Tax and Inflation – how does this impact your view on your investment class?
by Mark Causer
In the financial advice world, there are several ‘moving parts’, that when brought together, form the basis for a sound financial planning outcome.
One key component is ensuring that the investment recommendations provided to clients incorporate investments that are spread across a diverse selection of underlying investments, broadly in line with the client’s risk profile (i.e. their attitude to loss of capital and underperforming a specific benchmark).
An example of one asset class in a diversified investment portfolio would be an investment into Australian equities. The benchmark for most Australian equity managed funds is the ASX 200 Accumulation Index.
Cash and fixed interest are also asset classes within a diversified investment portfolio.
A client invested into Cash or Term Deposits might expect to use the Reserve Bank of Australia’s Cash Rate as a reasonable benchmark. But unlike an equity investment or other similar growth assets, there is NO growth outcome from this investment. Generally, this investment would form part of the defensive component of a client portfolio.
If we examine this a little closer and look at the NET return on cash / term deposits in this new norm of lower interest rate for longer environment (as reported in the January 2015 Insights) and also against a prolonged lower interest rate environment globally, then there is now an even greater RISK to be overweight cash / fixed interest. By applying inflation (let’s assume @2.5% - average rate from 1951 – 2014 was 5.21) and Tax into the consideration, the results might surprise many.
The following simple chart examines this.
Net Investment Return (after tax and inflation)
|Tax Rate (%)||Gross Investment
|Net Return (%)
|Net Return (%)
after tax and 2.5% inflation
Inflation FY2014/15 - Sep 2.3% & 1.7% Dec – rba.gove.au
Long term average inflation rate 5.21% - Trading Economics 28.1.15
The above results acknowledge that by holding cash at bank in the current interest rate environment, the real return for each tax bracket is NEGATIVE. Client’s holding Cash in the in the pension phase of life are also in a negative position.
The purpose of this illustration is to show that by holding cash and low yielding term deposits, we must acknowledge that the purchasing power of the net return in this current environment is indeed negative and that this does represent a risk or handbrake to the total return of portfolios.
As long as we acknowledge this and understand the risk relative to other asset classes, then we must be comfortable that the risk free rate of return (i.e. cash) DOES indeed carry risks, including longevity risk, cash flow risk and total return risk.
Financial Keys is constantly reviewing available investment options to ensure that if clients need to hold defensive assets as part of a measured and diverse investment portfolio, that these defensive assets are working as hard as possible.
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