With the huge bulge of baby boomers entering retirement, and yields at near-record lows, there is an emerging rediscovery of the vital role equities can play in delivering retirement outcomes.
Equities provide retirees with a regular and reliable income that grows over time. They not only generate income and strong expected returns, but also protect against inflation risk and longevity risk (the risk of outliving your savings).
In this environment dividends have become a major focus. And there is no doubt that equity products designed for retirees should focus on increasing dividend yields from high-quality companies.
But, apart from dividends, there is another crucial factor which can maximise retirees’ income from equity income funds – the impact of tax.
You might think that most retirees wouldn’t have to worry about tax anymore. But it’s a vital consideration when investors and advisers choose equity income funds in retirement. We believe that investors and advisers need to become much more ‘tax aware’.
A major uplift in income
As you know, franking credits were introduced in 1987 to avoid the issue of double taxation. Australian investors can claim a tax credit for tax already paid on a company’s corporate earnings. Dividend imputation boosts the average dividend yield on Australian shares by around 1.5%.
In the early 2000s, franking credits became refundable as part of changes to the dividend imputation system. This meant that investors who pay low tax (low-income investors, charities and super funds) got a cash payment for the difference between any franked rate of dividend income and their individual tax rate.
This has significant implications for income-seeking retirees. It means that franked dividends are extremely valuable to retirees.
For retirees on a 0% tax rate, they will be able to receive an uplift of up to 43% on each dollar of fully franked dividends. (For every 70 cents of dividends, investors can receive a tax credit of up to 30c, which equates to 43 cents per dollar of dividends).
So not all returns in retirement with tax-free status are equal.
Fully franked dividends are worth more than capital gains and unfranked dividends. If a retiree paying 0% tax receives $1 of capital gains or unfranked dividends, it will be worth $1 to them. But if they receive $1 of fully franked dividends, it will be worth up to $1.43.
To illustrate how tax status can boost returns, as at 31 March 2017 the S&P/ASX200 index had a 1 year return of 15.39% .That is just the level of price moment. If you incorporate dividends and franking credits, the ‘accumulation’ index had returned 22.10% for the same period.
Past performance is not a reliable indicator of future performance.
Source: Warakirri Asset Management
But going a step further, if we add in tax-exempt status, as measured by the S&P/ASX200 Franking Credit Adjusted Annual Total Return Index (Tax Exempt), the 1 year return as at 31 March 2017 was 22.39% due to the benefits of fully franked dividend cash refunds.
Many funds fall short
Unfortunately, not all income funds are managed with these after-tax performances in mind.
After the introduction of Australia’s dividend imputation system, we saw traditional value funds launch equity income funds, or ‘value rebadged funds’. It was an obvious step given value managers’ focus on undervalued stocks that can have relatively high yields. But those funds are not managed for the retired, income-focused investor. They don’t trade in and out of stocks to get the maximum benefit from franking credits discussed above.
This first generation of funds also don’t aim to pay smooth, consistent, monthly income, which means they are not effective at replacing salaries in retirement.
A second generation of funds focused on reducing volatility while maximising yield. These funds used derivatives, particularly options, to generate additional income. They sell (write) options on shares, and the capital from doing that that is paid to investors as income. That can boost income and lift the total yield as high as 10 per cent including franking credits.
Yet like the first-generation funds, these ‘buy/write’ funds typically pay quarterly income payments, which again doesn’t replace a monthly salary. And as these funds tend to have lower volatility, performance can be capped when markets rise. Investors are giving up potential capital growth.
New funds that truly deliver on retirement goals
But now a new generation of equity income funds has evolved. They are designed to truly meet the goals of a retiree – to replace a salary by paying a smooth, regular, tax-effective income from a portfolio with lower volatility than the market and which rises with the cost of living.
These ‘goals-based’ funds look at retirees’ goals and needs, then create a solution to meet them. They don’t try and fit retirees into existing products that may not be entirely suitable.
A major goal of retirees is to know their estimated ‘pay’ for the coming months. They need some certainty. Goals-based funds seek to deliver smoother incomes so that a similar level of income is paid each month, unlike the first and second-generation of equity-income funds where income could be highly varied depending on dividends and capital gains.
But most importantly, many of these goals-based funds, including AMP Capital’s Equity Income Generator, are designed with a focus on tax-aware management to maximise the income received from the investment.
With equities set to play a crucial role in delivering income for more retirees, investors need to begin focusing more on ‘after-tax’ returns, rather than ‘pre-tax’ returns, when considering equity income funds.
It could make the difference between meeting and missing retirement goals.
For more information about the AMP Capital Equity Income Generator click here.
Important note: Investors should consider the Product Disclosure Statement (PDS) available from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (AMP Capital) for the AMP Capital Equity Income Generator (Fund) before making any decision regarding the Fund. The PDS contains important information about investing in the Fund and it is important investors read the PDS before making a decision about whether to acquire, continue to hold or dispose of units in the Fund. AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMPCFM) is the responsible entity of the Fund and the issuer of units in the Fund. Neither AMP Capital, nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance. While every care has been taken in the preparation of this article, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to their objectives, financial situation and needs.