My Say No. 64 – Structuring For Cash Flow

“Retirement Income: the place of Listed Investment Companies & other managed funds”.

Although this newsletter is ostensibly about retirement, I would like you to keep in mind that the principles apply whether we are investing for our grandchildren, using the cash flow to help reduce a mortgage or retiring.
Retirement is a time for some serious mental adjustment (amongst other things!). Following decades of asset accumulation, we are faced with the switch to the initially unfamiliar scenario of income plus wealth maintenance in the best case or, in the worst case, gradual wealth consumption. I find too many potential retirees spend the last few years before retirement agonising over the amount of money they will need when, voluntarily or not, ones working life comes to an end.

Ultimately it is the income generated by the assets that will decide the quality of life in the future, not the ‘value’ of the investments. Having a multi million dollar house may make one feel wealthy but as it pays no income it will be difficult to live comfortably on the old age pension under these circumstances.

As a potential source of retirement income, I want to examine the role of managed funds, both listed and unlisted. Whether you are using unlisted managed funds or LIC’s the individual stock decisions are made on your behalf. You should not consider this as a ‘loss of control’. It is simply outsourcing to a professional manager where their investment goals are aligned with yours and of this latter point, you need to be sure.

The biggest examples of the older LIC’s I would consider to be Australian Foundation Investment Company (AFI), Milton (MLT) and Argo (ARG). Their major attributes are:

  1. A corporate structure.
  2. Management is integral within the company.
  3. Fees range from approx 0.12% to 0.2%+
  4. Low turnover
  5. Predominantly buy-hold strategy
  6. Stated aim of growing income and preservation of value
  7. Price is set by market
  8. Liquidity provided by ASX

The unlisted sector (unit trusts) is managed by fund managers, the major banks and insurance companies and a plethora of boutiques so I will deal with them generically. Their attributes are:

  1. Trust structure rather than a company
  2. Management is separate from the trust
  3. Fees range from approx. 0.15 (Index funds) to 2%+
  4. High turnover
  5. Predominantly trading funds
  6. Compulsory distribution of realised capital gains
  7. Total return benchmark so no distinction between capital and income
  8. Price is set by fund manager and reflects NAV
  9. Fund manager provides liquidity by appropriating (buying back) and expropriating (liquidating) units on demand.

I am going to restrict my comments to the older Listed Investment Companies (LIC’s) as opposed to the recent (last few years) batch of new entrants to the market. The reason for this is that many of the new entrants are run by fund managers from the unlisted sector. Based on their belief that they display superior skills they have set management contracts and fee scales that are quite disgraceful.

Fees are much closer to the unlisted sector of 1% and in many instances they have also granted themselves performance fees. In most cases they have separated their management company from the listed vehicle they manage. Bruce Teele, Chairman of AFI, put it quite succinctly, “They’re being set up with the aim of making money for their managers on the back of (previously) successful portfolio and trading activities, it would be sad if people went into a new one (LIC) thinking it was like the old.”

As our income will define our lifestyle it is clearly important to maximise this without jeopardising the capital base. As most of us do not have a ‘use by date’ on our birth certificates we must plan to ensure that our asset base remains effective in generating income for the longest life expectancy (I will not indulge in my pet topic, philanthropy, for this article.)

For the purposes of my example, let us consider that the stockmarket has an initial yield of 5%. If you had $1 million invested it would thus provide an initial income of $50,000 p.a. If this was sufficient for ones needs, then retirement is an option. Over the ‘long term’ this income would be expected to grow and enable one to maintain one’s lifestyle.

If we now consider the two investment options available; listed or unlisted then we will begin to see some compelling arguments for only one course of action. If I were to choose one of the LIC’s mentioned above the management expense would be, in the case of MLT 0.14% and I would therefore lose $1400p.a. in fees leaving a balance of $48,600 ($50,000 – $1400).

If, however, I was to choose a managed fund the management expense would be around 1.5% – 2.00%. Based on the amount invested, if I use a wrap account or platform to access cheaper fees, I should be able to reduce the fee to, say, 0.9% but the wrap fee and other commissions would potentially raise it again: Let’s therefore assume a total of 1.2%. This would mean a deduction of $12,000 from my $50,000 leaving only $38,000! The important thing to understand is that these fees come out of your income, not capital.

The next issue is one of the differing structures. Unlike LIC’s, unlisted managed funds must distribute all capital gains at the end of the tax year. As trading by most fund managers is claimed to be their competitive advantage, portfolio turnover can be high. It is not unknown for over 100% portfolio turnover in a single year. This may mean that CGT concessions are lost.

The result is that at year end, depending on the volume of trading, you could receive an ‘income’ cheque that equates to a ‘yield’ of 10% or more. It requires a savvy investor to distinguish between what is true underlying income and what are merely trading gains and therefore a potentially taxable return of your capital.

On top of that, when the distribution is paid, the fund price will reflect the drop in asset value caused by the distribution. So, if the price is $1.00 and the dividend is 10c; the price of the units will drop to 90c ex div as the fund manager adjusts the price to reflect the fact your capital has been returned to you.
To give you an indication of how this can work, consider the following. I invested in a Unit Trust in April 2001, never touched it, collected the dividends and eventually sold it in January 2012.

You should note three things in particular.

  1. The total capital gain over 11 years was 2.93%
  2. The total income paid was $89,000
  3. The dividends fluctuated from a low of $200 to a peak of almost $18,000

Basically, as a result of trading, all profits including dividends were being distributed to unitholders.
I had to pay tax on these each year at my top marginal rate and I was never sure just how much was going to be dropped in my lap. I should also add that ETF’s fall under this unit trust structure and share the same potential consequences. Adding a market maker hasn’t made them any cleverer.

Contrast this with the old fashioned LIC’s where a predominantly ‘buy-hold’ strategy is employed, and turnover is minimal. In addition, as a listed company, they are not required to distribute gains, they can be retained and reinvested thus helping preserve the capital base for investors. In addition, they can also use the retained profits to smooth dividends during market fluctuations. Finally, when the company goes ex div, the share price is set by the market, not the manager and may or may not change.

The LIC’s I have mentioned have been going for 50 plus years and have outstanding histories of unbroken dividend payments. The same cannot be said for the trust sector. Short histories, changes of manager and mandate, cancelled dividends and erratic distributions are commonplace.

As an example, I have attached below the dividend history of one of the LIC’s mentioned. The consistency is a great source of comfort for us as investors. You should note that the special dividends are a result of the underlying companies paying these and the LIC manager passing these through to their shareholders.

It is vital that managers are selected to match your investment goals. This is one of the key roles of an advisor. It is no good having a sound, high level strategy only to have it compromised by poor fund manager selection. This requires that the advisor is on top of these issues and that you ask the right questions. You cannot abrogate all responsibility for your decisions.

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