. This means that at the anniversary date of the investment – if the markets have increased in capital value – the investment growth would be locked in.
“So if the market does go down in the second or future years, the protected value is locked in at the anniversary date of the investment – and that’s what the client would receive (without breaking the guarantee term),” says Sadri.
As a case in point, he says the original $302,000 has already gone to $322,585 on the first anniversary date – and it’s this figure that gets locked in as the protected balance.
”This part of the strategy was particularly appealing to John and Janice as it met their specific need to be invested in the market with exposure to growth-style assets – albeit with capital protection for the term of the guarantee,” says Sadri.
While the “protected growth guarantee” associated with this feature does incur a 2.5 per cent protection fee, John says the benefits of having this type of insurance cover and exposure to growth-style assets far outweigh what equates to a relatively small premium cost.
Meantime, Sadri also suggested a change in the classification of the pension established four years earlier, from a pre-retirement pension to an account-based pension. By dispensing with the “non-commutable” feature, John and Janice can access their capital for any unforseen future expenses.
TAX
Prior to starting the initial transition-to- retirement (TTR) strategy, John was paying $39,000 in PAYE tax. But through salary-sacrificing and TTR implementation, this has since dropped by $6000 a year to $33,078.
