Investing for Income in Retirement

At a recent presentation at the ASX I was demonstrating the attractiveness of income investing in the share market. In attempting to justify my arguments I made use of a number of historical price charts that spanned a period of up to 20 years. The take home message was essentially that while the market can experience significant short term pull backs, the longer term picture has always been attractive compared with other asset classes, and that dividend yields could grow to substantial amounts over time. No arguments there.

At the end though, an elderly gentleman asked “what use is this to me, I can’t afford a 20 year investment timeframe?” True enough; in retirement we enter a phase where we are no longer generating an income and require our investment capital to sustain our lifestyles. Are the generally low quoted dividend yields and the uncertain short term outlook for the market worth accepting at a stage when we need to preserve as much capital as possible?

The first thing to point out is that while retirees don’t have the same investment timeframes as younger people, they do nonetheless have one significant advantage. That is, they have a lifetime of savings with which to invest. Their younger counterparts on the other hand are generally under a greater debt burden and have limited investment capital.

This means that although retirees cannot afford to wait for dividend yields to become significant, they will generally earn more in actual dollar terms from year one. Consider a retiree who is 60 and looking to support themselves with their investment capital. Let’s say they have $500,000 to invest with from their super and savings.

* If you’re 60 or over you pay no tax on the taxed element of your payout regardless of the type of payout it is. See www.ato.gov.au for more details

Because your investment earnings are tax free when you are over 60 and invested in the superannuation environment you not only receive all the dividend, but all of the franking credits are refunded. The beneficial tax treatment means that our hypothetical retiree is generating an after tax income of almost $43,000 annually. That’s over $800 to live off each week without ever having to touch the capital.

Furthermore, because dividends tend to rise on average over time, the annual income would likewise grow. Since 1980, the average annual increase in dividends for the All Ordinaries is around 7%, and if we assume that rate will generally hold, the weekly income would be around $1,000 in five years time. Maybe retirees cannot plan for a 30 year investment timeframe, but the fact is even five years can make a substantial difference.

What about people who had invested their money into the market just prior to the recent crash? Well there’s no avoiding the fact that things will look very nasty. But remember that while your capital is likely to be over 40% lower, your income stream would not have dropped as significantly. At the time of writing, around 47 stocks in the All Ordinaries have announced their dividends. Approximately 40% of these have lowered the dividends by 50% on average, but despite the economic conditions the other 60% have actually maintained or even increased their dividends. Taken altogether, dividends payments for these 47 stocks have dropped by only 15% on average (which provides yet another argument for maintaining a well diversified portfolio). Not what you like to see, but certainly significantly better than seeing a 40% drop in income returns.

In our example, if the retiree saw their income payments drop by this amount, they would still be receiving $700 a week after tax in the first year. Again, this is not ideal, but it’s not nearly as bad as some people make out. The other thing to note is that when corporate earnings recover, so too will dividends. Recently the Reserve Bank and Treasury forecast that the economy would likely start to recover in 2010, and even if it actually takes a year or two longer, it isn’t a long stretch of time in the grand scheme of things.

Another criticism I often hear is that to make dividend income attractive for retirees, they need to have a large amount of investment capital. If you only had $100,000 in total savings upon reaching retirement, unfortunately your return will be significantly less, in fact only around $160 per week after tax. What do you do in this situation?

Unfortunately the only way to generate higher returns than the market average – enough to make $100,000 generate sufficient income – is to take on significantly higher risk, either through investing in more speculative assets or using leverage. It’s one of the oldest rules in investing: higher returns require you to accept higher risk. But by taking on additional risk you are put in the position of potentially losing a vast amount of capital, and ending up in an even worse position. And for this reason I would advise against it. The reality is that if you don’t have sufficient capital and don’t want to assume much higher risk, there is little you can do. All the more reason to start early.

Besides, let’s consider your alternatives. You could opt to invest in safe and secure bonds or term deposits, but at current interest rates you will actually receive much less than what you would get through shares anyway, and with these products there is no possibility of capital growth.

Finally, I have used 6% as the expected yield in the first year with shares. The long term average dividend yield is much closer to around 4%, but the current capital depreciation on markets means that 6% happens to be quite achievable at present. There is a silver lining to every cloud – and this is the silver lining to the current situation. That, and the fact that you are also likely to generate better capital returns as the market recovers even if it takes several years for things to turn around.

Sensible investing is not about getting rich quick. Rather it is about achieving reasonable returns without taking on unacceptable levels of risk. If you are in retirement or approaching retirement, the share market can provide you with a very attractive and tax effective income stream that is currently above that offered by the other asset classes. The only problem is that your capital value can be quite erratic, but as long as dividends remain mostly stable and as long as you are not planning on drawing down your capital, this won’t be a major concern over time.

Make the markets work for you

Andrew Page