Did you know that allocated
pensions are designed to deplete over an investor’s lifetime?
How does this happen and why?

Allocated pensions are highly tax effective retirement income streams funded from superannuation monies. While the tax benefit is great, it is not unlimited. Allocated pension funds are exempt from tax. The income withdrawn by investors is eligible for a tax rebate, usually 15%, after allowing for any tax deduction of the annual deductible amount.

While the government grants very favourable tax treatment to
allocated pensions, they do not want allocated pension funds to be used as vehicles for the accumulation of excess tax free wealth. The funds are granted taxation relief because they are used for the purpose of providing for retirement. In short, the government wants you to spend the money in your lifetime.

The legislation governing allocated pensions determines how much the regular income payments are for each investor. Each investor must withdraw a regular sum, which falls between a minimum and a maximum amount that is set by legislation. These maximum and minimum amounts change annually and are dependent on the balance in the member’s account and the member’s age. In effect, as you get older the percentage of funds withdrawn accelerates. This happens more quickly if you choose to receive the maximum income payments, but even at the minimum levels, the account balance will eventually begin to fall.

The graph below demonstrates the point. In this example, Patrick aged 61, purchases an allocated pension with $600,000 and spends the minimum income payment from his allocated pension. His cost of living in year one is $30,000 yet the minimum pension is $35,000. The assumed earning rate is 8.0%.

What can investors do to extend the life of their investment?

With allocated pensions, it is very important to understand that the money you withdraw is regulated by legislation and is not directly related to the fund’s investment earnings. For funds with better investment returns, the fund assets will last longer and the regular income payments will be higher, but the capital reduction referred to above occurs, even for funds showing good investment returns.

The key is not to spend all that you withdraw. Investors need to determine what their cost of living is and stick to that, after allowing for inflationary increases. If your cost of living is lower than the amount you are required to withdraw from the pension fund, then you should reinvest the balance. If the income payments are insufficient to meet your living needs, then you will need to supplement your income from other means. You must also be aware in this case, that the allocated pension will contribute to a lesser portion of your income needs over time.

For many it would be a good idea to set up a regular reinvestment strategy to deal with excess income. In this way, the excess won’t be spent and can contribute growth to the total investment portfolio.

Using the above example, Patrick reinvests his surplus income and only spends what he needs. The calculations assume that Patrick’s cost of living increases each year at a rate of 3.0%.

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Economic Review

Over the last two years, the various world share indexes have gone through a relatively rough period. This has been a consequence of the slowdown in most economies and the constriction in economic activity. There is now evidence that this situation may be changing.

The US Federal Reserve (‘the Fed.’) noted in its
mid-March meeting that while there still remained some uncertainty over the domestic demand outlook, the US economy was growing at a significant pace.
The same situation is occurring in other parts of the
world, with European indicators turning more
positive across the region and the continuing trend in Asia with respect to recovering asset prices.

In Australia, the economy has remained resilient,
with retail sales and the housing market continuing their buoyant trend. It is therefore no surprise, that many economic commentators have noted, that in all probability, we have reached the end of the interest rate easing cycle. This prediction proved to be correct with the Reserve Bank of Australia (‘RBA’) increasing interest rates to 4.50%, from the previous level of 4.25%, on the 8th of May. This action is a result of the unexpectedly strong inflationary outlook, which has moved outside of its 2-3% target band.

Other central banks such as the Swedish Central Bank and the Reserve Bank of New Zealand have also begun the process by increasing rates by 25 basis points. More importantly, the Fed. has adopted a neutral stance as a consequence of this promising outlook. It is without doubt, that while the timing is still open to debate, the next move in US interest rates is likely to be up.

It has been a choppy quarter in equity markets around the world. The collapse of Enron sent shockwaves through the US and other markets in February. Companies have been forced to defend their accounting practices following negative media coverage.

The figures below illustrate that in March, world indexes and the US market outperformed the Australian indexes for the first time in almost a year. The primary reason for this is the prospect of stronger growth occurring in overseas markets.

The global outlook therefore, is one of economic recovery. Tax cuts and lower oil prices have aided the US in combating the weakness over the last year. While uncertainty still exists (when does it not?) in the form of higher oil prices stemming from the Middle East crisis, it is strongly suggested by economists, that the US will once again be the power behind continuing world economic recovery.

In past instances of economic recovery, equity markets experienced larger gains than we have seen to date. This is a reflection of what can be called a stubbornly range bound market, as has been seen so far this year. In terms of valuations, the bond yield/equity yield valuation remains in ‘fair value’ territory for both the US and Australian markets. As evidence of corporate earnings recovery continues, we can expect equity prices to move higher in an environment of excess liquidity, stronger economic growth and rising interest rates.

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Financial Keys Enters Mortgage Broking Market

Did you know that we can now provide access to home and investment property loans through over 20 different lenders, including the Commonwealth Bank, Rams, ING, Homeside, Westpac, HSBC and Citibank?
We can provide comparative quotes and eliminate the hassle of searching for the most suitable home loan. If you are thinking of purchasing a property and need advice on loan structuring, or would like to have your existing loan arrangements reviewed, please contact Marchessa Dy, Paraplanner – Lending Consultant at:
MarchessaDy@financialkeys.com.au
or call Marchessa on 92 333 888.

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Alternatives to Traditional Asset Class Investments

Hedge funds have recently caught the attention of Australian investors as they come to grips with volatile markets and, for the first time in many years, negative returns on their investments.

In the last 12 months, a number of hedge funds have become available to Australian investors as an alternative investment to the traditional asset classes (that is, equities, property, fixed interest and cash).

What is a hedge fund?
Hedge funds are also commonly known as "alternative", "strategic" or "absolute returns" funds. They typically employ strategies with the objective of showing positive returns in both rising or falling markets.

Generally speaking, hedge funds pursue active trading strategies, with an extensive use of derivative products (such as futures and options) and in some cases gearing. The strategies used are designed to take advantage of market anomalies or inefficiencies. As they generally do not invest in the traditional asset classes of shares, property, fixed interest and cash, the returns on hedge funds do not generally rely on broad market movements.

The important difference between hedge funds and the more conventional managed funds is that hedge funds generally pursue stated percentage performance targets while, for example, an Australian equities fund manager will try to outperform an index, such as the All Ordinaries.
There are no widely accepted benchmarks for hedge fund managers.

Examples of strategies used include:
• Managed share portfolio with gearing, or a short-selling facility.
• Merger arbitrage, which involves buying shares in companies that are takeover targets.
• Short-selling, which involves selling borrowed stocks in the expectation that they will fall in price, then buying those stocks at a lower price to return to the lender.
• Exchange rate arbitrage.
• Interest rate arbitrage.
• Commodity futures and options.
• Corporate debt.

What are the main advantages and disadvantages of hedge funds?

The main advantages of investing in hedge funds are:
• Potential ability to provide positive returns in weak or negative markets.
• Provides additional diversification for an investment portfolio, as the returns on hedge funds are not aligned with the returns on shares, property, fixed interest or cash.
The major drawbacks of hedge funds are:
• Only redeemable periodically, usually every
quarter. Liquidity therefore, may be an issue.
• Their lack of transparency is an area for concern, although they often use complex processes.
• Fees are often performance based, although these are argued to be an incentive to
management to align their goals with that
of their investors.

Is a hedge fund suitable for inclusion in my investment portfolio?

Hedge funds are not a "sure thing", as some promotional material showing spectacular past performance may suggest. Ideally, they should form part of a diversified portfolio, with investors usually advised to allocate no more than 10% of their total portfolio to hedge funds. Typically, hedge funds are used in place of fixed interest investments because they are used to reduce the volatility of shares in a portfolio.

What types of funds are available to invest in?
In a bid to reduce the risk of investing with individual hedge funds, fund managers such as Rothschild, Deutsche, AM, Colonial First State and Hedge Funds Australia have recently offered a "fund of hedge funds managers" model. In this model, fund managers put together a portfolio of hedge funds employing different strategies. In fact, only a few of the hedge funds open to Australian investors offer one strategy. The idea behind this approach is additional diversification, so that at least some of the fund managers’ strategies will perform well in any given market environment.

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