$1 Million for Life: How to Make It, Manage It, Maximise It [1 ed.] 0731407008, 9780731407002

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$1 Million for Life: How to Make It, Manage It, Maximise It [1 ed.]
 0731407008, 9780731407002

Table of contents :
$1 MILLION For Life: How to make it, manage it, maximise it
Contents
Acknowledgements
Important Notice
Author’s royalties
Preface
Chapter 1: The problem
1.1 Life’s great!
1.2 So what’s the problem?
1.3 Factors affecting your future finances
1.4 The alternatives
1.5 The plan
Chapter 2: Step 1—money sense
2.1 The foundation
2.2 Spend less than you earn
2.3 Eliminate personal debt
2.4 Deal with money in the right order
2.5 Small amounts add up to a fortune over time
2.6 Types of tax
2.7 What to avoid
2.8 A new way to look at spending
2.9 Investment principles
2.10 Key points
Chapter 3: Step 2—own your house outright
3.1 Owning versus renting
3.2 Own a house, not a unit or flat
3.3 Buying your first house
3.4 Own your house outright—pay off the mortgage
3.5 Your house as part of your wealth plan
3.6 Key points
Chapter 4: Step 3—superannuation (part I): how to use super
4.1 What is superannuation?
4.2 Putting money into super
4.3 Getting money out of super
4.4 Key points
Chapter 5: Superannuation (part II): maximising super performance
5.1 Maximising performance
5.2 Tax advantages of super for after-tax contributions
5.3 Self managed super funds
5.4 Lost super
5.5 Disadvantages of super
5.6 Super as part of your wealth plan
5.7 Key points
Chapter 6: Step 4—invest outside super (part I): shares
6.1 Share basics
6.2 Different ways to invest in shares
6.3 Direct shares
6.4 International shares
6.5 Summary of share strategies
6.6 Borrowing to invest
6.7 Further reading
6.8 Key points
Chapter 7: Invest outside super (part II): property
7.1 Residential property
7.2 Non-residential property
7.3 Further reading
7.4 Key points
Chapter 8: Invest outside super (part III): other asset classes
8.1 Income products
8.2 Cash accounts and online brokers for your investments
8.3 Other investments
8.4 Derivatives and trading
8.5 Further reading
8.6 Key points
Chapter 9: Step 5—protection in case things go wrong
9.1 Don’t rely on luck
9.2 Emergency cash fund
9.3 Insurances
9.4 Wills
9.5 Entities
9.6 Powers of attorney
9.7 Key points
Chapter 10: Step 6—do what you love doing
10.1 $1 million for life!
10.2 Do you really love your job?
10.3 Have a real plan for the rest of your life
10.4 Focus on your passion, not on the money
10.5 Case studies
10.6 What is your passion?
10.7 Making the transition
10.8 Key points
Chapter 11: Putting it all together
11.1. It’s your choice
11.2 Seven levels of financial freedom
11.3 Set and forget
11.4 Who to turn to for guidance
11.5. Stay positive and take action
References
Index

Citation preview

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Inside you’ll learn how to: • save money and pay off debts quickly • use low-cost, tax-effective ways to invest in shares • invest in residential and commercial property • maximise the performance of your superannuation • protect your investment plans and your lifestyle. There are no get-rich-quick schemes or trading systems — just practical steps almost anybody can take. $1 Million for Life gives you the tools to build enough wealth so you can start doing what you really want to do for the rest of your life.

Ashley Ormond

Ashley Ormond is a successful investor and former senior executive at major global finance and banking groups. He has degrees in economics, law and finance, and has been a director of several companies. He is the principal of Investing 101 Pty Ltd, which holds an Australian Financial Services licence, and lives in Sydney with his wife and two children.

$1 MILLION FOR LIFE

Want to build wealth that will last you a lifetime? Then $1 Million for Life is the book for you! In this step-by-step guide to financial freedom, investor and best-selling author Ashley Ormond outlines dozens of practical ways to increase your wealth by tens of thousands, or even hundreds of thousands, of dollars. It doesn’t matter how much you earn — it’s what you do with the money you have that makes the difference.

$1 MILLION FOR LIFE

How to make it, manage it, maximise it

Ashley Ormond The best-selling author of How to Give Your Kids $1 Million Each!

www.johnwiley.com.au/trade

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Praise for How to Give Your Kids $1 Million Each! ‘Ashley Ormond shows parents and grandparents how to set their offspring on course to understand, and benefit hugely from, the two Golden Rules of investing — start early and be disciplined. It’s a simple but effective approach which just about any family can use to learn about money and build long-term wealth.’ Dr Don Stammer, economist and investment commentator ‘A timely and practical introduction to investing with a distinct focus on long-term strategies — it will be particularly useful for anyone with an independent approach who wants to broaden their investing plans to include the future financial security of the whole family.’ James Kirby, editor, Eureka Report ‘A well-researched and informative piece, without the complexities of financial jargon. ‘Topics ranging from savings and inflation, right through to finding the right equity investment, all are visited in this highly referenced guidebook. He outlines a number of effective growth assets to ensure a great return in the long run, enabling substantial financial backing for the kids and more control over their lives … one of the most basic yet useful reference books out there on the market.’ Ailene Belesina, Your Mortgage Magazine

‘The book is a great way to teach your children the value of money and to get them involved in the savings routine from a very early age.’ Karina Barrymore, Herald Sun ‘His plan is simple, effective and smart. ‘This book should be read by all parents — I’m an instant convert and am starting the plan immediately for my two bundles of joy.’ Tania Grieg, Fitness Life Magazine

First published September 2007 by Wrightbooks an imprint of John Wiley & Sons Australia, Ltd 42 McDougall Street, Milton Qld 4064 Offices also in Melbourne Typeset in ITC Giovanni 10.5/14 pt © Ashley Ormond 2007 Reprinted November 2007 The moral rights of the author have been asserted National Library of Australia Cataloguing-in-Publication data: Ormond, Ashley. $1 million for life: how to make it, manage it, maximise it. Includes index. ISBN 9780731407002 (pbk.). 1. Finance, Personal. 2. Wealth. 3. Saving and investment. 4. Tax planning. 5. Estate planning. I. Title. 332.02401 All rights reserved. Except as permitted under the Australian Copyright Act 1968 (for example, a fair dealing for the purposes of study, research, criticism or review), no part of this book may be reproduced, stored in a retrieval system, communicated or transmitted in any form or by any means without prior written permission. All inquiries should be made to the publisher at the address above. Cover design by Brad Maxwell Cover image © iStock International Inc./Vaide Seskauskiene Wiley bicentennial logo: Richard J Pacifico Microsoft product screenshots reprinted with permission from Microsoft Corporation Printed in Australia by McPherson’s Printing Group 10 9 8 7 6 5 4 3 2 Disclaimer The material in this publication is of the nature of general comment only, and does not represent professional advice. It is not intended to provide specific guidance for particular circumstances and it should not be relied on as the basis for any decision to take action or not take action on any matter which it covers. Readers should obtain professional advice where appropriate, before making any such decision. To the maximum extent permitted by law, the author and publisher disclaim all responsibility and liability to any person, arising directly or indirectly from any person taking or not taking action based upon the information in this publication.

Contents Acknowledgements Preface

viii

xii

1

The problem 1

2

Step 1 — money sense

3

Step 2 — own your house outright

4

Step 3 — superannuation (part I): how to use super

5

Superannuation (part II): maximising super performance

6

Step 4 — invest outside super (part I): shares

7

Invest outside super (part II): property

8

Invest outside super (part III): other asset classes

9

Step 5 — protection in case things go wrong

10

Step 6 — do what you love doing

11

Putting it all together

References Index

394

392

26

359

72

338

115

171

239

317

288

138

Acknowledgements Thanks to the many thousands of readers of my first book — for their feedback and encouragement to write this second instalment. I also need to thank the hard-working team at John Wiley & Sons for getting the book from idea to fruition. A big thankyou also to Phil and Bob who kindly reviewed drafts of the book. Once again I thank my wife and family for putting up with me while researching and writing this book. Now that it’s finished I’ll have to find another excuse to spend days on end ‘up in the attic’.

viii

Important notice This book is intended to provide general information only, to assist readers to make their own decisions and choices. It should not be construed as a recommendation or a statement of opinion, or a report of either of those things. It is not intended to influence a person or persons in making a decision in relation to a particular financial product or class of financial products, or an interest in a particular financial product or class of financial products. This book is intended for educational and instructional purposes only, and is not intended to constitute personal financial advice. It merely describes what has worked for the author. Where particular products or companies are mentioned, it is done so because they have been found by the author to be useful and/or they are used as examples of what may be available in the market. Where the publication of this book constitutes provision of financial product advice in a public forum, the following statements are required by law: 9 the information in this book does not take into account your personal objectives, financial situation and needs 9 you should consider the appropriateness of the information on that basis 9 you should obtain a copy of the product disclosure statement in relation to any products you are considering buying, selling or holding. Each reader should obtain their own financial, tax and legal advice to determine whether information contained in this book is appropriate to their particular objectives, financial situation and needs. The author is the principal, owner and authorised representative of Investing 101 Pty Ltd, which holds Australian Financial Services Licence 301808 issued by the Australian Securities & Investments Commissions under section 913B of the Corporations Act 2001. This licence authorises ix

$1 Million for Life

the licensee to carry on a financial services business to provide general financial product advice to retail and wholesale clients in relation to securities, interests in managed investment schemes (managed funds) excluding investor directed portfolio services, and basic and non-basic deposit products. The licensee (or its authorised representatives) does not provide personalised financial product advice. The licensee (or authorised representatives) writes and publishes books and other publications about finance and investing. The publications are intended for a wide audience and are not intended to take into account each reader’s individual objectives, financial situation and needs. The publications are for instructional and educational purposes only. The licensee and author may be contacted at c/– Dawson Evett Chartered Accountants, PO Box 5125, Sydney, New South Wales, 2001, Australia, or at . Investing 101 Pty Ltd is a member of the Financial Industry Complaints Service (membership no. F-4847), a dispute resolution service, which may be contacted at PO Box 579, Collins St, Melbourne, Victoria 9008 or at . The author declares that from time to time he may hold interests in securities and companies mentioned in this book. In fact, several of these are used as examples in the book. The licensee and authorised representatives may receive remuneration from the sale of books and other publications. Other than as an ordinary investor, neither the licensee nor its authorised representatives, nor any related or associated party, nor any director employee of the licensee or authorised representatives, receives any remuneration or other financial or non-financial benefits from any product providers in respect of, or attributable to, the provision of any of the authorised services. Other than as an ordinary investor, there are no associations or relationships between the licensee, its authorised representatives, the providing entity or any related body corporate, and the issues of any financial products, being associations or relationships that might reasonably be expected to be capable of influencing the licensee or its authorised representatives in providing any of the authorised services. No company or product provider or issuer, whether mentioned in this book or not, contributed in any way to the costs associated with writing the book, or provides any financial or non-financial benefits to the author or any parties related or associated with the author. In plain English — nobody is paying me or otherwise influencing me to say what I say. I don’t sell any products, I don’t receive any commissions, fees or any other benefits from any product providers, and I don’t have any financial or non-financial relationships or associations with any product providers. A current Financial Services Guide is available from the address noted earlier or from . Past performance provides no guarantee or assurance of future performance.

x

Author’s royalties At least 50 per cent of the author’s royalties from the sale of this book go to the AJKM Charity Foundation (ABN 38 788 499 680), which is a registered charitable foundation that provides assistance to a range of causes, including disadvantaged families and children in Australia and developing countries, and medical research. My wife and I started out with nothing and worked hard for 20 years until we were about 40. We live in the best city in the best country in the world, we have everything we want, and we have enough investments to provide us with all we could possibly want for the rest of our lives. Our luck is a pure accident of fate. On the other hand, hundreds of millions of people are suffering in other countries (and even some in other parts of Australia) simply because of when and where they happen to have been born — suffering because of family circumstances, disease, civil wars, religious conflicts, corrupt governments, despotic dictators, natural disasters and dozens of other reasons not of their own making. We established the AJKM Charity Foundation as a way of helping people less fortunate than ourselves. Specifically, royalties from this book are going to World Vision’s ‘Micro Enterprise Development Program’ to fund the establishment and running of a new community bank in a rural township in northern Swaziland, a small country between South Africa and Mozambique. Swaziland suffers from chronic poverty and has the highest per capita HIV infection rate in the world (over 40 per cent of the population). There are 120 000 orphans out of a population of only one million, and life expectancy is under 35 years. The community bank established by royalties from this book provides essential, low-cost funding to families with small enterprises to help them generate money for food, health care and education for their children, and also creates employment opportunities in the local community. See . Your purchase of this book has directly benefited hundreds of children and families in this township. Your assistance will go a long way towards improving their lives. xi

Preface Australia is a nation of spenders and borrowers, not savers and investors. Australian households spend over $10 billion more than we earn each year and we have had a ‘negative savings rate’ for several years. Australia and New Zealand are about the only countries in the western world with negative household savings rates. If we spend more than we earn, where does the extra money come from? It comes from borrowing more or eating into our savings. The result is that, despite the tremendous economic growth and prosperity we have enjoyed over the past 15 years, we are carrying bigger levels of debt, there are more personal bankruptcies and there are more people relying on welfare than ever before. These days it has become far too easy to spend money and to borrow money to spend even more. We are constantly being bombarded with offers of pre-approved credit cards, personal loans, lines of credit and mortgages, and it’s all just too tempting. At the same time, however, investing money wisely is a seemingly difficult process. It’s hard to find simple, low-cost, tax-effective investments that can be used to build wealth. Aspiring investors xii

Preface

have to wade through a sea of get-rich-quick schemes, through the thousands of complex, expensive products loaded with myriad unnecessary fees and charges, through all the ‘experts’ who are just looking for their next sales commission, and through a whole lot of jargon and paperwork. But in among all the offers of easy money, easy loans, complex products and investment scams, there are some low-cost, tax-effective, low-maintenance products and investments that ordinary investors can use to build wealth, even if they are starting out with just a small amount of money. Most people don’t have time to spend on trading schemes and investment plans that require constant attention. The plan I outline in this book is a simple, low-cost, low-maintenance, ‘set-and-forget’ way to build wealth over the long term. Although the negative savings rate is a national problem, the solution is in your hands. I believe that everybody can take small, simple steps towards their own financial security, starting with as little as $1, and starting today. My first book — How to Give Your Kids $1 Million Each! — was a description of the savings plan I started for my two kids. This plan will provide them with financial security for the rest of their lives. It also teaches them about money and how to make money work for them, not the other way around. The same type of plan works for adults as well. In fact, my wife and I have been following the principles used in the plan for many years. We started out on our financial journey in the mid 1980s, before we were married. We have both had busy careers, working full time for 20 years from the early 1980s to the early 2000s. However, we found that despite our incomes from working full time, most years we made more money from our shares and property investments than from working. We discovered a very important lesson in life: income from working pays the bills — it doesn’t build wealth. Only investing builds wealth. Fortunately, we were able to build our investments up to a point that enabled us to stop working in our early 40s, while the kids are still young, and live primarily off our investments. The plan is based on sound principles that have been around for centuries and will remain constant forever — like the principle of compounding, spending less than you earn and putting money away for the long term before spending it. But putting the plan into action involves particular products and investments, and these do change over time. Most people don’t lack the motivation to spend and borrow less, and save and invest more. All too often it’s simply too difficult and complex. They start out with the right intentions, but don’t know where to look and what to do. One of the aims of this book is to make investing money as easy as it is to spend and borrow. I outline a plan almost anybody can use to build wealth for life. Enough wealth so they can live the kind of life they really want to live, without having to worry about money. xiii

$1 Million for Life

Why am I talking about money? Western society is dominated by the pursuit of money and material possessions, but there are far more important things in life. There are bigger problems we should be spending our time and energy trying to solve. More than a billion people survive somehow on less than $2 per day. The world is plagued by religious and ethnic wars, wars on terror, and the ever-present threat of nuclear war. Every day 30 000 kids under five die of preventable diseases. So why am I talking about making money? There are several reasons: 9 We can’t help others less fortunate until we get our own affairs in order. 9 Money problems are a major contributor to family break-ups, and family break-ups tend to lead to more financial and emotional stress for all concerned. 9 Money issues tend to consume so much of our time and energy. If you can solve the money issue it is like lifting a huge weight off your shoulders, and free up your time and energy to think about more important things. The plan outlined in this book doesn’t take a lot of time or effort. You can start building financial security and freedom for yourself and your family straightaway. Once you get the plan underway you can stop worrying about money and work, and that will allow you to turn your mind to the bigger issues in your life and in the world. Ashley Ormond Sydney August 2007

xiv

Chapter 1

The problem

1.1 Life’s great! Let’s take a snapshot of a typical Australian family. You and your partner, if you have one, are aged between 30 and 50. You have one or two kids in primary and/or high school. Family income is between $50 000 and $150 000 per annum, and you live in a nice house in the suburbs of a major Australian city. You may have recently upgraded to a bigger house or completed some renovations — the house now has new appliances, kitchen or bathroom, a rumpus room or study, or perhaps a pool. Your house is double the size of the house you grew up in, but there are fewer people living in it. It always seems to be full of ‘stuff’ and you need all the space you have. You may even rent a storage shed somewhere to keep all the stuff you can’t fit into the house. You may pay a cleaner, gardener or pool cleaner to help look after things because you are so busy. You may also pay for child care while you both go out to work so you can buy more ‘stuff’.

1

$1 Million for Life

There are a couple of cars sitting in the garage, and you plan to buy a car for each of the kids when they reach 18. One of your cars may be a four-wheel drive. You never take it off road and they cost a fortune to run, but it’s okay because they’re safer, aren’t they? Schooling is expensive, as one or more of the kids go to Catholic or private school. Even though you and your partner probably went to state schools when you were kids, you feel that standards have deteriorated since then and you can now afford private schools. On top of school fees, there are all of those extras that seem to add up — books, uniforms, ‘voluntary’ building-fund donations, fundraisers, school trips, music lessons, private coaching. Then you’re looking down the barrel at HECS/HELP (university fees) because it seems every kid in Australia wants to go to uni and study ‘communications’ (whatever that is!) because you don’t want your kids to be burdened with university debts for the next 20 years, so you are aiming to help them out financially with the fees. Perhaps you are undertaking part-time study in order to keep up in your field. The courses are expensive but you’re getting a tax deduction for the cost, and they may lead to more income down the track, so it’s okay. You have accumulated two or more computers — it seems you need to buy a new one every couple of years just to keep up with the endless upgrades in operating systems and software you need to run. Or the old ones died due to viruses. The kids need their own computers to do their homework. Then there are PlayStations, Xboxes, Game Boys and the like, plus all the games at $80 a pop! Everyone in the family has a mobile phone and the phone bills could finance a small country. It seems everybody needs their own phone these days. There are 20 million mobile phones in Australia — that’s one for each person across the entire country. You can’t imagine what they’re all saying to each other that is so earth-shattering or interesting, but you couldn’t dream of life without your mobile. You have lots of audio-visual and music gear — plasma TVs, DVD players, music players, and a growing bank of DVDs because it’s more convenient and cheaper than renting them all the time. You seem to have somehow accumulated three TVs (or more). It seems that cable TV is a necessity due to the low quality and variety of free-to-air TV — so you tell yourself that it’s worth the $60 or so per month. You take holidays to the coast or snow every few years, plus shorter trips on weekends and an occasional trip overseas. When you were a child the holidays were probably limited to the annual trip hauling a caravan up to Ettalong, Lakes Entrance, Surfers Paradise or Victor Harbour. None of that for this family — the kids would revolt! Then there’s the dog or cat and all the costs associated with a pet — food, kennelling when you go away, trips to the vet, tablets, treatments and so on. 2

The problem

You may eat out (and drink) more than you know you should — both with work and with the family — and your weight has been creeping up over the past few years. All this extra food and drink costs money, and you pay expensive gym fees or a personal trainer to help you take off the weight you have put on. You have a wallet full of credit cards that you don’t completely pay off each month; they seem to end up carrying a ‘core’ debt on an ongoing basis. But it must be okay, because you keep getting offers in the mail for limit increases and extra cards. The mortgage is growing instead of reducing, but the bank keeps telling you that you can afford more debt on your income. So you increase the mortgage to pay for the renovations, holidays and so on, and put the other things like electronics and furniture on credit. You may have one of these great home loans with a ‘redraw’ facility or a ‘line of credit’, which means that you can redraw the mortgage back to your limit whenever you need more cash. Too easy! Your investments outside superannuation are limited. You have a few thousand dollars in spare cash, but you need that money to pay for the next instalment of school fees, or that new hot-water heater, or new TV. You have shares in a couple of companies that a friend of a friend put you onto. Some have done well, but you don’t have the time to look into what to do with them. You may also have some money in managed funds. You look at the statements every year and the fees and commissions seem to eat away any gains in value. But it’s okay because managed funds are supposed to be good, aren’t they? That’s what the managed fund salesperson said. Perhaps you have an investment property or two. They are ‘negatively geared’ at the moment, so they chew up any spare cash, but you have been assured that rents will eventually rise enough to cover interest and outgoings. Nobody told you that you would lose up to 30 per cent of rent in running expenses like management fees, rates, water bills, repairs and maintenance. But negatively-geared property is supposed to be good, isn’t it? That’s what the salesperson said when you bought it. All in all, money comes in each month but it seems to go out again just as quickly with the ongoing expenses of everyday life. But you are both making good incomes, so you can afford it. All your debts, including mortgages, credit cards, personal loans, car loans and so on, total between $300 000 and $400 000. But it’s okay because the house is worth double that or more, so your net worth is still healthy, isn’t it? You probably don’t enjoy your job as much as you once did. You probably don’t jump out of bed every morning, punch the air and shout, ‘Can’t wait to get to work today!’ Too much paperwork, too many meetings, too much fighting the bureaucracy, too much travelling, too much rushing around. Not enough thinking time, or time to actually get things done. But the money’s good and

3

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the lifestyle’s good, and you’ve got lots of ‘stuff’, so it’s worth it, isn’t it? But you prepare to battle on until you’re around 50 or 55, then retire and live the same type of lifestyle you enjoy now, maybe up the coast on the beach or on a hobby farm just outside the city. Your superannuation fund will pay for all that, wont’ it? So, sit back and relax. Life’s great — you’re living the Australian dream!

1.2 So what’s the problem? There is a problem with this picture, though. If you’re in your 40s now, then you probably only have around 10 years of peak earning capacity left in your current job or profession before you reach some arbitrary ‘use-by date’. However, you will probably live for another 30 or 40 years after you retire or are retrenched at around 55 or even 60 years of age. The challenge is to generate sufficient investment assets to finance up to 30 or 40 years of retirement and medical expenses, plus: 9

pay off the mortgage

9

pay off all other debts

9

pay the kids’ uni fees and maybe buy them a car

9

help the kids get into the housing market

9

buy that new boat you’ve promised yourself

9

go on that trip around Australia or around the world

9

leave a legacy behind.

Add up all of your investments in the following table, but don’t include the following items because they are not investments: 9

your house — it’s not an investment unless you rent it out to others

9

money you are saving to pay upcoming bills or expenses, or to pay for that holiday or new TV

9

your business, if you own one, is not really an asset if you actually work in it day to day as the main employee

9

cars, boats or household items — they depreciate (fall in value) and don’t generate income. 4

The problem

Investments Superannuation balance Shares Managed funds Investment properties (be careful estimating values — if you bought flats off the plan in the last couple of years they may be worth a lot less than you paid for them) Savings or education bonds Shares or options in your employer company (only include vested shares or options that you can actually exercise now, and don’t forget to deduct tax payable) Other investments Total investment assets

$ $ $

$ $

$ $ $

Now, subtract all your debts:

Debts Mortgages Investment property loans Lines of credit Overdrafts Margin loans Credit cards Car loans Boat loans Personal loans Store cards Money owed to friends and family Tax liabilities Other Total debts

$ $ $ $ $ $ $ $ $ $ $ $ $ $

Net investment assets

$ 5

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If the total of your investment assets exceeds your debts, then you have positive net investment assets. If the total of your investment assets exceeds your debts by over $1 million, then you have positive net investment assets of over $1 million. Congratulations, you are in a tiny minority — about onethird of 1 per cent of Australians. If your investment assets barely cover all of your debts, then you have a lot of work to do. On the other hand, if you are like the vast majority of adults in Australia, then your total debts exceed your investment assets (even including super) by a big margin. If this is the case, you are not even starting from scratch — you are starting from behind the eight-ball. You have a huge task ahead of you if you plan to generate over $1 million in net assets after paying off all your debts. And you may only have a short time to do it. You are now in your peak income-earning years and they may not last as long has you may hope or need.

How much will you need? Over the balance of your working life you may have to generate well over $1 million in net investment assets — after paying off the mortgage and other personal debts — if you want retain the lifestyle you are used to now. And if you want to pay for the kids’ uni fees, give them a head start in the housing market, buy that new boat or go on a round-the-world trip, then the cost of these items must be added to the $1 million target. There are two simple rules of thumb to estimate quickly how much capital you will need to generate a particular level of investment income to cover expenses: 1

A capital base of 15 times your estimated annual expenses can generate the target level of income to cover expenses, but you will eat into capital and run it down until you die. If you live longer than the statistical tables say you should live, then bad luck. You’re back on the age pension and hoping your kids will look after you in your old age.

2

A capital base of 20 times your estimated annual expenses can generate investment income required (even rising for inflation each year) and avoid eating into capital. This means that, even if you live much longer than average, you still have plenty of capital and you can leave a legacy when you go.

Many people estimate that they will need a retirement income of around 60 to 70 per cent of their pre-retirement income in order to maintain their current lifestyle. Let’s say your family income is

6

The problem

$100 000 per year and you estimate that you will need about $70 000 per year in retirement income so you can do all the things you want to do. Using both the 15- and 20-times rules: 9

Fifteen times $70 000 is around $1 million in investment capital required, but it’s likely you will eat into this capital and run it down to zero.

9

Twenty times $70 000 is $1.4 million in investment capital required, and it could generate an income of $70 000 tax effectively for the rest of your life, increasing for inflation each year and not eating into capital.

Why not eat into capital? Old retirement models assumed most people would live only a handful of years after retirement, so you could eat into capital and run it down until your estimated age of death. However, these days you may live for another 30 years and you will need the extra money. Also, you may need extra capital for medical costs, or even to start a new business venture.

How long could you last without working? A useful exercise is to estimate how long your investments would last if you stopped working today. Take the total of your investments (including super) and divide it by your total living expenses per year. Include repayments on the mortgage, credit cards and any other debts. (Calculating total expenses and budgeting are discussed further in chapter 2.) For example, if your total investments including super came to $100 000 and your current living expenses are $50 000 per year, then your investments would last two years before running out. In practice, your investments would be generating investment returns during this period so the money would last a couple of months longer, but don’t forget that living expenses will also rise over time with inflation. This is an unfair test because you are not going to stop work tomorrow, but you may want to take a year off to study, travel or do volunteer work for a charity. The aim is to build your investments up to a point where they cover 20 years’ worth of expenses. This is the same as the multiple of 20 I used earlier. Investment capital of 20 times your expenses can generate an income of 5 per cent tax effectively, and still leave the capital intact so it grows over time and keeps the investment income rising each year to stay ahead of inflation. The types of investments that do this are covered in chapters 6, 7 and 8. The amount of money required for financial freedom will depend on each person and family. From my perspective, financial freedom is having enough investment capital so that you can do

7

$1 Million for Life

what you really love doing without needing to do it for the money and without eating into capital, so that you can help out your family during your lifetime and after you’ve gone. It also means having adequate protection in place for when things go wrong.

How your superannuation can help Take your current super balance. If you don’t know what it is, use table 1.1 to estimate it. Note though, this table is only a rough guide. It assumes that you started working at age 22 and have been working full time ever since, steadily increasing your income to your current level. Table 1.1 also assumes that you have been receiving compulsory super contributions from your employer. The final assumption is that the super fund has been invested in a mixture of growth assets generating 12 per cent returns before tax, with fund fees of 2 per cent per year.

Table 1.1: sample superannuation balances for different ages and income levels Current income Age 30 35 40 45 50 55

$50 000 $35 000 $47 000 $61 000 $65 000 $64 000 $67 000

$75 000 $43 000 $60 000 $78 000 $86 000 $87 000 $92 000

$100 000 $51 000 $71 000 $93 000 $106 000 $108 000 $115 000

$125 000 $58 000 $82 000 $108 000 $124 000 $128 000 $138 000

$150 000 $65 000 $92 000 $122 000 $141 000 $147 000 $159 000

$175 000 $72 000 $102 000 $135 000 $158 000 $165 000 $180 000

Divide your super balance by 15 to find the estimated amount of investment income per year, assuming you run down the balance to nil over time. Divide by 20 to find the level of investment income per year it could generate without eating into capital, allowing it keep pace with inflation and leave a legacy after you go. Finally, add the age pension of $13 000 for singles or $22 000 for couples to see what your retirement income looks like. The results may surprise you. For example, a 45 year old earning $100 000 is likely to have a super balance in the order of $100 000 to $120 000. Dividing this amount by 15 shows it can generate an income of around $7000 per year, but this would eat into capital and run down to nil. Dividing it by 20 shows it could generate around $5000 for life and leave the capital and income growing for inflation,

8

The problem

without eating into capital. Add to that the government age pension and the future still looks pretty bleak for someone accustomed to living off an income of $100 000. In reality, your super balance will continue to grow while you keep working. If you work for 10 more years and your income keeps rising by, say, 3 per cent per year, your super fund will increase an additional $300 000. This may sound great, but it is probably a similar amount to the total debt you are carrying now. About 50 per cent of Australians use their super payout to pay off their mortgage and other debts, and this is probably what you would need to do. Unfortunately, this will leave you with very little to live off for the next 30 to 40 years.

Action plan 1

Calculate your net investment assets.

2

Find out the current balance of all superannuation funds in your family.

3

Estimate your current annual expenses.

4

Calculate how many years your investments (including super) will last.

1.3 Factors affecting your future finances Our generation is the first in history to have to think about money beyond just earning enough to pay the day-to-day living expenses.

Living longer, but working shorter Life expectancy in developed countries is steadily rising due to medical advances. This is not just in the prevention, detection and cure of diseases; it is also in the prolonging of life while in medical care. Many of our grandparents lived until their 60s or 70s, our parents are living into their 80s and 90s, and we may live to 100. At the same time, the age of retirement or retrenchment is falling. A generation ago, retirement at age 65 was the norm. Today, the average age of retirement is 57, and many people are retrenched between 50 and 55. The age at which people start their careers is also rising. Our grandparents probably started work in their mid to late teens, our parents perhaps around age 20. These days, people often study 9

$1 Million for Life

and/or travel until they are in their late 20s before commencing their careers, which means that they don’t start saving or investing until then. The result is that, only a couple of generations ago, 50 years of work (from ages 15 to 65) needed to fund around five years of retirement. So they had at least 10 years of work to fund each year of retirement. There was no need for ‘superannuation’ and no need to ‘save’ for retirement because they probably wouldn’t have lived that long, and they always had the non–means-tested age pension. Today, 30 years of work (typically from about age 25 to 55) is expected to fund another 30 or 40 years of retirement. This means that for every year of work we need to fund at least one year of retirement. This is shown in figure 1.1.

Figure 1.1: amount of time spent at school, work and in retirement across generations

Our grandparents

Our parents

Our generation 0

School

Work

School

School 10

Retirement

Work

Retirement

Work 20

30

40

Retirement 50

60

70

80

90

Age

Don’t rely on the age pension The concept of governments supporting people in their old age is a relatively recent phenomenon. It was first introduced in Europe in the 1880s and in Australia almost 100 years ago, and the age at which it kicked in was well beyond the average life expectancy. It was an absolute last resort. There was no need for a means test to qualify because so few people lived that long. As life expectancy levels rose over the next century, what was a last resort began to be considered a ‘universal human right’. Originally intended for a minority of destitute people who needed help in their final few years, the pension became 10 or 20 years or more of taxpayer-funded ‘retirement’. 10

The problem

Before means-testing was introduced in the early 1980s, everybody above the qualifying ages automatically went on the age pension. This was never going to last long. It was bad for the economy, firstly, because it was costing the government (taxpayers) a great deal of money as the population aged, and secondly, because it didn’t encourage people to save and invest for themselves. Savings and investment is the engineroom of the economy. They are what provide funds for factories, mines, scientific research, service businesses and all the other activities that employ people and generate wealth in society. In addition, the ‘automatic right’ to taxpayer-funded income for life after a certain age didn’t promote self-reliance and independence. Ex-governor of California Pete Wilson had a saying, ‘Welfare should be a safety net, not a hammock!’ Today, the age pension of $13 000 for singles and $22 000 for couples is not going to buy much luxury — probably just enough for a hammock! This ‘universal right’ to a taxpayer-funded age pension is starting to be wound back. In the early 1980s means-testing in the form of an assets test and income test was introduced. Recently the qualifying age for women has gradually been increased and by 2013 it will be up to 65. Rules concerning what assets are exempt from the pension assets test have also been tightened as well. Much of the financial planning industry is based on using the intricate rules relating to tax, super and pensions to come up with elaborate schemes to rearrange people’s affairs so they qualify for the age pension. However, nobody should have a ‘right’ or ‘entitlement’ to live off taxpayer funds for over 30 years unless they are genuinely disabled or destitute through no fault of their own. It’s just not economically sustainable. The financial planning industry has lost sight of the big picture. It should be encouraging people to become self-reliant, not shuffling paper to get more welfare. My view is that there should and will always be taxpayer-funded welfare for the genuinely destitute and disabled in society. The way things are going it is likely that most elderly will be allowed to qualify for at least some part of the age pension, but it shouldn’t be the dominant factor driving people’s financial affairs for retirement. The financial planning industry should be helping people become financially independent of welfare.

Superannuation isn’t building net wealth The compulsory superannuation contributions scheme was introduced in Australia in the late 1980s and early 1990s. The aim was to make employees more self-reliant and encourage them to save for their retirement, thus reducing reliance on the government pension, but it isn’t working out that way.

11

$1 Million for Life

Super is encouraging more debt Consumers (and lenders) are increasingly viewing super payouts at retirement as an ‘asset’ that can be used to pay off debt. People are taking on more and more debt for housing and personal items because they know they can use their super payout to pay off the debts. There is $1 trillion in super funds in Australia and it is rising rapidly. But there is $1 trillion in household debt, which is also rising rapidly. This means that if everyone cashed in their super funds today and paid off their mortgages, credit cards and other debts, there would be nothing left to fund the rest of their lives. Figure 1.2 shows the rise of superannuation fund assets in Australia, which has been matched almost exactly by the rise in household debts. What this means is that we are no better off in net terms than we were a generation ago. The ‘super revolution’ has been neutralised by a ‘debt explosion’. Moreover, this trend of borrowing more will only increase because, since July 2007, you can withdraw your entire super balance as a tax-free lump sum at age 60, which has not been possible before.

Figure 1.2: household debts and superannuation assets $billions $Billlions $1200 $1,200 $1000 $1,000 HouseholdDebts debts Household $800 $800

Superannuation SuperannuationFunds funds

$600 $600 $400 $400

Jun-07 Jun-07

Jun-06 Jun-06

Jun-05 Jun-05

Jun-04 Jun-04

Jun-03 Jun-03

Jun-02 Jun-02

Jun-01 Jun-01

Jun-00 Jun-00

Jun-99 Jun-99

Jun-98 Jun-98

Jun-97 Jun-97

Jun-96 Jun-96

Jun-95 Jun-95

Jun-94 Jun-94

Jun-93 Jun-93

Jun-92 Jun-92

Jun-91 Jun-91

Jun-90 Jun-90

Jun-89 Jun-89

Jun-88 Jun-88

Jun-87 Jun-87

Jun-86 Jun-86

Jun-85 Jun-85

Jun-84 Jun-84

Jun-83 Jun-83

Jun-82 Jun-82

Jun-81 Jun-81

Jun-80 Jun-80

Jun-79 Jun-79

Jun-78 Jun-78

$0 $0

Jun-77 Jun-77

$200 $200

Source: Reserve Bank of Australia, tables B18 and D02.

The number of people on the pension is rising, not falling The compulsory superannuation contribution scheme has not resulted in fewer people going on the age pension. In fact, the reverse has happened. Prior to this scheme, less than 75 per cent of 12

The problem

pension-age people were on the age pension. Fifteen years after the scheme was introduced the proportion of people who are on the age pension has actually increased to almost 80 per cent. Although people are saving more in their employer-sponsored super accounts, more and more are using their super to pay off debts, or to pay for holidays and so on, and then going on the pension. In addition, there are a number of problems with super, including: 9

complexity and regulation — these issues lead to costs, which drags down performance

9

the increasing proportion of working-age people who are not covered by compulsory super — particularly sole traders and people in small businesses, which are the fastest growing sectors of the economy

9

cost — with layers of fees and commissions most super funds are very expensive, which further drags down performance.

Super does have some advantages and it can be used as a key part of your plan to build wealth, but you really have to work at it. Super is covered in greater detail in chapters 4 and 5.

‘Your’ inheritance may not be there You can’t afford to rely on inheritances from parents to help fix your finances. If your parents are alive and healthy today, the chances are that they will live to around 80 or 90, which means that you won’t receive an inheritance (if at all) until well after you have retired.

Spending the kids’ inheritance Increasingly, parents are seeking to enjoy life and spend their money, rather than simply handing it over to their kids. More and more retired people are ‘spending the kids’ inheritance’, and loving it. Their parents (your grandparents) probably had an extremely frugal Depression-era attitude towards spending. However, with the strong economies of the 1960s and 1970s this attitude wore off. Today, your parents are likely to want to enjoy their lives to the fullest. More and more have caught the baby-boomers’ bug of instant gratification. They are interested in undertaking further education, going on ‘eco-holidays’ and buying Ford Mustangs or Harley Davidsons. And all this spending leaves nothing for you.

13

$1 Million for Life

Government incentives to spend The age pension system encourages retirees to spend their capital and go on the pension, rather than save to become self-sufficient and leave a legacy for the next generation. If retirees give their money away as a gift (for example, to their children), it is still included as an asset for the assets test and therefore disqualifies them from the pension. But if they spend it on travel and indulgences for themselves, they will qualify for the pension or even increase their pension if they are on a part-pension. Many elderly gain comfort in the idea of relying on government pensions, rather than having to look after their own finances. Rather than having to deal with financial planners, accountants, stockbrokers and so on, many would rather spend their savings and rely instead on the government pension. This can seem incredible to people of their children’s generation, many of whom have a natural distrust of government. Nevertheless, this point of view continues to be held by many of today’s retirees, which is further driving the tendency to spend their savings and go on the pension.

Reverse mortgages For many people of our parents’ generation, their only major asset is the family home. Until a few years ago there was no easy way to access this capital and spend it. Often the home was only sold when they went into a nursing home and by then it was too late to go on a spending spree. Now there are reverse mortgages, equity release loans and shared equity schemes, making it easy for people to spend the capital tied up in their home while still living in it. In fact, the reverse mortgage sector is the fastest growing sector of the lending industry. So you may get a rude shock when you discover that your parents don’t actually have much or any equity in the family home anymore.

Expensive nursing homes Do you remember going to a nursing home 10 or 20 years ago? Lino floors, plastic curtains between beds in multiple share rooms, threadbare carpet in run-down common areas. Today’s retirees are not going to have a bar of this. They want modern, well-appointed accommodation in attractive areas. It’s their money and they will use it to enjoy life, even if it is in a retirement village or nursing home environment. Today, there are brand-new over-55s estates being built all over Australia. They often come equipped with golf courses, swimming pools, day spas, tennis and squash courts, marinas and a

14

The problem

host of other luxuries. These are not cheap — prices range from $500 000 to over $1 million for standard villas, and there are hefty annual management fees. These costs will eat into their asset base and your inheritance.

Medical expenses Medical advances are keeping people alive a lot longer. Increasingly, savings will need to be spent on medical expenses and high-cost health care for longer periods. In past generations death often came quickly from contagious diseases, accidents at work and war. These days, the process is much more likely to be a long, drawn-out decline accompanied by expensive medical procedures and medications. Much of your parents’ assets may be needed to pay for the care they deserve during their final years. So don’t count on getting any inheritance from your parents. It will either be nothing at all, or it will come much later than you may need. And that’s the way it should be. It’s your parents’ money and they should enjoy it. You have your own life so you need to make your own money to finance it.

The rising cost of kids Another factor affecting your future finances is the increasing cost of raising kids.

Education costs are rising The chances are that your kids will still be in high school when you are in your 50s. A generation ago around 25 per cent of Australian kids went to non-government schools — around 20 per cent went to Catholic schools, with the other 5 per cent attending non-Catholic and independent schools. At the time of writing, almost 40 per cent of children go to non-government schools. The proportion of kids in Catholic schools is still around 20 per cent; the big growth has been in independent schools. Private schools are no longer just for the wealthy — indeed, it is common for middle-income earners, professionals, small business owners and tradespeople to have their kids in private schools. At the same time, school fees are rising at rates well above the inflation rate — reflecting an increasing demand together with limited supply. Fees for many private schools are now in the order of between $12 000 and $20 000 per year. And some Catholic schools have fees of up to $10 000 per year.

15

$1 Million for Life

Even in the public school system education is no longer ‘free’. In addition to the cost of books and uniforms, parents are increasingly asked to make a whole range of ‘voluntary’ contributions. As governments shift their attention to chasing votes in the growing sectors (the elderly) they are slowly letting the declining sectors (kids) suffer. As a result, parents of kids at state schools are increasingly being asked to directly fund basic materials and even repairs and maintenance of the school.

University and higher education University and other forms of higher education are no longer for the wealthy — it has now been well and truly ‘democratised’. Up to 50 per cent or more of all current high school students are expecting to go into further education. One hundred years ago there was just one small university in each capital city offering a selected few places in medicine, law, sciences and the classics. Today there are dozens of universities and hundreds of other colleges offering thousands of courses in all sorts of strange topics. It seems that almost every job, apart from a shrinking blue-collar workforce, requires university or college qualifications. University fees are rising and you may want to help the kids out, rather than leave them burdened with the debt for years. With the current generation of parents having kids in their 30s and 40s, education costs will extend until we are over 60 years old.

The kids won’t leave home How old were your grandparents when they left home? They were probably around 16 or 17 years of age and they may have gone off to war, been posted away from home by their employer (the bank, post office, railway, or to teach) or left because they got married. When your grandparents left home, their parents (your great-grandparents) were probably between 35 and 40 years old. Your parents probably left home when they were around age 18 or 20 (when their parents were between 40 and 45 years old). A few may have gone to university or college, but most joined the workforce straight after leaving school after fourth or sixth form (year 10 or 12). Remember when you left home? You were perhaps aged between 20 and 25. This would have allowed your parents to downsize and accelerate their savings when they were in their 40s or early 50s, while they were still earning good incomes. Today, the picture is very different. People are increasingly waiting until their early 30s to early 40s to have children. And these days many kids don’t leave home until they are aged around

16

The problem

25 or 30. This means that they will continue to be a financial burden until you are in your late 50s or even 60s. These days kids want to earn a degree or two, or travel the world, and many don’t start a career until their mid to late 20s. Further, many don’t pay board as they did in our generation. They insist on having their own bedrooms, bathrooms and living spaces — leading to bigger houses and bigger housing expenses — rates, electricity, water and so on. And did I mention that they eat like horses? If your parents were in their 40s when you left home and remained in the workforce until their 60s, this will have left them with up to 20 years of accelerated savings capacity. In contrast, there is a good chance that your kids will still be at home long after your peak earning years have gone. This won’t leave you with time for accelerated savings to finance your own retirement, which will be a lot longer than your parents had. This is shown in figure 1.3.

Figure 1.3: having kids later and kids staying at home longer Kids at home Our grandparents

Our parents

Our generation 0

School

Kids at home Work

School

Retirement

Kids at home Work

School 10

Retirement

Work

20

30

40

50

Retirement 60

70

80

90

Age The bottom line is that parents today can’t expect to downsize and accelerate their savings until around 10 or 20 years later than parents one or two generations ago.

Your expenses won’t necessarily be lower in retirement Most retirement ‘calculators’ assume that people’s living expenses in retirement are going to be about 60 per cent to 70 per cent of their pre-retirement income. This may have been the case a 17

$1 Million for Life

generation ago, but you may need or want more than that. Australia has the lowest ratio of incomes of over-65s compared with 18 to 65 year olds in the developed world. In Australia the ratio is 60 per cent but in all other developed countries it is much higher — according to the Organisation for Economic Co-operation and Development (OECD), over 90 per cent in Canada and Switzerland, and over 80 per cent in the United States and in most of Europe.

Expensive recreation There have been huge changes in the expectations of retirement. And for many retirees who are perhaps planning to buy a sports car, a luxury boat, travel overseas or start a university course, the age pension is not enough to fund it. We are only here once so we should make sure we have the best time possible. You will see in the case studies in chapter 10 that many people who have made the successful transition to a fulfilling life after work view their 20 or 30 years of ‘work’ as merely a prelude to the ‘main game’.

Capital to start a business You may want to start a business after you leave full-time work. Doing so will probably require a certain amount of money to build the business and develop it to a point where it generates cash.

Helping the kids out in the housing market Many parents feel the need to help their kids get a foothold in the housing market, due to the perceived high cost of housing in major cities. However, this money from parents just pushes up prices even further — to a point where, because so many parents are giving their kids money, it has almost become a necessity just to keep up. (Housing costs are covered in detail in chapter 3.) But remember, any money you want to give your kids will have to come out of super or your other investments.

Divorce and separation Almost half of all marriages end in divorce and an additional unknown percentage are separated. This can have a devastating effect on finances, with assets, including super balances, split up. In most cases this puts a financial burden on both parties and means that both sides need to start their retirement plans all over again. After 15 years of compulsory superannuation contributions and 20 years of industry super, more than 40 per cent of adult women still have no super funds at all. 18

The problem

These factors highlight that you can’t afford to rely on others, including the following, to help you with you wealth plan: 9

your employer — gone are the days of ‘jobs for life’, and compulsory super contributions are not enough

9

taxpayers — the shrinking tax base means that the age pension may be limited or reduced

9

your parents — they may not leave an inheritance, or you may receive it long after you need it

9

your kids — you may have only one or two, or none at all

9

your partner — especially given rising divorce and separation rates

9

the lottery win — never rely on luck.

You can only rely on yourself. It’s up to you to stand on your own two feet and become financially independent. This book will show you how, but first let’s take a look at the main alternatives if you stay on your current course.

1.4 The alternatives There are four main alternatives to the current financial dilemma.

1 Welfare Going on welfare means trying to survive on the government pension and public health system. The public health system is fully stretched and will get worse, with a shrinking tax base and a growing elderly population requiring medical attention. The trend is towards shifting public services to private enterprise, a ‘user-pays’ system and rising medical costs. In Australia there are, at the time of writing, 10 million working taxpayers and 10 million recipients of a total of $100 billion in welfare payments. Of these 10 million people receiving welfare, 4.5 million have welfare as their primary source of income (two million of which are age pensioners and they are the fastest growing group). This means that for every person relying primarily on welfare there are just over two working taxpayers supporting them, and the ratio is

19

$1 Million for Life

falling steadily. The only possible solutions for the government are raising taxes and/or lowering welfare.

2 Working ‘till you drop’ Working till you drop is not a choice for many people. Many employees of large companies or government departments are likely to find themselves retrenched or forced out at around age 55. Formal age discrimination may be technically outlawed, but there remains an invisible ‘use-buy date’ stamped on every employee’s forehead. Older employees are often perceived as having difficulty keeping up with change and new technology, and as being harder to train, and their experience is not valued. Also, many industries have built-in retirement ages due to the physical requirements of the job. As a result, retrenched or retired people often have to settle for menial service jobs with low pay, low status and low job satisfaction. I’ve seen the future and it’s not pretty. Walk into any McDonald’s in the United States and you will notice that most of the workers are over 60. They’re not doing it for the challenge, the excitement or the intellectual stimulation — they’re on the minimum wage of $6 per hour and being ordered around by 16-yearold shift managers. Many are highly educated and skilled, but this is no longer valued once they reach some perceived ‘use-by date’. A large proportion of retirees use their retrenchment payout or super payout to buy a franchise, many of which require operators to work even more hours than they did before. All they have done is swap one job for another, but it’s cost them a lot of money in the process. Ask anybody who has followed the ‘dream’ of retiring to run a bed and breakfast or country motel and they will often tell you that it’s ‘work till you drop’ seven days a week with no holidays. Even if you are able to stay in your current job or industry for as long as you like, it may not be something you really enjoy doing anymore, and you don’t want to be working just for the money.

3 Earning more money while you can Earning more money is great if you can do it. However, there are often problems: 9

more responsibilities and stress, and less time with the family

9

additional training or education, which can be expensive, or moving interstate or overseas, which can be rewarding but disruptive to the rest of the family

20

The problem

9

more expenses, due, for example, to peer pressure to upgrade the house, cars and spending habits

9

more child care or babysitting, due to all of the extra hours a second or third job requires

9

you are taxed on extra income, but the costs are not tax deductible.

Building financial security and wealth is not about making more money — this doesn’t fix bad spending habits. It’s about what you do with the money you already have.

4 ‘Voluntary simplicity’ Voluntary simplicity involves downsizing to a remote hobby farm, buying second-hand clothes, home-schooling the kids, trading the car for bicycles, growing your own food and so on. This sounds to me like giving up too many of the good things in life. For many people it is simply too radical and requires too much sacrifice and hardship. This book is not about voluntary simplicity. It is about how to avoid involuntary simplicity — that is, how to avoid relying on welfare or living like a monk for the best years of your life. You can enjoy the good things in life that you are accustomed to or that you aspire to, but you need to start working towards them now.

1.5 The plan Fortunately there is a better way to become financially free! The plan outlined in this book consists of six basic steps that lead to financial security and freedom. Plenty of people have done it without following all six steps, but most people who have attained great wealth have mastered at least a few of these principles. The more you follow, the better your chances of building real wealth. The six basic steps are: 1

develop good money sense — chapter 2

2

own your house outright — chapter 3

3

maximise your superannuation fund — chapters 4 and 5

4

build your investments outside the superannuation system — chapters 6, 7 and 8

21

$1 Million for Life

5

have adequate protection in place for when things go wrong — chapter 9

6

do what you love doing — make sure you’re enjoying yourself because you’re only here once and it may end at any time. Here we look at how to best use and enjoy the decades after you are retrenched from, retire from, or are simply fed up with, your current job or profession — chapter 10.

The amount of money you will need for your financial freedom will depend on your individual circumstances and goals. In this book, financial freedom means having enough investment capital so you are able to do what you really love doing without needing to do it for money and without eating into capital, so that you can help out your family during your lifetime and after you have gone. It also means having adequate protection in place for when things go wrong.

Why the $1 million target? One million dollars ‘ain’t what it used to be’. One hundred years ago it was enough to buy all of the houses in a suburb, and it was more than a suburb full of people earned in a year. These days, however, we hear of single houses selling for $5 million or $10 million, and we hear of company chief executives ‘earning’ salaries of $5 million or $10 million in a single year. Today, $1 million will buy just two typical suburban houses in most Australian cities. While $1 million may not buy much these days compared with previous generations, it can still provide a nice tax-effective income of around $50 000, increasing each year to keep ahead of inflation, without eating into capital. This $1 million can buy you the ability to do whatever you want to do with your life, and it can allow you to leave a legacy when you go.

Money doesn’t buy happiness This plan is not about making money for the sake of it. Money doesn’t buy happiness. Numerous studies all over the world have shown that the happiest people on earth are often the poorest in terms of what we would normally call wealth. In Australia we have had 15 years of uninterrupted economic growth — in income, wealth and assets. But we have also had record levels of personal bankruptcies and debt — housing, personal and credit card — so our financial wellbeing is much more sensitive to ups and downs in the economy and interest rates.

22

The problem

With all this growth in income and wealth, the fastest growing illness is depression. According to national depression initiative beyondblue, around one million Australians suffer from depression. It reaches across all levels of society and all age groups. The greatest incidence of depression is among lawyers, who are among the highest paid in society. It seems that we’re all busier, more stressed and feel less in control of our lives: 9

For employees, it’s a result of more working hours, less job security and being on call 24/7.

9

For business owners, it’s greater regulation, red tape, competition, technological change, and finding and keeping good staff.

9

For parents, it’s increasing household debts, child care and schooling costs, less time with the kids and caring for ageing parents.

9

For kids, it’s growing pressure to succeed in school and at sport, and a tremendous increase in childhood obesity and eating disorders.

Above all else, happiness comes from a sense of control over our lives. The plan in this book is all about getting control back in your life — control over your money, your career and over the options available to you for the rest of your life. Money buys you options. It puts you in charge. But it is merely a means to an end, not an end in itself. It gives you the power to do what you want, when you want to do it. The aim of this book is to take simple, proven principles and help people put them into practice.

Stick to the basics If you take a look in the personal finance section of your local bookstore you will find lots of books full of complex, fancy schemes and trading methods, which may or may not work. This book does not contain any of these. Like most things in life, success comes from doing the simple things well. Once you have the basics mastered, then you can move on to the optional extras. A friend of mine is a well-known chef who runs a successful restaurant in Sydney. If I went up to him one day and said, ‘Serge, I want you to teach me how to make your magnificent blue-eye cod with shellfish, lentils, lardoons, vongole, mussels, calamari and scallops’, he would say that it would take me years to learn all the intricate steps to produce such a fine dish to perfection. I would need to learn everything, from how to source the best and freshest ingredients, to the preparation 23

$1 Million for Life

and cooking, presentation, and secret tricks of the trade that he has mastered during his 30 years’ experience all over the world. But then he would tell me that all of this was not really necessary for what I wanted to achieve. I could learn how to cook a decent blue-eye cod steak in a short time if I just kept it simple and got the basics right. It’s the same with money. Almost every Australian can build enough wealth to be able to achieve financial independence and freedom. We don’t all want to be as rich as Bill Gates, but we can achieve financial freedom by doing the basics well. If you follow the steps in this book and stick to them over the long term, you will achieve success.

No quick fixes or short cuts I’m an average ‘blue-level’ skier but I have always wondered what it would be like to tackle the ‘Blackhand’ double black-diamond run on the Turoa ski field on Mount Ruhapehu, an active volcano in the middle of New Zealand’s North Island. I have stood at the top of the run many times, looked over the cliff down the mountain to the bottom and wondered what it would be like to make it to the bottom without any broken bones. Unfortunately, a severe lack of skill prevents me from trying. One way to get from the top of the run to the bottom would be to hire a chopper to take me down. That would achieve the end goal but what would be the point? I would miss out on the experience of actually doing it. I would miss out on the feeling of being airborne as I flew over the cliff at the ‘Leaper’, rounding the corner at the bottom of the ‘Fingers’, the thrill of sliding down the ‘Frozen Waterfall’ and finally making it all the way down the ‘Cinch’. I would miss out on the pain of trying a dozen or more times, and then the sense of euphoria and achievement when I finally nailed it. That’s what life’s all about. It’s not about achieving the end goal and taking short cuts where you can — it’s about the trials and tribulations on the way. Let’s say you are 30 or 40 now and your goals the next 10 years are to be debt free, own your house outright, have $1 million in investments, help the kids get good jobs, and to be happy and healthy. If you could wave a magic wand right now and in an instant shift your life ahead 10 years so that all your goals are achieved, would you do it? Think about it. Would you be prepared to simply cut 10 years out of your life, just to fast-forward it to reach all of your goals? Would you want to miss all things you would otherwise have done over those years — the career, the challenges, the holidays, watching the kids grow up, seeing your team finally win a grand final, and all those little things that make up everyday life?

24

The problem

Of course not. Life is not about just reaching goals. It’s about the journey. Goals are great because they challenge us, they push us to try new things, to learn new skills, to handle new situations, to meet new people. That’s where the rewards in life are. That’s why, when we reach a goal, we don’t sit back and relax for the next 10 years. We set a new goal and the process starts all over again.

Nothing worthwhile in life comes easily There are no short cuts. It’s going to take action on your part and lots of decisions along the way. The plan in this book tries to make it as easy as possible. There are several simple things you can do today that can make massive differences later on. You can make tiny changes like ticking a different box on your super fund ‘asset allocation’ selection form and this can add hundreds of thousands of dollars to your super balance in 10 or 20 years. This book contains dozens of similar ideas that will help move you closer to achieving your goals.

No one path There is no one correct way forward. Everybody will find their own combination of solutions that best suits their needs and circumstances. The trick is to find the path that suits you, and then it’s up to you to decide how to move forward. The clock is ticking, so let’s get started.

25

Investments

Super

Step 1 — money sense

House

Chapter 2

Protection

Money sense

2.1 The foundation We need to start with the foundation for your wealth plan. Without it, it’s like building a house on sand — the more you earn, the more you spend and it doesn’t actually get you ahead. So you end up working because you have to, not because you want to. Having good money sense is a bit like dieting. It is not a one-off exercise you do to lose 10 kilograms and assume you will keep it off forever. Most people who go on a crash diet put the weight back on straightaway. The only way to take weight off forever is to change your everyday eating and exercise patterns permanently. Often, small changes here and there can make a huge difference over the long term. It’s exactly the same with investing. People who win the lottery or inherit money often don’t use it wisely because they haven’t developed the knowledge and skills to manage money and make it grow.

26

Step 1 — money sense

How do you stick to the plan? The solution is to start thinking about money in a different light. And always keep your mind on the main game — what’s important to you in the long term. It’s easy to get bogged down in the day-to-day issues, but always remember the bigger picture.

2.2 Spend less than you earn Australia is a nation of spenders, not savers. Despite the economic growth over the past 30 years, the productivity improvements, the new technology enabling us to work smarter, the resources booms, the export booms and so on, no matter how much extra money we have in our pockets, we just spend it again, and more. Figure 2.1 shows the net saving rates of each sector of the Australian economy over the past 50 years — households, non-financial corporations, financial corporations and governments.

Figure 2.1: net saving ratios — Australia %%ofofGDP GDP 14% 14% 12% 12%

Households Households Non-Financial Non-fi nancialCorporations corporations Financial Corporations Financial corporations General Government General government

10% 10% 8% 8% 6% 6% 4% 4% 2% 2% 0% 0% -2% –2%

2005-06 2005–06

2003-04 2003–04

2001-02 2001–02

1997-98 1997–98

1999-2000 1999–2000

1995-96 1995–96

1993-94 1993–94

1991-92 1991–92

1989-90 1989–90

1987-88 1987–88

1985-86 1985–86

1983-84 1983–84

1981-82 1981–82

1979-80 1979–80

1977–78 1977-78

1975-76 1975–76

1973-74 1973–74

1971-72 1971–72

1969-70 1969–70

1967-68 1967–68

1965-66 1965–66

1963–64 1963-64

1961-62 1961–62

-6% –6%

1959–60 1959-60

-4% –4%

Source: Australian Bureau of Statistics 5204.0 National Accounts

This chart shows that Australian households were in a great position in the early 1970s but have headed downhill since. In fact, over the past few years we have been net negative savers — that is, 27

$1 Million for Life

we collectively spend more than we earn. This is worse than almost every other developed country (New Zealand is slightly worse). The same is true of exports and imports. Despite the huge export boom over the past few years we still have a trade deficit, which means that we still import more than we export — we still consume more than we produce. I often hear people say, ‘If only I had an extra $1000 (or $10 000 or $100 000), I would be okay’. But when they get that extra money, it just disappears through extra spending. However, building wealth has nothing to do with earning more money. It’s about what you do with the money you have. Think back 10 years. You earned less money, but you spent less. Now you earn a lot more, but you probably spend more as well.

How you will earn and spend $1 million If a typical person or household earns an income of $50 000 per year, over a working life of 30 years (ignoring inflation), that person or household will earn a total of $1 500 000. That sounds like a lot of money, but where does it all go? About 10 per cent ($150 000) goes in income tax and about another 20 per cent ($300 000) goes in rent or mortgage repayments. That leaves the remaining 70 per cent ($1 050 000), which goes towards living expenses. So you have that $1 million in your pocket, but it just disappears again. The trick is to figure out where this $1 million in ‘living expenses’ actually goes, and how to use it in smarter ways. You will see a little later that if you can capture just a tiny portion of this $1 million and put it regularly into growth investments, you can generate an investment fund worth $1 million. But the first step is to figure out where that $1 million in spending money actually goes.

Outsourcing Australians now pay other people to do all sorts of things we used to do ourselves just a generation ago. Each item we outsource may look small and insignificant in isolation but it all adds up. The problem is we often end up paying twice. For example, we pay for someone to mow our lawns, and clean our houses and pools, and we spend money on petrol driving two minutes to the shops. We go out to restaurants where we are served meals that are far too big for our nutritional needs. Then we pay a personal trainer or expensive gym fees because we no longer get the exercise from mowing our lawns, cleaning our houses or pools, or walking to the shops, and we need to take off the extra weight we put on by eating too much.

28

Step 1 — money sense

We pay a dog walker to walk the dog, then we get in the car, use up expensive petrol to go to an expensive gym and stand on an expensive walking machine with a TV screen showing scenery of a park just like the park we could have been walking the dog in ourselves — for free. We pay to put our elderly parents into aged accommodation, and then we pay for someone to babysit our kids because the grandparents are not around to do it for free. The craziness of it all first struck me about 15 years ago in Melbourne. I used to commute home on a tram that went past the Yarra River. On any given day there was a handful of people rowing and kayaking on the river. It was a picturesque scene, with the green-grass banks of the Yarra, the brilliant colours of the trees lining the river and the city skyline beyond. What a great way to get fit. But where was everybody? They were all driving to the dozens of expensive gyms all over Melbourne, then sitting on fake rowing machines watching fake scenes of fake rivers on TV screens as they ‘rowed’ past. For a fraction of the cost of one year’s gym membership, they could buy a kayak and exercise on the river, or at any one of dozens of beaches around Port Philip Bay, every day for free.

Returning to work New parents have a lot of good reasons for returning to work after having kids — most of them tell me it’s mainly to get their sanity back! But often it doesn’t make economic sense because returning to work can cost more money that it generates. The extra income is taxed, but all the additional expenses must be paid for out of after-tax earnings — child care, cleaning, restaurant meals, pre-prepared meals, dry-cleaning, work clothes, travelling expenses and so on. For example, years ago we had a nanny who also paid a nanny to look after her kids while she looked after ours. She was a great nanny, but it made no economic sense for her to pay tax on her income from us, and then pay for her own nanny and child care costs out her after-tax income. It only makes economic sense if you can earn well over double the cost of the additional expenses incurred. There is an additional problem. The presence of another salary sucks lenders into thinking that the family has more borrowing power, so they allow them to borrow more and get into more debt.

One hundred and twenty-five per cent tax! To pay a cleaner, dog washer, personal trainer or nanny $100, you need to earn up to $187 in extra income before tax. But if you earn that $187 and you are in the top marginal tax rate of

29

$1 Million for Life

46.5 per cent, you lose $87 in tax, leaving you with the $100 cash. Of this $100 you pay the domestic worker, one-eleventh or $9 goes in GST, so he only grosses $91. If he is in, say, the 31.5 per cent tax bracket, he pays a further $29 in income tax and takes home just $62, before expenses. So you earned $187 to be able to pay the domestic worker $100, but he only grossed $62 or one-third of it. The other two-thirds or $125 is eaten up in taxes. That’s a tax rate of 125 per cent! Not only that, you probably had to work an extra couple of hours to earn that extra $187. You could have walked or washed the dog, cleaned the car and so on in less time and got some exercise and fresh air as well.

Spending less It’s all very well to plan to ‘spend less’. Everything seems important at the time. But it’s the money that is eaten up by all the little things we buy every day without giving them a second thought that’s the problem.

Take the 10-year test A useful way of putting things into perspective is asking yourself, ‘Will this item make a difference when I look back in 10 years?’ before buying anything. Putting it another way — think back to things you bought 10 years ago. You already do this unconsciously when you do a ‘spring clean’ or when you are packing to move house. As you think about each item you bought 10 years ago, ask yourself, ‘Did it really matter if 10 years ago I bought X brand or Y brand item, or if I missed out altogether on a particular item that particular month?’ If it didn’t really matter, then the same sorts of things you are spending money on today probably won’t be important either. If in doubt, don’t buy it — invest the money instead. For example, say you are going out to lunch with your family and you have to decide between a $30 café meal or a $100 restaurant meal. Will it really matter next week or next year or in 10 years whether you had the $30 meal or the $100 meal? If it was a special occasion, like a birthday or an anniversary, that’s different, but for 95 per cent of meals it makes no difference the next day, let alone 10 years later.

Celeb mags In 2006 Australians spent $600 million buying 240 million weekly magazines. Will it really matter in 10 years if you buy the latest celebrity gossip magazine about Britney’s new haircut, Justin’s new 30

Step 1 — money sense

girlfriend, or Brad and Ange? Is it important in the scheme of things? As a nation we could use the money we spend on weekly gossip mags to employ 12 000 new teachers, nurses or police every year. Or we could each invest the money and make a fortune. Surely it’s time to stop reading about other people’s lives and build your own life using the money you save!

Shop around for major items It pays to shop around for big-ticket items. For example, probably 90 per cent of people could save money if they shopped around when it came time to renew their car and home insurance. There is often a tremendous difference in premiums from different insurance companies, even for insuring exactly the same risk. One of the main reasons is market share. At any given time, one or two of the insurers will cut prices with the intent of picking up more business to build market share. You may as well take advantage of this. All the major insurers have online calculators to work out a premium quote. You can do it in a couple of minutes and it could save you hundreds of dollars.

Measure yourself for a day One of the biggest areas of household spending is in utilities — electricity, water and gas. Do you know what how much you use? Do you know the unit price for each? I guarantee that if you find out these things you will instantly start to find ways of saving money around the house. One day when the house will be empty for the day, or if you are going away for a weekend or week, take readings of your electricity, water and gas meters when you leave and again when you return. There should be zero usage for the gas and water, but perhaps a small amount for electricity (accounting for items that run all day like fridges and appliances on ‘standby’). Sometimes the extra ‘leakage’ is because you are actually paying for your neighbour’s water, electricity or gas, but most often it is because there is actual leakage somewhere in the house. Take the time to track it down because it is money going down the drain.

Garden watering In Australia garden watering accounts for around 25 per cent of all household water usage. A couple of houses ago we had a big garden with automatic drip-watering systems. When I was doing the budget I discovered that we were using 3000 litres of water per day! (This was before water restrictions came in.) With water costing about 1¢ per litre, our usage added up to $3 per day. Our current house has a bigger garden but it contains mainly native plants, which need very little water. Our water usage is now well below 500 litres per day, even though we have an extra child who

31

$1 Million for Life

loves taking baths. That’s a saving of 2500 litres per day or $2.50 per day, which is almost $1000 per year.

Mobile phones We have all heard stories about people running up $400 or even $4000 mobile phone bills and I simply can’t understand it. Kids these days have all sorts of schemes and scams involving swapping SIM cards, switching plans and doing all sorts of things I can’t even pronounce let alone understand — and they still end up with $400 or $4000 mobile phone bills! For example, I was listening to the radio the other day and there was contest in which listeners had to text in to win. The person who sent the most messages in a 60-minute period won $100. The winner made 560 calls — which probably cost him well over $100 to make! And what about all the other hundreds or thousands of people who sent less than 560 calls? The whole exercise probably made the radio station and the phone companies tens of thousands of dollars in call revenues. Then there are the TV shows that ask viewers call or text in to vote. The whole charade is simply a revenue raising exercise for the phone companies. Doesn’t make any sense, but millions of people do it every week. In America, more people vote in the American Idol final than in the US presidential elections! Go figure. A few months ago my wife and I finally gave in and let our daughter buy a mobile phone. She’s 13 and nearly the last in her class to get one. Some of her friends are up to their fourth phone already. I tried to ask one of these multiple-phone owners what was wrong with the other three phones she had. I got a filthy look and a completely incomprehensible explanation that started with, ‘Omigod — the last one was sooo last month!’ Whenever I drive past a school these days there are dozens of kids standing around in groups all phoning and texting each other — even though they’re only a few feet away! What they’re all saying to each other that is so important, I have no idea. Probably working out a solution for the Middle East crisis, or finding a cure for cancer perhaps!

Don’t spend the bonus A bonus is supposed to be a ‘bonus’ — that is, something you receive on top of your regular salary. But many people spend their bonus before they even receive it. In the US, bonuses are pretty universal across white-collar industries and most people get an extra month’s pay at Christmas. In Australia bonuses are becoming much more common and many people are beginning to expect

32

Step 1 — money sense

it as part of their normal pay. Never assume it will be normal. Don’t be lured into a false sense of security created by 15 years of economic good times. It is a much better idea to assume you won’t get it so you don’t spend it (mentally or physically). That way, if and when it does arrive you can put it to good use — paying off the mortgage, putting it into your super or buying investments outside your super.

Never buy retail In every city there are commercial auction firms that hold regular (usually weekly) auctions of all kinds of items. You can get practically anything at these auctions — in original packaging and with a new factory warranty — including toys, appliances, computers, furniture, bedding, building materials, carpets, tiles, whole kitchens and bathrooms, clothes, shoes, crockery, cutlery, linen, tools, machinery, musical instruments, cars and almost anything else. Many have online catalogues so you can see what’s on offer before you go, and you can usually inspect the goods for a few days prior to auction day. Most of the people who go to these auctions are retailers and wholesalers, not consumers. Consumers are not there because they’re all busy buying exactly the same stuff from the retailers the next day at double the price! The first time you go to one of these auctions it will change your whole outlook on spending. Generally, brand-new items in original packaging and with the manufacturers warranty, sell for about 50 per cent to 60 per cent (including GST) of their retail prices, often even less. The reason for this is simple. When you buy a new item for $1000 from a retail store, the item is not really worth $1000. The retailer would have bought it for $500 or less. The rest of your $1000 goes towards paying the retailer’s rent, staff salaries, electricity, council rates, land tax and to the retailer’s profit margin. You don’t want to pay for all that other stuff, you just want the item for $500, which is what it cost the retailer just yesterday. A word of warning, when you go you’ll probably find it hard not to buy more than you really need, because everything is so cheap. Have in mind exactly what you want and measure up first. Only buy what you really need and you will save a fortune.

New versus used As soon as you take a new item out of the shop it is no longer new and it is immediately worth significantly less — cars, boats, appliances, anything that wears out over time. For most types of cars, the difference between the price of a new car and a one-year-old car is around $5000 to $10 000. The more expensive the car, the bigger the difference in price. When the car is sold, say,

33

$1 Million for Life

10 years later, the difference in value between a 10-year-old car and an 11-year-old car is negligible. This means you can save around $10 000 each time you buy a car. If a car is going to last 10 years then it is also going to last 11 years. If you’re worried about what other people will think about you buying a used car instead of a new one, remember that when you drive your ‘new’ one-year-old car down the street nobody will know that you didn’t buy it new.

Zero-based budget Every couple of years I cancel all my subscriptions and memberships and only restart the ones I really need. This applies to newspapers, magazines, periodicals and newsletters. Publishers often offer an extra discount to re-establish former subscribers, and most offer another ‘free’ period before the new subscription cost kicks in. This way you get rid of the unnecessary subscriptions and you save extra money on the ones you want to keep.

Focus on what’s really important I often receive emails from readers asking me for ideas about how to save on big-ticket events like birthdays and year 12 end-of-school parties. There are some things everybody can do to save money, but these are the events that are significant in most people’s lives so it’s important not to get carried away with saving and end up ruining the occasion. These are major milestones in most people’s lives, and the memories will form a significant part of who they are for the rest of their lives. Instead, try to cut out some of the little day-to-day expenses that mean nothing today and are forgotten tomorrow.

Buying luxuries You don’t have to live like a monk. It’s okay to splash out on things once in a while. My wife happens to like shoes and I like cars. But most other things we buy are generic, no-name brands. Pick a few things that really give you the most satisfaction and spend your spare money on those items, instead of trying to keep up with the Joneses on every front. There are still some rules to follow when buying luxuries: 9

Only use investment earnings, never reduce your investment capital unless it really is surplus to your future needs.

34

Step 1 — money sense

9

Never spend on luxuries while you still have personal debts.

9

Never borrow — always use cash.

‘Will this make me money or cost me money?’ A friend of mine told me about the biggest single change he found when he started a new business after working in a large company for over 20 years. He said that every day in the business he had to make dozens of decisions — about advertising, stock, administration, overheads, staffing, pricing, premises and a host of other little things. For every decision he asked himself, ‘Will this make me money or cost me money?’ This is a great rule to apply to everyday life whenever we put our hands in our pockets and buy something. Money spent on expenses costs us money, but every dollar we save on expenses we can invest, and that makes us money.

Budgets Personally, I don’t like budgets, but they are great as a one-off exercise to find out exactly where all the money goes. We know about most of the big expenses — council rates, electricity, gas, water and so on. When the bills arrive they sit on the table for a few weeks before we pay them — by the due date usually! So there is plenty of time to think about them and perhaps shop around for cheaper alternatives. It’s all the little things that don’t come with invoices or bills that we can often make the most savings on. It’s the little things that really add up over time.

Petty cash budget Try doing this petty cash budget. Begin by estimating how much cash you take out at ATMs and via EFTPOS each month. Think about it for a minute and write the number down. Now check your bank statements for the last few months to come up with an average amount withdrawn in cash each month. (If you don’t keep bank statements, most banks let you view and print past statements online.) The total may surprise you. The majority of people underestimate the amount of petty cash they take out. Do you know exactly where all your petty cash goes? Draw up a list of where you think your petty cash goes each month (a sample petty cash budget is shown in table 2.1, overleaf). Write these figures down in the ‘my guess’ column. It should total the average amount you take out in cash each month.

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$1 Million for Life

Table 2.1: sample petty cash budget Petty cash

My guess

Actual cost

Lunches Coffees Newspapers Lottery/scratchies Public transport Pub Pokies Clothes Other Total per month

Starting cash Withdrawals Total cash Less total spent Balance left in wallet Difference still missing Most people find that there is a large amount in the ‘other’ category because they can’t remember where it was spent. Now, count the amount of cash in your wallet or purse and write that down as the ‘starting cash’. Fold up your petty cash budget and put it in your wallet or purse. Every time you buy anything with cash, write the amount next the appropriate category on the list. Don’t change your spending habits for this exercise. As you spend the money, add new categories to the list, so you don’t end

36

Step 1 — money sense

up with anything in the ‘other’ category. Whenever you take money out of an ATM or anywhere else to put into your wallet or purse, note it in the ‘withdrawals’ category and add it to the ‘starting cash’ figure. At the end of the month you will know exactly where all of the petty cash went. There shouldn’t be any money in the ‘other’ category. Count the amount of cash left in your wallet or purse at the end of the exercise and deduct that from the starting cash total and any withdrawals from the ATM. This should come to the same number as the total amount spent. The first time people do this exercise there is usually a large ‘difference’ at the bottom because this is the amount ‘missing’. Now multiply the amount for each category by 12 to find the total for the whole year. Also multiply the ‘missing’ amount by 12 because this is the amount that goes ‘missing’ for the whole year. This exercise always surprises. You realise just how much you spend on a whole bunch of ‘little things’ that really aren’t important in the scheme of things.

Credit card budget Another good way of tracking where your money goes is to look at your credit card statements each month. Estimate how much you spend on your credit card(s) each month. Write the number(s) down right now. Now take a look at the last half-a-dozen statements (or check online) to find out what you really spent. The amount you actually spent is probably at least double the amount you thought you spent each month on cards. Each time the statement arrives and it looks more than it should be, and more than your mental estimate of your average monthly spend on the card, go through each item and make sure you know what it is. If you come across an unknown item, ring the card company and get them to track it down. And remember, never use credit cards to borrow money. That means never leave a balance unpaid at the end of the month — always pay it off in full. One large item on credit card statements is probably going to be interest. If you carry credit card debt from month to month, you’re paying a huge price — probably between 15 per cent and 20 per cent interest rates — often even more. And if you leave a balance at the end of each month, you end up paying interest on the previous month’s interest. It gets very expensive very quickly. If you’re not paying off the credit card fully each month, then you’re carrying debt at exorbitant interest rates and you’re living beyond your means. There are also more ways to spend less and invest more in my first book, How to Give Your Kids $1 Million Each!

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$1 Million for Life

Action plan 1

Estimate how much you earned last year (after tax).

2

Estimate how much you spent. Was it more or less than you earned?

3

Make a list of five small expense items that are not important in the long term and you could do without, or could reduce.

4

Do the leakage test on your water, gas and electricity meters for a day.

5

Check your local paper (the weekend edition) for auction firms dealing with household items.

6

Work out how much petty cash you spend each month and find out where it actually goes.

2.3 Eliminate personal debt In chapter 1 I noted that the $1 trillion in superannuation accounts in Australia is matched by the $1 trillion in household debts, so that if everybody in Australia cashed in their superannuation fund balances today, they would only just pay off their household debts, leaving nothing for the future. The nation’s super accounts are growing rapidly, but so are our debts. As a nation, we are not actually getting ahead.

Debt — the ‘good’, the ‘bad’ and the ‘okay’ Almost everybody has to borrow money at some point. It’s impossible to go through life without debt of some sort at various times. The problem is that there are some situations where debt can be good and others where debt can be bad. Generally, the best kind of debt is where the asset being bought with the debt generates income and appreciates in value over time, and where the interest is tax deductible. The worst kind of debt is where the asset depreciates (or has no monetary value at all, like living expenses or holidays) and the interest is not tax deductible. Ironically, debts to buy things with the least value carry the highest interest rates. Table 2.2 is a summary of the various kinds of household debts.

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Step 1 — money sense

Table 2.2: ‘good’, ‘okay’ and ‘bad’ debts Items bought with debt ‘Good’ debts

‘Bad’ debts

Value appreciates or depreciates

‘Good’, ‘okay’ or ‘bad’ debt

Investments

Yes

Appreciates

Good, but select wisely

Own business

Yes

Appreciates

Good, but high risk of failure

Generates future income

Good, but ensure there is clear link to future income

Education and training ‘Okay’ debts

Tax-deductible interest

Some

Your home

No

Appreciates

Okay, but pay it off quickly

Home renovations

No

Most depreciate

Okay, but only if selling immediately

Personal and household items

No

Depreciates

Bad — never do it

Expenses

No

No monetary value

Bad — never do it

The best types of debts are to buy investments, to fund your own business or pay for education and training that will increase your future income. In the case of education and training, some expenses will be tax deductible and others will not. Generally, courses that help you in your current career are tax deductible, but courses that prepare you for a new or different career are not. In both cases, debt should be used as a last resort if you have no other money available. Taking on debt to buy a home is okay because the asset grows in value over the long term, and because the interest rates are the lowest of all debts. You should still try to pay it off as soon as you can because the aim is to ultimately be completely debt free. The value of house renovations is discussed in chapter 3, but most don’t add value except in the very short term if you are planning to sell straightaway. What is of most concern here are the debts for household items and expenses, including credit cards, car loans, personal loans, boat loans, store loans, payday loans and all those wonderful sounding ‘buy now, pay nothing for two years’ loans. These are high interest rate loans that end up costing much more than the original price of the item you bought.

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$1 Million for Life

Pay off non-deductible debts The simplest, most basic, most tax-effective and most powerful thing you can do with surplus cash is pay off high interest rate non-deductible debts. The higher the interest rate on the debt, the more sense it makes to pay it off. As the interest is not deductible and you are making the repayments out of after-tax money in your pocket, the ‘true’ rate of these loans is much higher than the rate you think you are paying, as shown in table 2.3. This will depend on what tax bracket you are in. For example, if you are in the 31.5 per cent tax bracket and have a personal loan with a 20 per cent interest rate, the loan actually costs you more than 29 per cent per year.

Table 2.3: true (pre-tax) interest rates on personal debts True (pre-tax) interest rates in different tax brackets Types of loans

Interest rate

16.5%

31.5%

41.5%

46.5%

Car or boat

10% 12%

10.0% 12.0%

14.6% 17.5%

17.1% 20.5%

18.7% 22.4%

Personal

14% 16%

14.0% 16.0%

20.4% 23.4%

23.9% 27.4%

26.2% 29.9%

Credit card (including fees)

18% 20% 22%

18.0% 20.0% 22.0%

26.3% 29.2% 32.1%

30.8% 34.2% 37.6%

33.6% 37.4% 41.1%

Store, lines of credit, ‘buy now, pay later’

24% 26% 28% 30%

24.0% 26.0% 28.0% 30.0%

35.0% 38.0% 40.9% 43.8%

41.0% 44.4% 47.9% 51.3%

44.9% 48.6% 52.3% 56.1%

$100 costs you more than $100 Another way of looking at this is the actual dollar cost of these loans. As you are paying tax on the income you earn, and as interest on personal debts is not tax deductible, for every dollar you pay in interest on personal debts, you have to earn more than $1 in income. How much more will depend on your tax bracket. Table 2.4 shows the figures for each of the tax brackets for 2007 to 2008.

40

Step 1 — money sense

Table 2.4: additional income needed to earn to make each $100 repayment Income per year

Income tax bracket (including 1.5% Medicare levy)

Amount of money needed to make repayments of $100

$150 001 +

46.5%

$187

$75 001–$150 000

41.5%

$171

$30 001–$75 000

31.5%

$146

$6001–$30 000

16.5%

$120

Therefore, if you are in the 31.5 per cent tax bracket and you are considering taking on a personal debt with repayments of $100 per month, you need to earn an extra $146 per month just to make those payments.

Credit cards When I started out in the finance industry about 80 per cent of people paid off their credit card in full each month while the other 20 per cent carried the balance into the next month. It has gradually become worse over the past 25 years and now the figures are reversed — today only 20 per cent pay their credit card off, the other 80 per cent carry it into the next month. Not only that, but many people now have two, three or more cards. Credit cards have their advantages — the convenience of not carrying around cash and many have points schemes (so you can save up and buy a toaster in 10 years!). But the golden rule with credit cards is always pay off the balance each month. Never carry ‘core’ debt, which means carrying a balance over until the next month. And don’t even think about paying out the balance with a cash advance from another card — you won’t even get the interest-free period.

Debit cards are much better The rise of debit cards in the past few years has meant that there is no reason to have a credit card. If you need cash in an emergency, you should have an emergency cash fund for that purpose (see chapter 9). By using a debit card you are spending money in your bank account, not borrowed money.

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$1 Million for Life

If you want points, American Express and Diners Club have better points schemes than credit cards. They also have good interest-free periods and there is no credit — the balance must be paid off each month. But don’t get lured into taking the line of credit facility attached to these cards, because that’s just getting back onto the credit card treadmill again. Having a credit card is not like having money. If you are thinking of buying something with a credit card and you are not certain that you will have the cash by the end of the month, don’t buy it. You can’t afford it. The best plan is to pay off you credit card, cut it up and get a debit card instead.

‘Buy now, pay no interest for three years!’ We’ve all seen these advertisements on TV. But ‘interest-free’ doesn’t actually mean there are no fees or other costs. Usually there are application fees, establishment fees, service fees, late-payment fees and all sorts of other fees and costs buried in the fine print. If you are late with just one repayment, you can be hit with the entire interest bill for the whole period, plus more fees and charges. When you read the fine print you find out what the deal really is. ‘Interest-free’ periods of 24 months often turn out to be only 12 or 18 months in the actual contract. Don’t trust the big sign in the shop window. Even the interest rate specified in the contract is usually near 30 per cent but once you add in the fees it can be over 50 per cent per year interest. This should be outlawed, but it’s a free country, I guess. Never sign anything on the spot. Take the paperwork home and read in from front to back including — and especially — all the fine print. The best plan is to always pay cash (which includes debit cards). Retailers generally give you a discount when you pay cash, so a $2000 TV may only cost you $1800 instead of the $4000 or so it would end up costing with a ‘pay nothing for three years’ store loan. If you can’t afford to buy what you want with cash, then you can’t afford it. Save up for it instead. For most electrical goods, in the time it takes to save up for them, the cost will often have come down so you will save even more. So, make your first and most urgent priority to pay off all non-deductible debts — starting with the one with the highest interest rate.

Payout penalties Many types of personal debts are fixed rate loans such as most car, boat and personal loans. This usually means that they have restrictions on making extra payments or paying out early. Often if

42

Step 1 — money sense

you make extra payments on these types of loans it just pushes the loan into ‘advance’ and doesn’t actually reduce the loan principal. The best way of finding out is to read the fine print or ring the lender direct and ask how to pay it off early or more quickly. In many cases there are penalties for paying out the loan early, but the penalty may be worth paying if it ends up saving you much more in interest over the whole term. The best plan is to negotiate. Tell the lender you are having trouble making payments, even if you aren’t, so the lender will be keen to help you — to save hassles and legal costs later. You’ll generally find lenders willing to find the easiest way out, which may be to your advantage.

Action plan 1

Total the balances of all debts and loans in your family.

2

Which are the ‘good’, ‘bad’, or ‘okay’ debts and why?

3

Find out the interest rate and fees on all your loans and debts.

2.4 Deal with money in the right order Australia is near the top of the table in terms of highest income per head in the world, but we’re near the bottom of the table for net savings rates. The problem is that most people deal with money in the wrong order. When they have money in their pocket they spend most of it, then try to put aside some for savings, and then have nothing left over to invest for the long term. That’s why most people spend too much — they have very little savings and no investments. So whenever you receive any money you must learn to deal with it in the following order every time — no exceptions: Invest first, save next, spend last. That’s all there is to it. You must learn to do this like clockwork, without even giving it a second thought. Do this every time you are paid, or receive a pay rise or bonus or an inheritance, or when you sell a car, or are given money for Christmas or a birthday. Every time you have to make a decision about what to do with money.

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$1 Million for Life

Investing versus saving There is a huge difference between investing and saving. ‘Investing’ means putting money away to generate wealth for the long term. It is invested in growth assets and never cashed in and spent. If you do sell an investment asset, the money should be put back into other investment assets. ‘Saving’ means putting money away to pay for specific items in the future. Saving is just deferred spending. Once you buy the item you’ve saved up for, the money’s gone and you have to start saving all over again for the next item. Both investing and saving are very important parts of your financial plan. How to select different types of investments, products and accounts depending on whether you are saving or investing is covered in chapters 6, 7 and 8.

How to get the order right You are never going to build wealth if you spend first, save next and invest last. It’s never going to work because there is no built-in discipline. This method is bound to fail because it relies on there being something ‘left over’ to invest — it’s the last priority. But investing for the future should be your first priority, not your last. Fortunately, it’s easy to change the order of your actions so they happen like clockwork every time: 1

Invest first — have part of your salary paid directly into your investments (for example, into an online broker cash account).

2

Save next — have the balance of your salary paid directly into a high interest rate account. You can also increase the direct payments into your mortgage.

3

Spend last — when you need cash to pay expenses, transfer it into your transaction account.

You can set your own ‘budget’ of, say, $200 per week for expenses, by setting up an automatic online transfer from your high interest rate account to your transaction account. Every week you will see whether you spend the $200 or not. If you spend less than $200 in a particular week, it sits there in the transaction account and carries forward into the next week. The great benefit of setting up direct salary deductions and direct debits into your savings account, your mortgage and your investment account, is that the money is not in your spending

44

Step 1 — money sense

account in the first place. You can’t be tempted to spend it because it is not there to be spent. It’s already been put to better use elsewhere. You can set up this structure starting today and it costs nothing. This is covered further in chapter 8.

Action plan 1

Ask your payroll manager whether your pay can be split and put into two or more separate accounts.

2

Make a list of the specific items you want to save for over the next couple of years. How are you going to pay for them? Do you have a separate account or accounts specifically for these items?

2.5 Small amounts add up to a fortune over time We have seen how spending small amounts can really add up over time. This same principle can be used with investing money to build wealth. Small amounts put away regularly and invested wisely can turn into a fortune.

The $1 per day plan In my first book I set out a plan that just about every family could use to build a $1 million fund for their kids by putting aside $1 per day. There are four simple rules: 1

Make regular contributions.

2

Invest the money in low-cost, tax-effective growth assets.

3

Reinvest all earnings to make the fund grow faster.

4

Never cash it in and spend it.

If you start from when the kids are born, you can turn $1 per day into $1 million by the time they turn 50. There are plenty of ways to do it more quickly — by putting in more than $1 per day, by increasing the contributions each year, or by topping it up with extra amounts at birthdays and

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$1 Million for Life

Christmas. The money is invested in the same low-cost, tax-effective growth assets that are set out in this book. Here’s how the basic $1 per day plan works:

Initial amount invested

$1

Contributions per month

$31

Increase in contributions per year

0%

Additional one-off contributions per year

$0

Total returns after tax per year

12.0%

Inflation rate per year

2.5%

The outcomes of the $1 per day plan are shown in table 2.5.

Table 2.5: outcomes of the $1 per day plan Years

Total contributions

Value of fund

Real value of fund (in today’s $)

Real value of income stream p.a. (in today’s $)

10

$3 721

$6 883

$5 377

$269

20

$7 441

$28 257

$17 245

$862

30

$11 161

$94 642

$45 120

$2256

40

$14 881

$300 825

$112 036

$5602

50

$18 601

$941 196

$273 834

$13 692

The fund will reach the $1 million target in just over 50 years on the basic $1 per day plan, without ever increasing the contributions or topping it up along the way. Money buys choices. This plan is designed to give kids real choices later on in life. They will be able to choose to work because they want to, not because they have to. Following the success of my first book, there are thousands of parents who have started this plan for their kids. It works, you can start it today with just $1 and it costs nothing to set up. This is fine for the kids, but 50 years is a long time to wait. These same principles and investments can be applied to adults as well, by putting in more money each month.

46

Step 1 — money sense

Compounding Table 2.5 shows that it is possible to generate $1 million, even though you contributed less than $19 000 to the fund. The rest of the money came from reinvesting all of the investment earnings and leaving it alone for the whole period. It’s called compounding. The trick is to take the investment earnings from the fund and reinvest them in the fund so they add to it. Year after year of earnings upon earnings results in $19 000 turning into $1 million. We have already seen how the average family earns about $1 500 000 in their working life and, after tax and mortgage or rent, has $1 million left to spend. This $1 per a day plan takes just $19 000 of that $1 million spending money and turns it into another $1 million.

The $500 plan If you can afford to set aside $500 per month ($16 per day) to invest, you can start the $500 plan. It is based on the following assumptions:

Initial amount invested

$500

Contributions per month

$500

Increase in contributions per year

5.0%

Additional one-off contributions per year

$500

Total returns after tax per year Inflation rate per year

12.0% 2.5%

Notice that, in addition to making the regular $500 contributions per month, you increase the contributions by 5 per cent each year (to stay ahead of inflation) and you make an additional one-off contribution each year, perhaps from your bonus. The fund is invested in the same types of growth assets — shares and listed property. In chapters 6 and 7 I explain how a broad spread of shares and listed property trusts can generate annual returns of about 12 per cent, tax effectively and with low costs, over long periods. The returns from shares and listed property are so tax effective that it makes very little difference whether the assets are owned by a super fund or by taxpayers even in high tax brackets. In practice, investment funds outside super are usually in the name of the spouse in the lower tax bracket so that the tax effectiveness of the plan is maximised. The outcomes of the $500 plan are shown in table 2.6 (overleaf). 47

$1 Million for Life

Table 2.6: outcomes of the $500 plan Years

Total contributions

Value of fund

Real value of fund (in today’s $)

Real value of income stream p.a. (in today’s $)

5

$36 154

$47 964

$42 394

$2120

10

$80 967

$143 744

$112 292

$5615

15

$137 471

$328 021

$226 488

$11 324

20

$208 896

$672 542

$410 433

$20 522

25

$299 363

$1 304 922

$703 863

$35 193

30

$414 133

$2 451 580

$1 168 773

$58 439

Using this plan it would take just under 23 years to reach $1 million. It would take 29 years to reach $1 million in today’s dollars (after inflation). This $1 million fund would then generate investment income of $50 000 in today’s dollars per year, rising for each year for inflation and never eating into capital. This $500 plan would allow somebody who is, say, 30 years old today to build a $1 million fund (in today’s dollars) over 28 years — and start living off the $50 000 investment income for life at age 58. This would be on top of her super fund and any other investments she may have.

The $1000 plan If you can afford to set aside $1000 per month ($33 per day) to invest, you can use the $1000 plan. This plan is based on the following assumptions:

Initial amount invested

$1000

Contributions per month

$1000

Increase in contributions per year

10.0%

Additional one-off contributions per year

$1000

Total returns after tax per year

12.0%

Inflation rate per year

2.5%

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Step 1 — money sense

The outcomes of the $1000 plan are shown in table 2.7.

Table 2.7: outcomes of the $1000 plan Years

Total contributions

Value of fund

Real value of fund (in today’s $)

Real value of income stream p.a. (in today’s $)

5

$79 261

$104 122

$92 029

$4601

10

$202 249

$344 472

$269 101

$13 455

15

$397 270

$862 447

$595 490

$29 775

20

$708 300

$1 927 324

$1 176 190

$58 810

25

$1 206 165

$4 048 844

$2 183 908

$109 195

30

$2 004 928

$8 182 006

$3 900 711

$195 036

Using this plan it would take 16 years to reach $1 million. It would take just over 18 years to reach $1 million in today’s dollars (after inflation), which would generate investment income of $50 000 in today’s dollars per year, rising for each year for inflation and never eating into capital. The $1000 plan would enable somebody who is, say, 30 years old to build a $1 million fund (in today’s dollars) over 18 years, and start living off the $50 000 investment income for life at age 48. Again, this would be on top of his super fund, which he could access at age 60.

The $2000 plan If you have a high income and want to really accelerate your investments, you can try the $2000 plan, which requires $2000 per month ($66 per day). This plan is based on the following assumptions:

Initial amount invested

$2000

Contributions per month

$2000

Increase in contributions per year

20.0%

Additional one-off contributions per year

$2000

Total returns after tax per year

12.0%

Inflation rate per year

2.5% 49

$1 Million for Life

The outcomes of the $2000 plan are show in table 2.8.

Table 2.8: outcomes of the $2000 plan Years

Total contributions

Value of fund

Real value of fund (in today’s $)

Real value of income stream p.a. (in today’s $)

5

$190 598

$245 757

$217 214

$10 861

10

$645 008

$1 016 951

$794 441

$39 722

15

$1 760 843

$3 226 092

$2 227 506

$111 375

Using this plan it would take just 10 years to reach $1 million. And it would take only 11 years to reach $1 million in today’s dollars (after inflation), which would generate investment income of $50 000 per year, rising for each year for inflation and never eating into capital. This $2000 plan would enable somebody who is, say, 40 years old today to start living off the $50 000 investment income for life at age 51. Again, this would be on top of her super fund, which she can access at age 60. The products you can use to set up these plans and invest your money are set out in this book. You can set up the accounts for free in a couple of days and start on your way to $1 million.

Action plan 1

Estimate how many years you would like to take to build your $1 million fund (be realistic — don’t just say ‘next week’).

2

Using tables 2.5 to 2.8, estimate how much you would need to put aside each month for investment.

2.6 Types of tax You have probably heard of a popular book called Men are from Mars, Women are from Venus. It’s about how different men and women are, it’s like they come from different planets. I don’t know about that, but the tax system has its own planetary system — salary slaves are from planet Tax, business owners are from Pluto and investors are from a different galaxy altogether. 50

Step 1 — money sense

Salary slaves are hit the hardest by income tax. The marginal tax scales — going right up to 46.5 per cent tax rates — may look scary, but only salary earners end up paying anything like the marginal tax rates. Income tax is taken out of their pay packets by their employers before they are even paid, and there are relatively few deductions available for salary earners to reduce tax.

Business Business owners are on a different tax planet — a planet a long way away like Pluto. Business owners generally have much more flexibility in tax planning than salary slaves. Ask most business owners how much they pay in tax each year and they will often say something like, ‘It depends on how much I want to pay’. It’s not that they can choose to pay tax or not, it’s that they can pick and choose the timing of transactions and events that can affect when tax is paid. Business owners have a lot of control over many aspects of their business, which can vary the tax they pay — for example, when to send invoices, pay creditors, buy new equipment, pay interest on business loans, write off bad debts, how much salary to pay themselves, how much to contribute to their super, how to depreciate assets, the list goes on. If you run a business make sure your accountant shows you how to plan your business so that you pay no more tax than you need to. The tax office has a set up a simplified tax system (STS) for small businesses — generally those with an annual turnover of less than $2 million. It includes a number of benefits. The problem is that the STS is so complex only about 20 per cent of eligible businesses use it! And most accounting firms and tax agents don’t even bother using it. It is far too expensive to implement and there is too much extra paperwork involved. If you run a small business, talk to your accountant or tax agent about the STS. If they don’t use it, ask if they can recommend another firm that does. It could save you thousands in tax.

Tax on investors Investors are in a different galaxy altogether when it comes to tax on investments. When you own long-term growth investments, like shares and property, your investment income will come in a variety of forms. For every dollar of investment income you receive, some is taxed at the normal rates, some is tax free, some is tax deferred (meaning it’s only taxed when you sell the assets, which may be never), some comes with franking credits, some with capital gains tax discounts, and some is from capital returns, buybacks and all sorts of other things that have tax breaks attached to them. The proportions in this mix are different depending on the types of investments you own and what

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$1 Million for Life

has happened in the investments each year. But the net effect is that tax rates on investment income generally end up being very low.

‘Shock, horror — investor pays less than 1 per cent tax!’ Not only do investors pay low tax-effective rates on investment income, they generally pay no tax on any increases in value of the investments themselves. Let’s look at how the tax rules work for Ian the investor and Sally the salary slave.

Ian the investor Let’s say Ian the investor has an investment portfolio of Australian shares worth $100 000 at the start of the year. Over the course of the year the shares produced a total pre-tax return of 12 per cent ($12 000), made up of capital growth of 8 per cent (a gain of $8000) plus dividend income of 4 per cent ($4000) — these are the average returns achieved by shares over the long term. These dividends are fully franked. (Returns, franking and tax relating to shares are covered in chapter 6.) Of this total pre-tax return of $12 000, the $8000 capital gain is tax free because Ian didn’t sell the shares, and the $4000 in dividends comes with a tax break in the form of franking credits. Ian’s total pre-tax return of 12 per cent after tax if he was in different tax brackets is shown in table 2.9.

Table 2.9: total returns after tax for different tax brackets — fully franked Australian shares Total returns after tax (% p.a.)

Effective tax rate on total return (%)

Tax paid

Direct investor in 31.5% marginal tax bracket

11.91

0.71

$86

Direct investor in 41.5% marginal tax bracket

11.34

5.5

$657

Direct investor in 46.5% marginal tax bracket

11.06

7.9

$943

Even if Ian was in the highest marginal tax bracket of 46.5 per cent he pays tax of only $943 on his total investment return of $12 000. His effective tax rate is only 7.9 per cent of his total return and he achieves a total investment return after tax of 11.06 per cent for the year, as shown in table 2.9. Most working Australians earn between $30 000 and $75 000 and are in the 31.5 per cent tax bracket. If they held the same investments they would pay tax of only $86 on the investment return. This means the effective tax rate is only 0.71 per cent of the total investment returns of 52

Step 1 — money sense

$12 000, and the total after-tax return is 11.91 per cent for the year. So taxpayers in the 31.5 per cent tax bracket pay less than 1 per cent tax on investment returns. These are the results for fully franked Australian shares. Different mixes of investment assets have different tax outcomes, and these are dealt with in later chapters. But the overall effects are very similar to these results.

Sally the salary slave Let’s compare Ian the investor’s result with the situation of Sally the salary slave. If Sally was in the top marginal tax bracket and she received a bonus or a pay rise of $12 000 for the year, she would lose a whopping $5580 or 46.5 per cent of it in tax. Ian and Sally both generated additional wealth of $12 000 before tax for the year. If they were both in the top marginal tax bracket, they would pay vastly different tax. Sally made her money by working hard at her job, but she loses nearly half of it in tax. On the other hand, Ian made his money while sitting on a beach and he loses less than 8 per cent of it in tax. Not only that, Ian’s investment income will keep rising by around 5 per cent each year as economic growth flows through to company earnings and dividends, without Ian doing anything. Sally’s income will only rise next year if she works even harder than she did this year. The lesson is clear — refocus your efforts toward paying off debts and build your investment portfolio as soon as possible. It sure beats working!

Capital gains tax In Australia the owner of an asset generally pays no tax on the rise in value of the asset unless the asset is sold. If you own an asset for more than 365 days, if and when the asset is sold, only 50 per cent of the amount of the gain is added to your taxable income in the year in which the asset is sold. This is often referred to as the 50 per cent capital gains tax discount. Increases in the value of assets that have not been sold are called ‘unrealised’ gains (or unrealised losses if the value has fallen). Sales of assets for more than their cost are called ‘realised’ capital gains. Generally, only realised capital gains are taxable. Long-term investment plans usually use growth assets where most of the investment returns are in the form of unrealised capital gains and are therefore generally tax free. As seen in the case of Ian the investor, taxes can be minimised by holding growth assets over the long term. Try to minimise buying and selling assets if your aim is to generate long-term wealth. The best plan is to choose long-term growth investments carefully and never sell them. 53

$1 Million for Life

Tax deductions, rebates, offsets and allowances About 75 per cent of Australians use tax agents and accountants to do their annual tax returns. The Australian tax system is one of the most complex in the world and it is impossible to keep up with all the changes. If your tax agent or accountant isn’t finding new deductions, rebates and offsets each year, then he probably isn’t doing his job. You can visit the Australian Tax Office website for information but it is extremely complex and very hard to use. The names and locations of documents are constantly changed, so the best thing to do is start from the home page and search the various databases for the topic you are after. There are also dozens of different benefits and allowances paid to individuals and families. Most are for low-income earners, but many extend to families earning up to $100 000 and others are non–means-tested, meaning they are available to all. See the Family Assistance Office website for more information. The net effect of all these tax deductions, rebates, offsets, benefits and allowances is that families earning up to around $50 000 per year should end up paying no tax at all. In addition, seniors can draw unlimited tax-free pensions from their super funds and can also earn over $40 000 per couple in investment income outside super before paying income tax. Remember, every dollar you save in tax is a dollar you can put towards your investments. Don’t spend it, invest it.

Who should own investments for tax purposes? Generally, if you are going to start an investment plan the investments are held in the name of the family member in the lowest tax bracket. This often means the spouse who is not working or working only part-time, or who is planning to take time off work in the future. This will ensure that the tax is minimised and that more money can be reinvested into the investment portfolio to make it grow faster. There are a lot of different factors that come into play, including entitlements to benefits and allowances, so it is important to talk to your tax agent or accountant first.

Negative gearing For negative gearing plans, think about who should hold the investments and the loans. In the early years the plan is most effective if held by a person in a high tax bracket, but in later years, once the cash flow is positive, it is better if held by someone in a low tax bracket, especially if you plan to sell the property or shares later on.

54

Step 1 — money sense

Kids over 18 Adult children (over 18 years of age at 30 June in the particular tax year) can also hold investments as they have the full benefit of tax-free thresholds and low-income tax offsets.

Tax on kids Kids under 18 years old are taxed at the normal rate on income earned from genuine employment — for example, from casual work. Any income received by kids from investments (including interest, dividends and so on) is taxed at penalty rates. At the time of writing, the tax rules for children’s investment income are as follows: 9

The first $416 of investment income is tax free.

9

Investment income between $416 and $1445 is taxed at 66 per cent.

9

Investment income over $1445 is taxed at the top marginal rate for adults.

This all sounds nasty, but it is not as bad as it seems. There is a low-income offset that is available to all Australians earning low incomes. If the income is below $30 000, they will receive a credit of up to $750 on any tax payable. Low-income earners are also able to avoid paying the Medicare levy of 1.5 per cent. All of this ends up being quite favourable for kids. If they own growth investments, they can earn up to about $2500 before paying any tax (depending on the tax advantages attached to the income distributions), which means they can hold investments worth up to about $50 000, assuming tax-advantaged yields of, say, 5 per cent. I go into much more detail about how to set up investment funds for kids in my book, How to Give Your Kids $1 Million Each!

Companies and trusts The advantages and disadvantages of holding investments in companies and trusts are explored in chapter 9.

Action plan 1

If you have a tax agent or accountant, did she find new deductions and offsets for you last year? 55

$1 Million for Life

2

If you operate a small business, are you using the simplified tax system? If not, ask your accountant why.

3

Are your investments in your name or your spouse’s? Why?

2.7 What to avoid Most of this book discusses what to invest in, but there are a host of things that you need to avoid. When something looks too easy and there are great promises of high returns, you’re bound to end up in trouble.

Scams The Australian Competition and Consumer Commission (ACCC) estimates that over $1 billion is scammed from Australians each year. There are thousands of different types of scams. You may have heard of one or more of the following: 9

Nigerian scam. This scam is in the form of an email supposedly from a Nigerian government minister trying to get several million US dollars out of the country. The email asks for your bank account details so the sender can use it to get the money out. In return, you are promised 10 per cent of the money, but of course you lose everything in you bank account. This scam continues to rake in millions of dollars from people who are tempted by the chance to make money quickly.

9

Spanish lottery. There are variations on this simple scam, usually the scammers send an email announcing that you have won a prize in a foreign lottery. The catch is you need to provide them with identification and bank details, or a fee, or both, in order to claim your prize. Sounds silly, but it rakes in millions from innocent victims each year.

9

Stock ‘bucket shops’. This scam is usually in the form of emails or phone calls from people pretending to be stockbrokers — generally operating in Thailand or Malaysia. They promise quick money by buying stocks. Often the stocks are real, so they actually exist if you check them out on any free US stockbroker website. The problem is that you need to provide your bank details so they can buy the stocks for you. This scam has also been going on in various forms for many years.

56

Step 1 — money sense

9

Fake bank websites. Over the past couple of years there has been a huge increase in the number of spam emails from scammers pretending to be banks. The emails look legitimate — they have all the right logos and pictures. They usually warn of a system problem, website maintenance or security check, and ask you to click onto a bogus site and ‘confirm’ your security details. Never answer or click on any emails from what claims to be a bank or other financial institution — even from your own bank. The only exception is if it is from a specific person who you know in your bank and you have told them that they can email you.

Tax-based investment schemes Beware of anything that is sold purely or primarily on the basis of tax savings. If you are going to invest in a scheme promoted just before the end of the financial year, do your own independent enquiries and invest in the business on its merits. The tax deductions are a nice bonus on top, but first and foremost make a decision on the merits of the actual business involved. The best way is to have recommendations from people you know and trust, and who have their own money in it as well. In the early 1990s I got a call from a good friend of mine in Melbourne who had bought into a tax-based investment scheme based on a tree plantation somewhere in remote Queensland. The investment cost $40 000 and he borrowed the whole amount and pre-paid the first year’s interest on the loan, so it didn’t actually cost him any money up-front. The loan was organised by the same firm promoting the scheme. That way he got an immediate tax deduction for the first year’s interest on the loan. Not a bad deal — no money to pay to get into the deal and he got an immediate tax refund in the first year. I said that I was naturally sceptical about these types of schemes, but I hoped that he was lucky and that maybe it was legitimate. I encouraged him to find out where the plantation was supposed to be and visit it to fi nd out whether it actually existed. A couple of years later we were talking again and he said that he didn’t have time to go and see it for himself, but he reasoned that it was a legitimate venture because he received a distribution cheque a few months earlier. I warned him that the promoters often send back a little bit of the investors’ own money in the first few years, just to keep them happy and make it look as if the investment is producing some returns. Unfortunately, about five years later he told me the whole sorry story. After the first two small annual cheques in the mail, the cheques stopped and the promoters were neither seen nor heard

57

$1 Million for Life

from again. They disappeared with the money and there was no plantation. It was a scam right from the start. The lesson is this — just because a scheme seems to be supported by legitimate-sounding accountants, lawyers and ‘expert’ consultants, don’t trust it. Check on the operation yourself. After all, it’s your money. If it’s too far away to check personally, and if you don’t have someone you trust completely to check it out for you, then don’t touch it.

Time share and flats off the plan You can’t walk down the street on the Gold Coast or Sunshine Coast without being harassed by numerous offers of free cameras and phones if you just attend a seminar selling flats off the plan or time share. I have met many people over the years who bought timeshare units. Probably 75 per cent had negative experiences and 25 per cent had great experiences — they used the unit regularly and they could swap their time for time in other resorts all over the world. The best advice I can give is: 9

Never buy retail, only buy on the secondary market, which is usually at least one-third off the ‘new’ price. The rest is sales commissions. Try eBay or google what you are looking for. There is a generally a healthy secondary market for timeshare units in good resorts.

9

Only buy after you get positive recommendations from friends or colleagues you know and trust.

Don’t follow the herd Most investment markets work in cycles. This goes for property, shares, bonds, gold and just about everything else. The general rule is that when everybody is buying it’s time to sell, and when everybody is selling it’s time to buy. Markets have always been dominated by two factors — fear and greed. Markets swing between frenzies of fear and frenzies of greed. Buy (or at least don’t sell) during periods of frenzied fear, when everybody thinks the sky is falling and it’s the end of the world. Sell (or at least don’t buy) in periods of frenzied greed, when everybody is piling in as if there is no tomorrow. For example, when everybody is talking about how easy it is to make money in dotcom shares or mining shares, that’s when you know it’s time to sell dotcom shares or mining shares, or at least

58

Step 1 — money sense

don’t buy any. If you are a long-term holder of those stocks, you probably bought them before they became ‘fashionable’ so you would not sell them now in the frenzy of greed. But you would probably not buy any new ones because market greed has pushed the prices too high. Markets always overshoot on the upside, meaning that prices rise way above where they should really be. At the bottom of the cycle, prices also overshoot on the downside, meaning you can buy bargains when everybody else is selling. As long-term investors we are going to try to ignore all this short-term cyclical ‘noise’ in the market and focus on what we are investing in, not what the share price might be today or tomorrow. The share price often has little to do with what’s actually going on inside the company.

Don’t invest in anything you don’t understand Most people become successful by doing what they know best — that is, by getting to know their area of specialty inside out. At the same time, it’s important to try new things and learn new skills. But start slowly, take one step at a time and learn the basics before getting into some complex schemes you don’t fully understand. Several years ago I got a call from a friend of a friend who wanted to borrow $30 000. She had been talked into buying a header used for harvesting cotton. She had signed a lease deal on the machine and she didn’t have the $30 000 to make the first lease payment. The plan was to rent out the machine to harvesting teams who would use it to harvest crops up and down the cotton belt in western New South Wales and up into Queensland. She was based in Sydney and didn’t know much about cotton farming and couldn’t explain to me how the profitability of this sort of venture worked. I made a few calls and talked to a few people but nobody could explain to me in simple, clear, practical terms whether or how it would make money. I had to say no to her because there was no way I was going to take on a five-year leasing commitment on a machine worth several hundred thousand dollars without a clear onepage business plan I could understand. Perhaps I missed out on a great opportunity to make a lot of money, but perhaps I saved myself a lot of pain and headaches. I will never know. It wasn’t worth the risk to find out. The fact is, there are plenty of ways to build wealth that don’t involve complex schemes. You can do it using simple investments that don’t pay sales commissions and therefore have low costs and no pushy sales reps. Take your time and learn about each new type of investment as you go. The Australian Securities & Investments Commission (ASIC) has a useful website that provides updates on the latest scams, see .

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$1 Million for Life

2.8 A new way to look at spending Think back to the last time you made a decision to spend $20 000. Perhaps it was buying a car or a boat, renovating the kitchen or taking a holiday. Now think about that $20 000 in three different ways: 1

As the cost of the item you bought.

2

If you had invested the money in shares and listed property instead of spending it, that $20 000 would not only produce investment income of around 5 per cent or $1000 per year tax-effectively, it would also keep growing well ahead of the inflation rate. So think of that $20 000 as $1000 investment income per year for the rest of your life, starting today, and rising for inflation along the way — it’s not much, but it’s not a bad start.

3

If you don’t need the investment income right now, you could buy those same shares and listed property investments with the $20 000 generating total returns averaging 12 per cent per year and you could reinvest the earnings for 10 years into more shares and listed property. After 10 years of reinvesting the earnings, your $20 000 initial investment would have grown to $62 000, without you putting in one more cent. After 10 years that $62 000, still invested in those same investments, would be generating 5 per cent tax-effective income or $3000 investment income per year for you to live off for the rest of your life, increasing for inflation each year.

Now you know how it works, think of all the $20 000 decisions you can apply this thinking to: 9

a $30 000 car versus a $50 000 car — that’s often the difference between a new car and a similar one a couple of years old

9

a $10 000 kitchen renovation consisting of new bench-tops and appliances versus a $30 000 complete kitchen refit

9

a $10 000 holiday versus a $30 000 holiday

9

a $30 000 second-hand boat versus a $50 000 new one

9

$5000 spent on bathroom resurfacing and new fittings versus a $25 000 renovation

9

a $20 000 upgrade package when buying a new house (better carpets, tiles, appliances and so on). 60

Step 1 — money sense

Each of these items either depreciates rapidly over time or is gone immediately.

Renovations In the case of improvements to your house, whatever you do now will be out of date or broken and need replacing in a few years. Unless you are selling immediately, renovations — especially to kitchens and bathrooms, which have a high component of appliances and fittings — depreciate quickly and don’t add value in the medium to long term.

Holidays In the case of holidays, what you are buying is memories. When it comes down to it, a $500 per night bed is the same as a $100 per night bed. All the fancy extras at expensive hotels — restaurants, bars, health spas, massage treatments and so on — you have to pay more for anyway. Cheaper holidays can often create more memories than the expensive ones. Take a look in your photo album to see which holidays have the most pictures. Often the best memories come from the simple things in life.

It all adds up Each of these decisions can make a $20 000 difference in cost today, or can be turned into $3000 in investment income beginning in 10 years, every year for the rest of your life, rising for inflation each year and not eating into capital. If you make just one of these decisions every two years over your working life of, say, 30 years, that makes 15 lots of $62 000 capital, generating 15 lots of $3000 annual investment income. That’s a total of $930 000 in capital generating $45 000 in tax-effective investment income for the rest of your life and increasing for inflation each year. There’s a good chunk of your investment income for life taken care of, even without super or other types of investments. You don’t have to wait for a $20 000 decision. It works for any amount of money you spend. Think to yourself: ‘Do I really need it? Will it make any difference in 10 years whether I spend this money now?’ When in doubt, invest the money instead. You want $1 million generating an income for life? There it is — just by making one good $20 000 decision every couple of years, or a lot of smaller ones every few months or so.

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$1 Million for Life

Making these decisions is one thing, but putting each lot of $20 000 to good use by investing it wisely is another. Use this book to invest the money, watch it grow and never cash it in and spend it. There’s your $1 million fund for life.

2.9 Investment principles There are a number of principles to follow when investing.

Investment objectives The aim of investing is to build wealth and provide financial freedom. There are several objectives to keep in mind when choosing how to invest: 9

generate capital growth

9

generate income

9

beat inflation

9

ensure safety of capital

9

manage risk

9

minimise fees and costs

9

minimise tax

9

maintain liquidity.

Investment returns — growth and income When we invest we are aiming to generate an investment ‘return’ on our money. The return we achieve is the reward for giving somebody else the use of our money over the period. Different types of assets generate capital growth or income, or both. ‘Income’ returns are in the form of interest on cash or fixed interest, dividends from shares and rent from properties. ‘Capital growth’ is in the form of increases in the value of our investments over time. Capital gains are realised when we sell the assets, or unrealised if we don’t sell them. 62

Step 1 — money sense

The total returns from an investment consist of any increases in capital value plus any income from the investment. To build wealth over the long term investment assets that comprise mainly capital growth plus tax-effective income — shares and property — should be used.

Inflation Inflation eats away at the value of money over time. If you put away $100 in a drawer today and take it out at the same time next year, it will have lost about 2 per cent to 3 per cent of its buying power, because prices will have increased by that much over the year. The cost of some things will have increased by more than this rate like child care, school fees and health insurance. Other things will have dropped in price like electronic gear and toys. The price of other items could be up or down — like petrol, which depends on the international oil price, and fruit and vegetables, which depend on the drought. But the overall inflation rate will be about 2 per cent to 3 per cent for the year. The government uses a broad selection of household items to measure the inflation rate each quarter. The annual inflation rate averaged just below 4 per cent during the 20th century. Figure 2.2 shows Australia’s annual inflation rate between 1901 and 2006.

Figure 2.2: annual inflation rate — Australia 1901 to 2006 20% 20% 15% 15% 10% 10%

-5% –5% Annual inflation rate Annual infl ation rate

–10% -10%

10-year moving average 10 year moving average

–15% -15%

Source: Australian Bureau of Statistics 6401.0

63

2005

2001

1997

1993

1989

1985

1981

1977

1973

1969

1965

1961

1957

1953

1949

1945

1941

1937

1933

1929

1925

1921

1917

1913

1909

1905

0% 0%

1901

5% 5%

$1 Million for Life

You can see that the inflation rate was negative during the Great Depression in the 1930s when prices dropped, and was highest in the early 1950s and early to mid 1970s due to a big-spending Labor government and the oil shocks. High inflation is bad — it discourages investment, which then limits employment and productivity growth in the economy. It is the Reserve Bank of Australia’s (RBA) responsibility to keep inflation within the range of 2 per cent to 3 per cent per year. It does this by setting the official ‘cash rate’ target. When inflation creeps above the target range (3 per cent), the RBA raises cash rates to slow the economy down, and when inflation falls below the target range (2 per cent) it cuts rates to stimulate spending and investment. You can find the current inflation and cash rates at the RBA’s website . Since Paul Keating’s recession ‘we had to have’ in the early 1990s, inflation has largely been kept within this 2 per cent to 3 per cent range. In the projections in this book I have assumed inflation will remain at an average of 2.5 per cent in the future. (It will generally be higher in times of economic boom and lower during the slowdowns.)

‘Real’ rates One of the key aims of investing is to make sure that our investments at least beat the inflation rate, otherwise they go backwards in ‘real’ terms. You will often hear people talk about the ‘real’ return from an investment. The ‘real’ rate means the rate after accounting for inflation. If a return is 6.0 per cent per year and inflation was 2.5 per cent per year, the ‘real’ rate is 3.5 per cent per year. When I talk about amounts of money in the future having a ‘real’ value ‘in today’s dollars’, it just means the amount it is worth today after taking inflation into account. For example, if an investment is going to grow to $100 000 in five years, it is worth only $88 385 in ‘real’ terms or ‘in today’s dollars’, because that is the buying power of that amount of money if I had it in my hands today.

Safety of capital and managing risk The first rule of investing is to not lose money. The safest assets are cash deposited in a licensed bank, and state or federal government bonds. Although these may be 99.99 per cent risk free, they are not 100 per cent risk free. There is still a remote risk that Australia will be invaded and all deposits and savings confiscated. There is no such thing as a completely risk-free investment. The second rule is that higher risk investments require higher rewards to compensate for the risk — that is, if an investment is offering a high reward (for example, high interest rate or high capital growth), it must be higher risk than an investment offering a lower reward. 64

Step 1 — money sense

There is a Macquarie Bank TV advertisement that promises ‘high rewards with no extra risk’. It shows a man throwing a small boomerang and when it comes back to him it has miraculously grown about 10 times. I always expect it to whack him in the head when it comes back. The ad reminds me that whenever you deal with those highly structured complex products promising high returns, you are likely to get whacked in the head with a giant wood boomerang. Higher rewards always carry higher risk. And, in the case of those highly structured complex products, higher fees as well.

Different types of risk There are a number of different types of risks. Let’s take a look at some of the main ones.

Loss of capital Loss of capital is what most investors usually consider to be ‘risk’. If you buy into a mortgage fund or debenture offering a much higher rate than the cash rate, there is a high risk of losing some or all of your capital. Some examples include Estate Mortgage, Westpoint, Fincorp and Pyramid. On the other hand, there is almost no risk of losing capital if you put your money in a bank deposit or government bond.

Rates of return will vary from year to year Fluctuation in rates of return is how professional investors define risk. Growth investments, like shares and property, may produce greater returns on average over the long term, but the ‘price’ of these higher returns is that returns vary significantly from year to year. If you buy shares in a broad range of, say, 20 listed companies, the risk of losing all of your capital is almost nil, but the returns will vary greatly from year to year. Even cash (for example, in bank deposits) is ‘risky’ because, while your capital value remains constant, the level of interest you receive will go up and down as interest rates rise and fall. Let’s say you have $100 000 in the bank and you are relying on the interest to live off. Your capital will always remain at $100 000 with almost no risk of loss, but the interest income might range from $2000 in some years up to $10 000 in other years if interest rates vary from 2 per cent to 10 per cent. You can’t rely on the interest income being steady, so it is ‘risky’. Bonds and other fi xed-interest investments are also risky. Let’s say you invest $100 000 in a 10-year 5 per cent government bond. It will generate a fi xed level of income each year, so you can rely on it to live off. However, the capital value will fluctuate as long-term interest rates rise

65

$1 Million for Life

and fall from year to year. If you try to sell your bond a couple of years later, it may only have a market value of, say, $90 000 if interest rates have risen since you bought it. You can rely on the income, but you can’t rely on the capital value remaining constant, even with a so-called risk-free government bond. Every type of investment asset carries risk because the returns always vary over time — even cash and government bonds. The greater the variability of returns (in income or capital or both) the greater the risk. When choosing investments you will need to consider the variability of returns in relation to what your investments are trying to achieve and what time period you have in mind.

The investment will not achieve what you want it to If you put your long-term investments into bank deposits and government bonds, there is a high risk (almost a certainty) that they won’t provide decent retirement capital or income because they will hardly keep pace with inflation after taxes. Growth assets offer greater, but more variable, returns that are tax effective and outpace inflation.

Owing more than you invested To end up owing more than you invested is worse than losing all your capital. In particular, with many types of derivatives, such as options, contracts for difference, futures and so on, you can end up owing more than you invested. Derivatives are covered in chapter 8.

Minimising costs and fees Another key principle with investing is to minimise costs and fees. 9

Transaction costs. Some types of assets have very high transaction costs. Property, for example, will often cost up to 5 per cent of the value of the asset to buy, and another 3 per cent to 4 per cent of the value to sell. In contrast, you can buy and sell listed company shares through a discount broker and it will cost only around 0.1 per cent of the value of each way.

9

Management or holding costs. Shares cost nothing to hold; property has ongoing costs like management fees, council rates, insurance and land tax; and managed funds generally charge annual management fees of around 2 per cent per year. The more complex the product, the higher the fees.

66

Step 1 — money sense

9

Sales commissions. Many investment products are sold by sales reps, who are generally paid an up-front commission and a ‘trailing commission’ each year you hold the investment, which really eats into your returns.

All of these fees and costs come out of your pocket and reduce your investment returns.

Minimising tax Income is generally taxable each year when we receive it. Some types of income returns have tax relief such as franking credits on dividends and tax deferrals on rent. On the other hand, capital growth is usually tax free until the investment is sold. Even when we sell, we generally receive a discount on the capital gains tax if the asset has been owned for more than one year. However, many investments we buy for the long term we will never sell, which means we never have to pay tax on the gains in value. Returns from growth investments, like shares and property, are in the form of capital growth; the income also has tax advantages. Income products provide income, but no capital growth, and these are generally used for reaching short-term financial goals.

Liquidity Liquidity is the ability to access your funds when you want them. Some assets are very liquid like cash held in a bank account. Cash can be withdrawn at any time the bank is open or via an ATM. Other assets take a few days. Shares in listed companies, for example, take three business days after you execute a ‘sell order’. Some listed companies are more liquid than others. For example, large ‘liquid’ stocks, such as the largest 100 or so listed companies, can be sold at the ‘market price’ in a few seconds because there are always lots of buyers and sellers in the market. Other smaller stocks are less liquid because there are fewer buyers and sellers in the market; you may have to wait several days or weeks to find a buyer for the price you want. Some types of assets have fixed terms, like bank term deposits, so they are locked away for a fixed period of time. Other assets are ‘illiquid’ because they take months to sell like real estate. Your superannuation fund is extremely illiquid because it is locked up until you reach your ‘preservation age’, which is 60 if you were born after June 1964. It is important to match the liquidity with the time in which you are likely to need the cash. For example, if you are planning to leave full-time work and rely on your investments at age 50,

67

$1 Million for Life

there is no point putting all your money into super because you won’t be able to access it when you need it. Likewise, you shouldn’t lock up cash in term deposits for, say, three months if you are going to need it the following week or month. Liquidity has a price — you generally receive higher returns on your investment as a reward for giving somebody the use of your money for longer periods. For example, some unlisted investment trusts and property syndicates don’t allow redemptions or they allow only partial redemptions during a fixed term. And they generally offer higher yields than listed trusts with essentially the same types of assets in them because your money is locked up for several years.

Diversify or specialise? Most people who build great wealth invariably do so by specialising, not diversifying. They usually throw everything they have at one particular business idea and stake everything on it. People who built great businesses generally got there by starting when they were young and putting their whole life into the business, but this practice is very high risk. However, most people don’t want to take the one-in-a-million route to building a business worth $100 million. The aim of this book is to give you the knowledge to build enough wealth to live life doing what you love doing. We have all seen stories in the news where investors ‘lost everything’ by investing in a failed venture. Often they have put their entire life savings into just one investment. They were invariably lured in by the promise of high returns, but didn’t understand the risks involved. In your long-term investment plan you should be minimising risk by diversifying your investments — across different assets, different classes or types of assets, and even across different countries. You will also need to include some protection measures for when things go wrong. Life is fickle. Things come up all the time that throw all sorts of obstacles and setbacks in your path. Your chances of success are much greater if you have all strategies working at once. As you get further along the journey to wealth you will start to develop a sense of which aspects interest you most. Invariably you will end up specialising in one or more things. It might be particular types of shares, renovating houses, or any one of a host of other areas. But take your time and diversify in the early years while you build up some expertise.

Different types of investments There are dozens of types of investment assets but they generally fall into four main asset classes:

68

Step 1 — money sense

9

shares (also called equities)

9

property

9

bonds (also called fixed interest)

9

cash.

Each of these asset classes can be further broken down into subclasses: 9

Shares can be divided into Australian shares, international shares, small companies, emerging markets companies, growth shares and defensive shares.

9

Property can be divided into residential, commercial, industrial, listed property trusts, unlisted property trusts and international property.

9

Bonds can be divided into government bonds, corporate bonds, preference shares and international bonds.

9

Cash can be divided into bank deposits, cash trusts and listed variable-rate debt securities.

These are covered in detail in chapters 6, 7 and 8 but for now, what’s important are the four broad asset classes. Each of these asset classes performs in a different way over time and is used to achieve different outcomes. Table 2.10 sets out their expected levels of return and characteristics.

Table 2.10: levels of return and characteristics of shares, property, bonds and cash Shares

Property

Bonds

Cash

Growth p.a.

7% to 9%

4% to 6%

Nil to 3%

Nil

Income

3% to 4%

6% to 8%

5% to 6%

4% to 6%

Inflation hedge

Good

Good

Some

None

Volatility

High

Moderate

Low to moderate

Low

Tax benefits

Good

Good

Some

None

69

$1 Million for Life

Shares and property — long-term growth assets Shares and property are referred to as growth assets because they are the primary ways of building wealth over the long term — that is, more than 10 years. Shares and property can be used to generate capital growth plus income. The value of these investments can vary significantly over the short to medium term, so if you are going to need access to the money in less than 10 years, you generally would not invest in shares and property. These are the primary assets used to create wealth in this plan — both inside super funds and outside super.

Bonds (fixed interest) — short-term and medium-term savings If you are going to need your money in less than at least 10 years, you should generally not be putting it into shares or property, and certainly not into your super fund unless you are nearing preservation age. You can use fixed-interest products for saving where you are planning on having cash for a particular purpose in a specific time period under 10 years. For example, if you are planning to upgrade your car in two years, go on a holiday in six months, or to save a deposit for a house in three years. We will look at various types of fixed interest (bond) products in chapter 8.

Cash — immediate or short-term access Money in cash accounts needs to be readily accessible as the funds are used to cover day-to-day living expenses. It is also useful to have an emergency cash fund, in case of unexpected bills, or temporary reduction or loss of income. This would normally be held in a separate account so it is out of temptation’s way and is not spent on day-to-day expenses. Searching for and selecting cash accounts are covered in chapter 8.

2.10 Key points 9

The average family spends at least $1 million over its life. If you capture just a tiny proportion of this and invest it instead of spend it, you can generate wealth and build your own $1 million fund for life.

9

There are lots of ways to spend less, but the trick is to find out where it goes in the first place.

70

Step 1 — money sense

9

Investing means using your money to build wealth and provide financial security over the long term. Investments should generate capital growth and income, beat inflation, manage risk, minimise taxes, fees and costs, and maintain liquidity.

9

There are four main asset classes — shares, property, bonds and cash. Shares and property are growth investments and have significant tax advantages, while bonds and cash provide income.

9

Investors pay low taxes compared with salary earners and businesses.

9

The only ‘good’ debts are those used to buy assets that generate income and appreciate, and where the interest is tax deductible. Taking on debts to buy your own house is ‘okay’ because it will appreciate, but pay it off as quickly as possible. The worst kind of debt is that used to buy items that depreciate like cars or household items — never do it.

9

Whenever you receive any money, invest first, save next and spend last. Regular salary deductions and debits into the mortgage and your investment plans ensure that you invest first, before you get a chance to spend it.

9

Almost anybody can build a $1 million investment fund by following four basic rules:

9

1

Make regular contributions.

2

Invest the money in low-cost, tax-effective growth assets.

3

Reinvest all of the earnings to make it grow faster.

4

Never cash it in and spend it.

Small amounts make a big difference in the long term, and the more you contribute the faster the fund will grow.

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Investments

Super

Protection House

Chapter 3

Step 2 — own your house outright

Money sense

Owning your own house is the most fundamental basis of all personal wealth and financial security. For the majority of households, the equity they have in the family home is by far their biggest asset. Although not counted as an investment asset because it doesn’t produce income to live off, equity in your home can still be a powerful asset to help create wealth. You may be tempted to skip past this chapter because you believe you have this topic covered. Perhaps you have bought your own place and taken on a mortgage, and are now paying it off. Or you may have decided go through life as a renter — for economic or philosophical reasons. I urge you to read on. Get this step right and it can make a huge difference between just owning a home and using your home to form a key part of your whole wealth plan. There are three elements to owning your house outright: 1

Own it, don’t rent it.

2

It should be a house — not a flat, unit or apartment.

3

Own it outright — pay off the mortgage. 72

Step 2 — own your house outright

3.1 Owning versus renting Renting the home in which you live does have some advantages over owning it. Renting allows freedom to move. The downside is that this requires short-term leases, which gives landlords the freedom to move you whenever the lease is up. Renting generally costs less than owning. If you take just about any house or unit in Australia, it’s likely to cost less to rent each week than to own. For example, a three-bedroom house in a typical suburb about 20 kilometres from the city in Sydney or Melbourne would cost about $400 per week to rent. But if you owned the same house it would cost around $750 per week in mortgage repayments. On top of that you would need a deposit of, say, $50 000 to start with. This example uses a house worth $500 000 purchased with a $50 000 deposit and a $450 000 loan at 7.25 per cent per annum over 25 years. The figures for houses in other cities would be a bit lower, but the relative cost of renting versus borrowing are very similar.

Dead money? Paying rent is not really ‘dead money’ because it means that for any given budget to spend on housing, a renter can live in a much better house and location than an owner can. This is why many renters find themselves stuck in a ‘rent rut’. The money they pay in rent can get them into a comfortable house or unit close to where they need to be, but they believe that the same money spent on a mortgage will only buy them a house in the outer suburbs. Many inner-city renters are put off by the prospect of going to the outer suburbs, so they put off buying for many years.

The ‘renting and investing is better than owning’ theory There is a theory put forward by some economists that renting is better than buying over the long term. According to this theory, as renting any given house or unit costs less than the mortgage payments required to own it, if you rent the house or unit and invest the extra money in long-term growth investments you would otherwise have spent on mortgage repayments, after, say, 20 or 30 years, your investment fund would be worth more than the house you would have bought. For example, take the typical three-bedroom house 20 kilometres from the city that costs $400 per week to rent or $750 per week in mortgage repayments. The theory says that if you rented and put the extra $350 per week into long-term growth investments, over time your investment fund would be worth more than the house.

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This theory is based on good economic logic. There is no doubt that the main type of growth assets (shares) will outperform the average suburban house or unit over the long term. The reason is that residential housing is a passive asset — it just sits there. The average suburban house will generally grow in value by a couple of percentage points above the inflation rate over the long term, and your average suburban unit may just keep pace with inflation. While you’re living in the house or unit it doesn’t produce income, just the capital growth. On the other hand, the sharemarket generally grows at a rate of several percentage points above the inflation rate each year and, in addition to capital growth, shares also produce income in the form of dividends at a rate of 3 per cent or 4 per cent every year. So homeowners who put their money into mortgage repayments will only have growth in the value of their home, of around 3 per cent to 6 per cent per year, whereas renters who put their surplus cash into a broad range of shares can achieve total investment returns averaging around 12 per cent per year over the same 20- to 30-year period. That would put renters and investors way ahead of most homeowners over the long term. How to obtain these kinds of returns is covered later in the book.

Theory versus practice The problem with this theory is that I have never actually seen it work in real life. Most of the people who advocate the theory are academic economists, and I have never actually met a wealthy academic economist. The one famous economist in Australia who supports the theory actually owned houses for the first couple of decades of his career before seeing the light and renting from the mid 1990s. I have met several people who rented and used the extra cash to start their own businesses and build fortunes that way. But for normal salary and wage earners and most small business people, it takes extreme discipline and determination to put the entire difference into an investment plan week after week, year after year. Further, investments are easy to cash in and spend — your house is not. For the vast majority of people (including me), it’s just too hard. I can remember when I was younger — there were just too many temptations to spend the money rather than invest it.

Forced savings One of the advantages of having a mortgage is that it’s a forced savings plan. If you fail to make your mortgage repayments, the lender will be on your back threatening to repossess your house. So

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you are forced to make sacrifices elsewhere in your budget to make sure that the mortgage is paid first. You have to — you have no choice. For renters/investors, however, it’s not a big deal if they miss a monthly contribution to their investment plan. They can simply make a contribution next month. What’s a few months missed here and there? Having a mortgage doesn’t give you the luxury of these choices. There is no choice — you make the repayment or lose the house. Buying your first home and taking on a mortgage is scary at first, but all your emotional energy is focused on re-arranging the budget to allow for those mortgage payments. After a few years, the pressure eases as you see the value of the home — and your income — grow. You look back and wonder how you managed with such a big mortgage, but somehow you got through it. For readers who are still considering going down the renting and investing route as a longterm plan, consider this — most tenants dream about becoming a landlord one day, but not many landlords dream about going back to being a tenant. For most people, buying their first home brings a tremendous sense of achievement and relief. On the other hand, the few homeowners I have talked to who have gone back to renting (for example, because they have been posted to another city for work) plan to buy a place as soon as they can. For tenants, it’s hard to become emotionally attached to a place if you aren’t allowed to change it to suit your own needs. You can’t knock down a wall, add on a room, change the carpet, repaint the walls or even put a nail in a wall to hang a picture without approval. Any authorised improvements tenants make to a property just add value to the landlord’s asset — the tenants cannot take the improvements with them when they go. In Australia and New Zealand the tenancy laws are not set up to cater for long-term rental. Tenants are basically at the mercy of landlords, who can kick them out at any time once the lease is up.

Your home is your biggest tax shelter Another advantage of homeownership is that it is the last great tax shelter in Australia (apart from superannuation if you’re over 60). You can buy a home, sell it, then buy another one, and keep doing this as many times as you like, never paying tax on the capital gains as long as each home is your principal place of residence and that you own it for at least 365 days. This is not possible with any other type of asset. Some people build up a lot of wealth over their lifetimes by continually buying, renovating and then selling their principal place of residence. It’s true that you can still do the buy-renovate-sell exercise even if you are a tenant living in a rented house. But as a tenant living somewhere else, you would pay capital gains tax on any 75

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profits from the houses. Worse still, if you bought, renovated and sold a number of houses in quick succession, the tax office could start to consider it a business and you would pay income tax on any profits and not receive the 50 per cent capital gains tax discount. You would also have to pay oneeleventh of the sale price in GST each time if the renovations are substantial. On the other hand, if you do it to the house you use as your principal place of residence, the tax office generally can’t touch you.

Rents rise forever but mortgage repayments don’t Another factor to consider if you plan to rent and invest is that rents generally rise along with, or ahead of, the inflation rate, but mortgage payments remain constant (apart from the regular ups and downs in interest rates). It’s true that the other costs of ownership rise each year — such as council rates and the cost of repairs and maintenance — but these are minor compared with mortgage payments. So when comparing renting versus buying, you need to take into account that rents will rise and keep on rising forever, long after the owner has paid off the mortgage.

Renters — don’t despair Some people are philosophically opposed to owning and are committed to a lifetime of renting. Others believe they simply can’t afford to buy and that they will be renters for the foreseeable future. However, just because you are renting doesn’t mean you can’t build wealth and financial freedom. Focus on the other steps and strategies outlined in this book and you will be well on your way to achieving your goals. If you plan to rent long term, you need to have about $500 000 more in net investment assets. To work out exactly how much extra capital you require, divide your annual rent by 5 per cent. For example, if you plan to rent a home for, say, $500 per week in today’s dollars, that’s $25 000 per year in rent or a capital sum of $500 000. If you invest this money (for example, in shares and property trusts — either inside or outside your super fund), it can generate 5 per cent ($25 000) each year tax effectively, and it will rise each year to stay ahead of inflation and rising rents. In summary, the renting and investing route to wealth is possible but it is a difficult road to travel. For many people it turns into renting and spending instead of renting and investing, because of all the distractions and temptations along the way. For most people, buying their home is the first and greatest step to financial independence and freedom.

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Action plan 1

Think about the last time you got a pay rise or tax cut. How much extra cash did you receive? For example, if one year ago you received a pay rise or tax cut of $50 per fortnight, that is $1300 for the year. Where did that extra money go? Into an investment plan, or is it just ‘gone’. Can you point to anything specific you have to show for that $1300?

2

Ask friends or relatives who own a house how they bought their first house. How did they save for a deposit? Would they do it again or would they rather still be renting?

3

Do you know any wealthy people who rent? (Are they wealthy or do they just look wealthy because they spend a lot?)

3.2 Own a house, not a unit or flat Now we come to one of the most misunderstood and controversial principles of property investing, and one that gets me into a lot of arguments — the principle that land appreciates (increases in value), but buildings depreciate (decrease in value) over time. This applies to all types of property, not just residential. But what does it mean? Surely if you buy a house or unit it will go up in value over time, won’t it? Well, yes and no.

Land versus buildings When you buy any property you are really buying two things — land and buildings. When you pay, say, $500 000 for a house, part of that $500 000 is paying for the land the house is on, the other part is for the building itself. Likewise when you buy a unit for $500 000, part of the price represents the value of the land on which the block of units sits, the other part represents your share of the value of the building. For example, if the unit is one of 10 identical units in a building sitting on 1000 square metres of land, then you would effectively be paying roughly one-tenth of the value of the land, plus one-tenth of the value of the whole building.

Mix of land and buildings Think about the building you are in right now. If it is a house worth, say, $500 000, think about how much might be land value and how much might be building value. One way to do this is to

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think of recent sales of vacant blocks of similar land in your area, or similar land with ‘renovator’s special’ on it. This will give you an idea of the land value; the balance is the value of the building. If you are in a unit, try to do the same. This may be difficult, however, because there could be a large number of units all sharing a single block of land. In the case of houses in the major cities, the value of the land makes up most of the overall value of the property. A typical $500 000 house on a block of land would consist of, perhaps, $300 000 to $400 000 in land value, and $200 000 to $100 000 in building value. Units are quite different. For a unit worth $500 000 in the major metropolitan areas, the value of the land is generally only a small part of the overall value of the property. So it might consist of $100 000 to $200 000 in land value, with $400 000 to $300 000 in building value. The actual proportions of land and building value will vary depending on several factors, including location, condition, age and views, but the principle applies to all property markets.

Land appreciates Let’s go back to the first part of the property principle — land appreciates. This applies to just about all property markets in areas where population and incomes are growing over long periods of time. Economists talk about ‘the three Ps’ that drive growth in incomes — population, participation rate and productivity. The ‘population’ is growing primarily because people are living longer, due to better health, nutrition and medical advances, and because of net migration. ‘Participation rate’ refers to the proportion of working-age people who are actually participating in the workforce and earning incomes. Participation rates are rising primarily because women are having kids later, having fewer kids and returning to the workforce in greater numbers, and also because more women are opting not to have kids. ‘Productivity’ of workers is also rising, due to advances in technology. The population and income of the planet is growing, as is the population and income of Australia as a whole, as well as the major cities and coastal towns. Cities and towns are growing at different rates because of their different economies; levels of desirability, including employment opportunities; retirement attractiveness; weather; and a host of other factors. Housing is a basic commodity — everybody needs somewhere to live. More and more people want to live in the major metropolitan centres and close to amenities including schools, and medical and recreational services. All housing requires land, whether it is in the form of houses sitting on land, semi-detached houses, town houses or high-rise units. Land is a finite resource — ‘they’ve stopped making more land’.

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Another major factor in the appreciation of land is that the average size of households in Australia has been falling over the past 200 years. The average household now has 2.7 people in it, which is about half what it was a couple of generations ago. This means that the number of households is increasing at a faster rate than overall population growth. Australia is one of the least populated countries on the planet — you’d think that there would be plenty of land to go around. In Australia there are 7.7 million square kilometres of land and there are 21 million people living in 7.7 million households. That’s an average of 2.7 people per square kilometre of land, or almost exactly one household per square kilometre of land across the whole country. Take a look out of your window. If the population was spread evenly across the country, your closest neighbour’s house would be one kilometre away in each direction. But of course we are not spread evenly. Most of the land is remote and far away from what many people are looking for — that is, employment, shops, schools, hospitals and so on. The govenment is constantly releasing land in outer regions around the metropolitan areas, but that’s not necessarily where people want to live. All of this results in two things. Firstly, that the overall value of land is rising along with population and income levels. Secondly, that land closer to desireable areas increases in value at a faster rate than other areas. This generally means land that is close to major city centres, where there is a concentration of jobs, schools, universities, shops, restaurants, medical services, sporting and recreational attractions, parks, beaches and so on. The entry price to get into the more desirable areas is higher, but it pays off in the long run because the growth in value will be greater than in the remote outlying areas.

Buildings depreciate The other part of the property principle is that buildings depreciate. While the value of the land component of a property will generally increase over time, the value of the buildings will almost always decrease. As soon as you finish building a new house or unit, things start to go wrong (usually immediately after the warranty runs out!). The roof starts to leak, appliances break down, paint starts to peel, taps need fixing and so on. On top of the repairs and replacements, a building’s value is also affected by fashion trends. You may spend a lot of money on the latest, trendiest design and colour schemes, but they will be out of fashion in only a few years. You will probably look back and say, ‘What were we thinking?’ A state-of-the-art new house or renovation will be out of date five to 10 years later. Buyers will no

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longer be willing to pay a premium for it. The value of the building drops because buyers will factor in the cost of replacing and renovating all over again. Every time you go to a house inspection and say ‘Yuck!’ to a 1960s green and orange colour scheme, or to 1950s pink and blue bathroom tiles, or 1980s pastel pink carpet or 1970s mission brown exposed raked ceiling beams, just remember that they were fashionable at the time, and buyers paid a premium for them. It’s a bit like new cars, boats or TVs — as soon as they leave the showroom their value drops by a significant percentage because they’re no longer new. Many people will have bought a new house and will have experienced the ‘buzz’ of moving into a brand-new house. In contrast, moving into a ‘used’ house is very different. They’re full of nasty surprises you didn’t see during the inspections — leaking roofs, taps that don’t work, floors that aren’t level, doors that don’t close properly, chipped tiles and so on.

House and land together If land appreciates and buildings depreciate over time, let’s take a look at an example of a house and land package. This package was bought for $200 000, 20 years ago. The land was worth $100 000 and the house cost another $100 000 to build. Today, the cost of replacing the house with a new one could be $250 000 due to increases in the cost of building materials and labour, and improvements in the standard and quality of building materials and fittings. However, that’s just the replacement value, not the current value of the 20-year-old house. The current value may be only $75 000 or less. If that property was on the market today, prospective buyers wouldn’t walk in and say, ‘Wow — a brand-new house!’ The chances are they would notice that the kitchen needed to be opened up to the living area, the colour of the bathroom tiles needed to be changed, the pool needed resurfacing, the carpet needed replacing, the pastel-coloured exterior paint job needed updating and would consider adding a new ‘media room’, and the list goes on. Or they might just make plans to start all over again with a new house. The 20-year-old house may still function well but it would be unlikely to suit the needs of families today, and probably wouldn’t have all the things that are regarded as standard in new houses today. If you bought that house and land for $200 000 20 years ago, it would probably sell for around $600 000. This works out to be a compound annual growth rate of 5 per cent per year over the 20-year period. What has provided the growth in value is the land as shown in table 3.1.

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Table 3.1: growth in value of a 20-year-old house 20 years ago

Today

Growth rate (% p.a.)

Land value

$100 000

$525 000

+8.6

Building value

$100 000

$75 000

–1.4

Total value

$200 000

$600 000

5.7

Table 3.1 clearly shows that, while the building has depreciated in value over the period, the land has been growing at a healthy rate of nearly 9 per cent per year.

Land value ratio changes over time Let’s look at the break-up of the total property into the value of the land and the value of the building. When the house was built 20 years ago it was in an outlying area a long way from the capital city centre. Because it was so far out the land value made up 50 per cent of the total property value. However, over the past 20 years new freeways and train lines have been built, making transport to the city and other metropolitan centres quicker and easier. New shopping centres, schools and medial facilities have sprung up, providing new services and employment in the area. What was an outer suburb 20 years ago has become a ‘middle-ring’ suburb. Today, the land content makes up 88 per cent of the total property value.

Hierarchy of values Properties in outer-suburban areas are cheaper to buy, but the land component makes up only half or sometimes less than half of the total property value. Properties closer to cities and beaches are more expensive because the land is more expensive, and the land component makes up two-thirds to three-quarters of the total property value. These properties will almost always be better growth propositions than outer suburban properties. Inner-city and suburban beachside properties are the most expensive; the land content is often 80 per cent to 90 per cent of the property value. These houses will provide the best growth in value over the long term because they are almost all land content. Only a tiny proportion is the building, which depreciates. When you read about a house selling for $10 million in Vaucluse, Toorak or Peppermint Grove, you can be sure that the actual house is probably worth only a very small proportion of the total price.

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My favourite saying about property is — ‘There are three important things in real estate: location, position and where it is!’ The number of bedrooms, bathrooms, garages, the condition of the kitchen, bathrooms and so on are pretty much irrelevant. They can all be changed. The only thing you can’t change is the land. That’s what grows in value and that’s what builds wealth.

Units and flats As mentioned earlier, the value of most units is mainly in its share of the building, while the land content is only a minor part. In a block of 200 units, the land component of the value of each unit would be only a 200th of the value of the block of land. Even if the block of land was right in the middle of the city and had great views and was worth several million dollars, the land component of each unit would still be a minor portion of the value of each unit. This means that, if you buy a unit for $500 000, most of that money represents your share of the buildings and will decrease in value over time. The theoretical value of your share of the land may appreciate at a very healthy rate, but this would be weighed down by the depreciation of the building value. We have covered how houses depreciate. In the case of units it is often worse for a number of reasons. Blocks of units have additional areas that depreciate through age, weather and general wear and tear, including elevators, foyers, swimming pools and central air conditioning. They can also suffer from the dreaded ‘concrete cancer’. Items of ‘common property’ in unit blocks tend to decay at a faster rate than similar items in domestic houses because nobody actually ‘owns’ them and looks after them as an ‘owner’ would.

Unlimited future supply Another fundamental problem with most units is a result of supply and demand. Land values rise over time because of increasing demand, and it is a scarce resource. Units, on the other hand, are not as limited. All through the major cities and suburban centres blocks of units are springing up. The most extreme example is the Gold Coast in Queensland. Every property cycle over the past 40 years has resulted in tens of thousands of new units being built along the beach stretch. For example, Melbourne’s Docklands, the southern end of Sydney’s CBD and along the river in Brisbane’s CBD. Areas in other cities that were vacant industrial and commercial areas only 10 years ago are now packed with dozens of new blocks of units.

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The density of unit blocks has also increased. A century ago unit blocks were only two or three storeys high because most had no elevators. From the 1940s to the 1960s most unit blocks were only three to six storeys high. From the 1970s and 1980s blocks started to reach over 30 storeys. These days, some of the newest buildings are over 80 storeys high. All this extra density is being made possible by new technology, new building materials and new zoning laws. And while demand for units continues to rise, as a result of the growing population and rising income levels, there are almost no limits to the number of units that could be built in the future. We have all heard stories from friends or read in the paper about people who bought units in new buildings during a property boom and then had to sell them at a loss only a few years later when the boom ended. It is possible in any market to buy at the top of the market and then have to take a loss a short time later, but it tends to happen more with units because of the sheer number of new units built and marketed during each property boom.

Control Another major difference between units (including semi-detached houses and terraces) and houses (including town houses) is one of control. In the case of a house you control what you do with it. Of course you are subject to the normal planning and zoning laws, but once you get the right approvals you can modify the house, add rooms, add a second storey, or bulldoze it and start again. None of this is possible with a unit — all you basically own is the air space between the common walls. In a unit you can add little value. Although you can renovate inside the unit, it won’t add a lot of value if the common areas and façade still look the same as they always did. A blond-brick 1960s block will always be a blond-brick 1960s block. The only way that can change is if you somehow get the owners of the other units to agree to pay for major works to upgrade the building. The bigger the block, the harder it is to get everyone to agree and to actually get them to pay for it. In a unit you can’t control your destiny. You can’t even control whether or not you can keep a dog or cat or bird in the unit. Your life is controlled by a body corporate.

Where did our view go? Another common cause of value depreciation in units is the loss of views. Your unit in a 10-storey 1980s block may have had fantastic views when you bought it, but 20 years later it is dwarfed by 20- or 30-storey blocks of units. What was once a panoramic, uninterrupted view is now just a few peeks between the surrounding towers. You now look straight into the rooms of dozens of

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surrounding units, and they look straight back at you! You might have been protected by height limits 20 years ago, but zoning rules are always changing.

Always consider the worst-case scenario Another factor to consider with units is what happens to a unit title if the building is destroyed — for example, by fire, natural disaster, terrorist attack and so on. If you own a 200-square-metre unit on, say, the 10th floor of a block of 150 units, what you effectively own is about 500 cubic metres of air space 30 metres above the ground plus a 150th share of the land. If the building is destroyed somehow, your 500 cubic metres of air space 30 metres above the ground will not be worth a lot. All you have left is your 150th share of the land. These days insurance policies exclude damage from wars and terrorist activities, so you won’t get an insurance payout to help rebuild.

Tara Think of Scarlett O’Hara in Gone with the Wind. When the Yankees were invading the South and destroying everything in their path, the only thing of value was not the grand old antebellum (pre-Civil War) mansions, it was the land — the red earth of ‘Tara’, the family farm. Buildings come and go, they are built, rebuilt, burnt down or fall into disrepair. But it is the land that matters. Land lasts forever. Despite all these issues, units do have their place. For many people, buying a unit is their first step up on the property ladder. My wife and I started out this way. Often the budget will only extend to a unit because the only cheap houses are in the outer suburbs. Purchasing a unit first is a great way to start building some equity, learn how to pay off a mortgage and build a credit rating. It is also a good first step in terms of renovating because there are only a limited number of things you can change in a unit. Nevertheless, you should move on to a house as soon as you possibly can.

Choosing locations When looking at a house to buy, remember that a small, run-down ‘renovator’s delight’ on a tiny block of land near the city or beaches will almost always grow in value at a faster rate than a larger, newer house on a small block of land in the outer suburbs. There are two reasons for this. Firstly, the run-down shack near the city or beach will be almost all land content, so it will appreciate. Secondly, the inner-city land will appreciate more quickly than the outer-suburban block, because

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of limited supply and increasing demand for properties close to employment, schools, shops and so on. Obviously make sure that the house is in an established residential area, not next to a factory or freeway!

But we can’t afford it! The main problem with this approach is, of course, that houses in inner-city and beachside suburbs cost much more than houses in outer suburbs. But not as much as you think. It’s important not to get caught up in the emotion of wanting the latest gadgets and colour schemes. Don’t think of your house as a fashion statement; think of it as a great block of land that happens to include a building you can live in. You can always improve the building to make it better to live in but you can’t change the location of the land. For example, if you had a budget of, say, $400 000 to spend on a house to live in, you could buy a brand-new house and land package about 40 to 50 kilometres from any capital city. It would have all the latest colour schemes, a new kitchen and new bathrooms. The land would be around 500 square metres (whatever happened to the quarter-acre block?) and it would be hours from anywhere. The land might appreciate but the house would gradually depreciate over time.

Inner city On the other hand, for the same $400 000 you could buy a tiny, run-down semi-detached house or terrace in an established inner suburb within 10 kilometres of the city. The building would be worth almost nothing, but the 200 square metres of land would be worth the entire purchase price. Regardless of what you did to the house — left it alone, renovated it or rebuilt it — that $400 000 worth of land would probably grow in value by at least 7 per cent or 8 per cent per year over the long term. It may not be a fashion statement, but the inner-city terrace or semi would generally be a much better investment over the long term than the new house and land package in the outer suburbs. While you are living in it you could add value by making cost-effective improvements. In the brand-new house there’s not much you could do, other than hope that the land value rises over time.

Tree change Another option is to buy a run-down house on half an acre or so near one of the emerging ‘tree-change’ locations just outside the big cities. In a few years’ time a good percentage of ageing 85

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baby boomers will be heading your way, pushing up prices. You can renovate, rebuild, subdivide, or just wait for a developer to make you an offer. So, there are options. If you are looking to buy a house you are not necessarily doomed to rent, buy a unit or be forced out to the new subdivisions in the outer fringes. There are opportunities in growth areas near the cities, beaches and tree-change locations that are just waiting to be found. Take your time and do plenty of research.

Median house prices People often disagree with me over the issue of houses and units appreciating at different rates. They come up with all sorts of examples showing how the ‘median’ price of a house or unit in a particular suburb has grown from, say, $200 000 to $400 000 over a certain number of years, proving that properties have doubled in value. The main problem with looking at median property prices, however, is that you’re not comparing like with like. Rates of growth based on median property prices will always artificially inflate the true rate of growth. Statistics that compare median property prices (or even average prices) and use them to calculated price growth are meaningless because an average or median property today is nothing like an average or median property 10, 20 or 100 years ago, so you are not comparing like with like. For example, picture a typical house sold 50 years ago. It was probably about 10 squares (100 square metres), red brick, single-storey with two bedrooms, one bathroom, L-shaped living–dining room, laminate benchtops, single tin carport and so on. In contrast, picture an average house in the same suburb sold this year. It was probably twice the size, with three or four bedrooms, two bathrooms, double garage, 30 power points, modern appliances, air conditioning, heating and so on. To try to calculate a growth rate using the prices of these two properties makes no sense at all. It’s like comparing apples with oranges. The only sensible comparison would be between exactly the same house in exactly the same condition sold at two separate times. Only then can the true growth rate over the period be calculated. We need to find individual properties that have been sold at two separate times when no improvements have been made over the period, so we are comparing like with like. For example, my wife grew up in a house in Beverley Hills (a suburb in Sydney’s middle ring — about 15 kilometres from the city). Her parents bought it in 1976 for $62 000. That house was sold again in 2004 for $670 000 in exactly the same condition as it was in 1976 with no

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improvements at all. The only things done to the house in the 28-year period were minor repairs and maintenance. Capital growth from $62 000 to $670 000 over 28 years represents 8.9 per cent compound growth per annum. Over this period inflation averaged 5.5 per cent per year, so the real growth for that house was 3.4 per cent per year above inflation. One of the houses I grew up in was a house in Canberra that my parents bought new in 1968 for $26 000. I was driving around Canberra in 2005 and I noticed a sold sign on the house so I called the agent. It had just sold for $525 000 with no major improvements or renovations. This represents an average capital growth rate over the 37-year period of 8.5 per cent per year. Over the same period inflation had averaged 6.1 per cent per year (due to the very high inflation rates from the early 1970s to the early 1980s), so the real growth rate for that house was only 2.4 per cent per year above the inflation rate. Both of the houses would have represented a median or average house when originally sold, but in both cases the median or average house sold today would be a much larger and newer house. Comparing the average or median prices of houses sold in 2007 with houses sold 20 or 30 years ago is meaningless and would overstate the true growth in value.

Timing is important Growth rates also very much depend on the particular period you choose. In the late 1980s we renovated an old 1920s house in Pymble, a middle-ring Sydney suburb about 20 kilometres from the CBD. We sold it in 1989 for $640 000. It sold at auction in 2001 for $935 000 without a single improvement made to it during the 12-year period. That represents a compound annual growth rate of only 3.2 per cent, which is just a fraction above the inflation rate over the period. This means that the owners basically had no real growth over that period. The reason for this is that when we sold the house in 1989 it was at the peak of the great late-1980s house price boom in Australia. In contrast, 2001 was a mini-slump in the economic cycle, brought about by the introduction of the GST and the global slowdown in the aftermath of the ‘tech wreck’. So when you buy at the top of the market (as the people who bought from us did) and then sell in a slump, it’s hard to make money — even after 12 years. However, if we had bought that house again for $935 000 at the auction in 2001, we could probably have sold it again at the top of the next boom market in 2004 for between $1.3 million and $1.4 million — representing a gain of between 12 per cent per annum and 14 per cent per annum growth over the three-year period. We would have been buying in the slowdown and selling in a boom, so the returns would have been good.

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Property (like shares) should always be seen as a long-term investment — which normally means 10 years or more. Here the buyers in 1989 got no real growth for 12 years, purely because they were caught in the cycles. Three blocks away in the same suburb is a house that we sold in 1988 for $405 000. That house was sold again in 2006 for $1.15 million. Over that period of 19 years few improvements were made to the house apart from routine repairs and maintenance. The compound annual growth rate over the period was 5.7 per cent. That’s almost 3 per cent above the inflation rate at that time. We sold the house during the property boom of the late 1980s and the new owners sold after the boom in the early 2000s. Purely as a result of timing, the return for the house sold in 2006 was much better than the house, only three blocks away, sold in 2001. The lesson is that property markets work in cycles. Growth rates can vary dramatically depending on the particular period you choose to measure. Also, because of these cycles, property should be considered only for long-term investments — 10 to 20 years at least — in order to ride out the cycles.

3.3 Buying your first house If buying a house is such a fundamental part of building financial security for the rest of our lives, how can ‘ordinary’ Australians afford it? Median house prices in Sydney and Perth are around $500 000, and prices in the other cities are not far behind. ‘How can the average family possibly pay that much for a house?’ the headlines scream. If you are looking to buy your first house, this may seem daunting but it’s not as bad as it appears.

Median price is not the entry price If the median price in your city is, say, $500 000, it does not mean that this is entry price for first-home buyers to get into the market. Remember, the median price is the middle price in the market. It means that half the prices are below $500 000 and half are above it. The actual range of prices is very large, from a couple of hundred thousand dollars at the bottom end to tens of millions of dollars at the top end. Obviously, the majority of first-home buyers aim to start at the low end of the range, which is much more attainable than a statistical median price that is of academic interest only. The median price is irrelevant for fi rst-home buyers because it is a reflection of the expensive houses bought by 80 per cent to 85 per cent of the buyers who are

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second-, third- and fourth-time buyers. Forget about the median price and focus on 50 per cent of houses that are selling for less than the median price. Further, the median price for the first-home buyer market is probably 30 per cent to 40 per cent less than the overall median.

They’re all mortgaged to the hilt! First-home buyers today need to borrow as much as they can in order to buy a house, but this has always been the case. Twenty years ago my wife and I and all our friends had to borrow as much as we could to buy our first homes, as did our parents a generation before that. First-home buyers have always been ‘mortgaged to the hilt’. Yes, today’s home loan borrowers are taking on much bigger mortgages, but interest rates are half or less than half what they were a generation ago. One of the biggest changes that has contributed to house price rises has been the deregulation of the home lending industry. As a result, people are borrowing more, and more people are borrowing. Until the mid 1980s banks and building societies controlled the home lending market tightly. Fewer people ‘qualified’ for a home loan and you could borrow only 80 per cent of the purchase price. The other 20 per cent plus expenses had to be paid for from genuine savings. Today there are hundreds of lenders offering thousands of home loan products with much looser lending rules. As such, more people can get into the home loan market now than in the past. And it means that more money is available for each person to spend. This increase in borrowed money has simply pushed prices up to where they are today.

‘But now Mum and Dad both need to work’ Many couples think that both partners need to work because housing is so expensive. But in fact the reverse is true — house prices are so high partly because both partners are working in many families and can afford (according to the lenders’ formulas) bigger mortgages. It is simply a result of supply and demand. More people with more money to spend simply push the prices up further. Don’t get me wrong — I have nothing against spouses returning to work, I’m all for it. My wife always earned as much as I did when we were both working. But don’t use the extra income to borrow more to buy a bigger house or to buy more stuff. Use it to pay off the mortgage and accelerate your investments. Then you can both leave work early and buy as much stuff as you want — out of your investment earnings.

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Take advantage of the lending competition Today, a single borrower with an after-tax income of $1000 per week (or about $60 000 before tax per year) can borrow more than $300 000 from any one of dozens of lenders. A couple earning a combined $2000 after tax per week can borrow about $700 000, which is much more than the median house price. To me, these loans sound like huge amounts for a single earning $1000 per week or a couple earning $2000 per week. Even if you don’t go to these extremes and leave a safety margin, it gives you an idea of what is possible with lenders these days. Just because a lender gives you money doesn’t mean that you can afford it or that it makes sense. Trust your own judgement about what is sensible.

First-home buyer breaks Every state and territory has a variety of exemptions and discounts for first-home buyers including exemptions and discounts on stamp duty on property transfer, and mortgage duty and free cash grants. These can add up to around $30 000 in many cases. For more information visit .

Shared equity loans A new form of home lending that is emerging in Australia is called a ‘shared equity loan’. In addition to lending a borrower, say, $300 000 to buy a house, the shared equity lender will also lend the borrower an additional 20 per cent of the house value. The borrower doesn’t repay any interest or principal on this additional shared equity loan, instead the lender takes a percentage of the capital gains (usually 40 per cent) when the house is sold. This puts an additional $100 000 in the hands of borrowers, enabling them to buy a house worth, say, $500 000 rather than $400 000. These shared equity loans are intended to assist home affordability, because they give borrowers more money for the house purchase. But in all likelihood they will do the opposite. If these shared equity loans become widespread, those borrowers with an extra $100 000 to spend will just push house prices up by another $100 000, and further out of reach of homebuyers who don’t use shared equity loans.

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Prices are high, and they’re heading higher All of these factors have brought house prices to where they are today. Prices are high, and they will continue to rise over the long term for the same reasons, discussed throughout this chapter, that have driven them to where they are today. 9

The population will continue to rise with improving health and medical advances and immigration.

9

The proportion of the population participating in the workforce is continuing to rise.

9

The average number of people per household will continue to fall, so the number of households needing somewhere to live will continue to rise at an even greater rate than the rate of population growth.

9

Incomes will continue to rise.

9

Lenders will continue to find new ways of lending more money to more people.

There will be the inevitable cycles along the way, but the long-term upward trend will remain, so do your research, understand your market and the cycles, and get into the market as soon as you can. The sooner you get into the housing market with a property in a desirable area — even if it’s a ‘renovators delight’ on a tiny block of land — the quicker you can get on the road to wealth over the long term. In about 15 years the median house price in the major cities is likely to hit the $1 million mark and we will look back nostalgically at today’s median price of ‘only’ $400 000 to $500 000, in the same way that today we look back at house prices in previous generations. Like the other steps outlined in this book, owning a house is not mandatory in order to build wealth. Not all wealthy people own a house instead of a unit. It may be possible to build wealth by owning a unit, but in almost all cases it will be more difficult. Even in densely populated cities like Manhattan, London, Paris and Hong Kong, the really wealthy people live in houses on land. The wealthy inhabitants of those 5th Avenue penthouses in Manhattan and those grand apartments in Knightsbridge in London often also own big houses on big land in Long Island or Surrey.

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The chicken or the egg? ‘Aha, but they own a big house because they’re rich!’, I hear you say. Actually, it’s the other way around — unless they inherited the houses, they’re rich now often partly because they own houses. If you ask any wealthy person who lives in a large, expensive house in any part of the world, including in Australia, you will inevitably find that the house they live in is not their first house — generally they have traded up through several houses to get to where they are today. As I’ve mentioned, owning a house is not mandatory in order to build wealth, but it does make it easier. Over the past 20 years, my wife and I have bought and renovated old wrecks. We’ve done about a dozen that we’ve lived in. With each house we gradually reduced the mortgages and 10 years ago we finished paying them off. The houses we have owned and renovated since then have generated cash to put into other investments including shares and property. We live in a great house now partly because of the houses we used over the years to build wealth. Some people see a great house as a trophy, a statement, a show of wealth. We think of a great house as being primarily a great piece of land in a great location, which can play a key role in building wealth for the future.

Action plan 1

Estimate the value of the house or unit you are living in at the moment. Do this even if you are renting.

2

Estimate how much of this value is for the land and how much is for the building. Have there been any vacant blocks or derelict shacks for sale recently in the area to help you put a value on the land?

3

Visit some real estate websites (or check your newspaper’s real estate section) to assist in your valuation.

4

Use the real estate websites or newspaper to find out the other types of properties in your city that the same amount of money could buy. Look for houses in various locations in and around the metropolitan area.

5

Ask your parents or other older relatives what they paid for their houses. Ask them what prices they sold for years later, and estimate what those houses might be worth now.

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3.4 Own your house outright — pay off the mortgage Finally paying off the mortgage and owning your own house outright is a tremendous milestone that will happen only once in your life (hopefully!). It completes the first step towards financial independence and freedom. As mentioned in chapter 2, one of the principles of wealth building is to avoid or minimise all forms of non–tax-deductible debt. Interest on loans is only tax deductible if the asset bought with the loan generates taxable income. Your mortgage payments are probably the biggest non–taxdeductible payments, so it’s taking the biggest chunk out of your income. The sooner you pay off the mortgage, the less non–tax-deductible interest you will pay, and the sooner you can start investing the money instead.

Is paying off the mortgage better than investing? To find out whether paying off the mortgage is better than investing, let’s take a look at an example. Say you had a 7 per cent mortgage and a spare $1000 per month. Do you use this money to make extra payments off the mortgage or do you invest it? The general rule is that it will be tax effective to invest the money instead of putting it against the mortgage only if you can get after-tax returns from your investments that are more than the mortgage rate. So, can you invest and get after-tax returns of more than 7 per cent per year? Putting spare money into long-term growth investments, like shares and property, either inside or outside super can achieve after-tax returns of more than the interest rate on your mortgage, but they don’t do it consistently and they don’t do it without you taking on risk. On the other hand, making extra payments on your home loan is the equivalent of receiving a return of 7 per cent after tax every year guaranteed. There is simply no other investment that is guaranteed to do this consistently year after year.

Accelerate your investing Paying off the mortgage can lead to a huge boost in your investment efforts. As soon as the mortgage is paid off you can start putting all that extra cash into your investment plans. When the mortgage is paid off, there is an extra $2000 or so per month that can be put to good use elsewhere. Investing this extra money can be the single biggest step in the wealth-creation process for most salary earners and small business owners.

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The road to wealth is not straight or flat — it’s full of tricky corners, dead-end side streets, hills, bumps and potholes; it’s also full of traffic going in the opposite direction. While you are paying off your mortgage and building equity in your home, you are moving forward on the road to wealth but with all that non–tax-deductible debt you’re travelling uphill making slow progress. As soon as you pay off the mortgage, life is a lot easier and your wealth-creation progress accelerates rapidly.

Tell the bank to go jump There are great financial reasons for paying off the mortgage quickly, but often the emotional reasons are even more powerful. Paying off the mortgage means you finally own the house, instead of the bank owning a big chunk of it. When most people buy their first house it is ‘geared to the hilt’, with the loan representing around 90 per cent or more of the purchase price, which means the bank really owns 90 per cent of it and it holds the title deeds. Only a tiny proportion of each repayment pays off the actual loan; the bulk of the repayments goes towards paying interest. You look at your loan statement five years later and you discover that you still owe the bank nearly as much as you borrowed in the first place! When you do finally make that last mortgage payment and own your house outright it is one of the best feelings, and it only come along once in your life.

Why doesn’t everyone aim to do it? Despite all the benefits of paying the mortgage off quickly, some people can’t bring themselves to do it. There are a variety of reasons and many of them are not financial. About 10 years ago a family I know had been working hard for 20 years and finally had their home loan balance down to less than $20 000. They had one of those nasty ‘redraw’ facilities that enabled them to withdraw their money whenever they had to pay for something. Crazy idea, redraw facilities. Why would anybody slave away to reduce their mortgage balance, only to withdraw it and have to pay it off again? Surely paying off the mortgage once is enough! On several occasions the family could easily have cleared the balance with spare cash, but they always put it off. Every time they were in a position to get rid of the balance they found some other use for the cash. I ran into them a couple of years ago and asked them how their investing was going since they surely had paid off the last of the home loan. Unfortunately, they told me they had just redrawn money again to buy a new car.

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Not sure how to invest One reason some people are reluctant to get rid of the mortgage is that they are unsure of what to do with the spare cash they will have once there are no more mortgage payments. This is a real problem because most people are never taught how to invest money wisely. They’ve heard about the scams and financial collapses, so they keep paying non–tax-deductible mortgage payments, because they feel that at least money going into the mortgage is going to a good cause — their own home. In reality, they would be much better off in the long term if they just paid it off and started investing their surplus cash in growth assets as soon as they could. But now you no longer have this excuse — it’s all set out in this book.

‘But we need to stay friends with the bank!’ Many people have said to me that they don’t want to pay off the last of the mortgage because they are afraid the bank won’t lend them money in the future once they are no longer the bank’s client. This may have been an issue 30 years ago when a relationship with your bank meant something. Back in those days you had to qualify for a mortgage by banking with them for a number of years. These days you can get dozens of lenders to compete for your business. If you own your home outright and have built up a good credit rating while paying off your mortgage, lenders will be falling over themselves beating a path to your door to lend you money.

It’s boring Imagine a conversation at the pub or club, or at lunch with friends — each person takes a turn telling the group what they’re doing with their spare cash. The conversation goes something like this: 9

‘I’ve got some great shares in a new float coming up!’

9

‘I’ve just bought a half-a-dozen flats off the plan — didn’t cost me a cent. Did it all on deposit bonds on the credit card, and I’ll flick them all for a profit before I have to settle — should be great!’

9

‘I’ve got into this great tax-based scheme involving ostriches! Brilliant tax deduction!’

9

‘I’ve bought some gold bullion — I reckon gold’s headed for $700 US dollars an ounce!’

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9

‘I’ve just bought this great new options trading system. The guy who sold it to me reckons I’ll make 20 per cent per month — and it only cost me $15 000!’

9

‘I spent $2000 going to a seminar last weekend that showed me an easy way to make $1 million — spend 10 minutes every morning writing “covered calls” and spend the rest of the day at the beach!’

When it’s your turn you say rather sheepishly, ‘Um, I’m … er … paying off the mortgage’. At that point everybody else stares at the floor and suddenly remembers a meeting they had to be at. The crowd mysteriously breaks up and leaves you standing there alone. It’s a sure-fire conversation stopper. Very un-cool. But there is a better than 99 per cent chance that you will be way ahead of every single one of these people in your journey to build real wealth over the long term by just paying off the mortgage and not being lured in to the latest flavour-of-the-month scheme or scam.

The so-called professionals will rarely advise you to do it Many advisers will not recommend putting extra money into the mortgage because there’s nothing in it for them. They would rather sell you something that earns them a sales commission instead. A stockbroker will say, ‘Yes, you could pay off the mortgage, but I’ve got this great stock here that you really must get in on’. A commission-based financial planner will want you to put money into a managed fund that pays them a big up-front commission plus an annual trail commission. A real estate agent will want to sell one of their properties.

Trading up and staying in debt One of the most common ways people avoid paying off their mortgage is that they continually ‘trade up’ to more expensive houses with bigger mortgages. They are back on the mortgage treadmill again instead of being debt free. When I fist started out in the finance game 25 years ago there was a rule of thumb that went something like this: 9

Up to the age of 20 you went to school and had fun.

9

Between 20 and 30 you got a job, got married, had kids and bought a house (not much fun there).

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9

Between 30 and 40 or 45 you worked hard and paid off the mortgage (still not much fun).

9

From 40 or 45 up till age 65 you had some surplus cash because the mortgage and the kids were gone (fun again!) and perhaps built up your investments. If your employer was contributing to a super scheme for you then that was a bonus, because most people didn’t get super.

9

Retire at 65. The investments you built up after you paid off the house at around 40 to 45 years of age was enough to live on until you left the planet — at around age 70 or 75 (too old to have fun!). If all else failed, there was always the pension, which was not meanstested.

These days, the accepted view seems to have changed. Many people now consider it ‘normal’ to have a huge mortgage well into their 40s and 50s. After all, we can get hold of our super fund as a tax-free lump sum when we are 60, so we can use that to pay out the mortgage, can’t we? But if we do that, what are we then going to live on for the next 30 to 40 years? Whoops — didn’t think of that one! We’ll just have to live on the government age pension of about $13 000 per year. That’s not living — that’s barely surviving! Also, what if you are retrenched or sacked before the age of 60 when you can cash in the super tax free and pay off the mortgage? The old days of ‘jobs for life’ are well and truly gone. Under the workplace laws maybe you will get a payout or maybe you won’t. Maybe you will find another job in your 50s, but maybe you won’t. It’s not worth the risk — don’t rely on luck. Pay off the mortgage so you don’t have to worry about it ever again.

False sense of security Over the past 15 years we have had an uninterrupted economic boom — unemployment below 5 per cent, jobs everywhere and businesses expanding in pretty much every industry sector across the entire economy. This won’t last forever — it never does. When (not if) the next recession hits, it will be like every other recession before it — businesses collapsing, rising unemployment, tougher competition and lower margins for those businesses that do survive, family homes being repossessed, and all the other problems that go along with these catastrophes. During the boom times it is easy to get lulled into a false sense of security and think that it will last forever, but they never do.

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How to pay off the mortgage faster and save a fortune in interest The first thing to understand when you take out a mortgage is that most of the repayments go towards paying off interest, not paying off the loan principal. The loan principal is the amount of money you originally borrowed. Loan interest is the rent you pay for the use of the money over the term of the loan. For example, on a $300 000 mortgage over 25 years at an interest rate of 7 per cent per annum, the principal is $300 000 and the repayments would be $2120.34 per month. If the interest rate is variable (as it is on most mortgages) the interest rate and repayments will move up and down over the period of the loan. But let’s assume for this example that the rates remain at an average of 7 per cent over the term of the loan. So the total repayments over 25 years come to $636 102 ($2120.34 × 300 months). This means you pay the lender more than double the amount you were lent in the first place. Fifty-three per cent of your total payments goes towards interest, not the principal. This might look bad but it’s much better than it was 20 years ago. In those days the interest rate on a $300 000 loan would have been 15 per cent, with a total interest bill of $1 152 748, including $852 748 in interest. A whopping 74 per cent of total payments went towards interest, not principal. Over the next few pages are some ways to help pay off your mortgage as quickly as possible. Of course, different steps might be more appropriate for different people in different circumstances but even if only one or two of these steps are followed, most people can save tens of thousands of dollars in interest and pay off their mortgage several years sooner.

Get a lower interest rate by switching to a ‘basic’ loan Don’t pay for any fancy features you may not need — for example redraw and offset facilities. Most ‘standard’ variable-rate loans have an interest rate about 0.5 per cent above the ‘basic’ or ‘no-frills’ loans offered by the same lender. The extra features and options are mainly designed for people who want to redraw the money paid off the loan to buy things like cars, holidays and even pay for day-to-day living expenses. As we all know, this is a big no-no if you want to build wealth as it keeps you in debt longer. Another feature you pay can extra for on a home loan is an offset facility. If you deposit extra money into the offset account, the amount is offset against the mortgage account when calculating each month’s loan interest. For example, if you have a $300 000 mortgage and

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you have $20 000 cash in the offset account, the bank will calculate interest on only $280 000 for that month. You can take the extra cash out of the offset account and use it later. Banks like these too because they keep you in debt longer, but you need to use that extra cash to get rid of the mortgage and never pay it back to the bank again! If you don’t need the extra features of a standard loan, such as redraw and offset facilities, ask your lender to switch you to the basic loan. If you can reduce the interest rate by 0.5 per cent and keep the repayments the same, you will save $65 000 in interest and cut two-and-a-half years off the average mortgage term (the average new mortgage in Australia is about $300 000 over 25 years at 7 per cent interest). Never borrow to buy things that decrease in value, or to pay expenses. Redraw loans are designed to lure you into reborrowing the money you have paid off. Banks love them because they keep you in debt for longer, which is the opposite of what we want to do.

Shop around for a lower interest rate Even after you have investigated the best rate basic loan your lender has to offer, you should still look around to see what else is available. There is always a range of lenders who consistently have low rates. Probably nine out of 10 borrowers will find they can get a better rate if they shopped around. If the interest rate on your mortgage is over 0.5 per cent more than the current official cash rate (6.5 per cent at the time of writing), then there are better deals around. If the rate is over 0.75 per cent more than the official cash rate, then the lender is just robbing you blind. You can check the current cash rate on the Reserve Bank of Australia’s website . It’s listed under ‘cash rate target’, usually in the middle of the home page. There are several websites you can visit to find mortgage rates on hundreds of different loans from dozens of lenders including and . There are also some good magazines to help you research lenders including Your Mortgage Magazine (has comparisons of mortgages), Smart Investor (often has articles and tables on mortgages and mortgage lenders) and Money Magazine (covers all personal finance topics). Another approach is to use a mortgage broker (mortgage brokers are discussed later in the chapter). Use competitors’ rates as a bargaining chip to get your existing lender to match the rate, or threaten to switch lenders. If you switch lenders, ask the new lender to waive the application fee and establishment costs — they will often do this if there is other business as well (such as investment loans, business loans and so on).

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Once you have reduced the interest rate, don’t drop your repayments to the new lower level For example, if you were paying $1000 per month on the old loan, keep paying $1000 on the new loan so you pay it off sooner.

Increase the amount of your repayments By increasing the repayments you shorten the term of the loan, which saves interest. For example, if you increase your repayments by, say, 10 per cent you can save 24 per cent of the total interest bill — that’s a saving of $80 000 on the average mortgage and pays it off five years sooner. Even if you were to increase repayments by just $1 per day ($31 per month) you could save $15 000 and cut one year off the average mortgage term.

Make additional one-off payments off the principal One-off repayments off the principal make a huge difference to the overall interest paid. You could use cash from Christmas bonuses, gifts, inheritances and so on. Even small contributions make a huge difference over the term of the loan. For example, one extra principal payment of $1000 will save $4700 in interest on the average mortgage and pay it off three months sooner.

Whenever you get a pay rise, increase your loan repayments by part or all of the increase You won’t notice it’s gone because it’s extra money you didn’t have before. For example, if you increased repayments by just 3 per cent each year (in line with inflation and wages growth), you could save $107 000 in interest and pay off the mortgage eight-and-a-half years sooner. If you increase repayments by 5 per cent each year, you could save $138 000 in interest and pay it off 11 years sooner.

Make payments fortnightly or weekly Make the fortnightly repayments half what the old monthly repayments were, or weekly repayments one-quarter of the old monthly repayments. Fortnightly repayments are ideal for people who are paid fortnightly. The money is taken out for the mortgage from each pay packet, so it doesn’t get a chance to sit in your bank account where it may be tempting to spend. By making the fortnightly repayments, half the amount of the monthly repayment, you are effectively making an additional

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month’s repayment each year. On an average mortgage this will save about $10 000 in interest and will pay it off one year sooner.

Don’t redraw money Don’t be tempted to redraw money from the mortgage to pay for expenses or depreciating assets like cars, boats, furniture, TVs, holidays and so on. Remember, if you can’t pay cash for something, then you can’t afford it.

Don’t consolidate other debts into your home loan Mortgage brokers generally like ‘debt consolidation’ loans because it means you take out a larger mortgage, and larger mortgages mean greater sales commissions. Let’s say you have the following loans: 9

$200 000 mortgage at 7 per cent interest

9

$20 000 car loan at 10 per cent interest

9

$10 000 personal loan at 15 per cent interest

9

$5000 on your credit cards at 19 per cent interest.

A consolidation loan will combine all of these debts into a new mortgage for $235 000 and clear the other debts. Sounds good — you have no more high interest rate loans, just a bigger mortgage at a lower rate. If you refinance high interest rate debts into a lower interest rate loan secured by your home, don’t fall into the trap of extending it for the full 25- or 30-year term of the mortgage. Pay off the increase on your loan over the same period or even shorter than the existing high interest rate loans. For example, let’s take the $10 000 personal loan at 15 per cent payable over five years. The total cost of that loan is $14 280 ($238 per month × 60 months) in total cash out of your pocket. However, if you refinance it by increasing your home loan by $10 000, you can reduce the interest rate from 15 per cent to the home loan rate of, say, 7 per cent per annum. This sounds good because you are reducing the interest rate. But here is the problem — the home loan runs for another, say, 25 years, so you will effectively be paying for it over a much longer period than you would with the old high-rate loan. Adding the personal loan to your home loan reduces the

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monthly payments from $238 per month to $70.68 per month. So you would be about $167 per month better off, but the total cash outlay would be $21 204 ($70.68 × 300 months). So, even though you have reduced the interest rate from 15 per cent to 7 per cent, you end up paying much more interest over a longer period. Is this good or bad? It’s good because the interest rate is much lower, but it’s bad because the total cash outlay is much more, and you are in debt for much longer.

Invest the rest? I can almost hear you say, ‘Aha! The monthly payments are lower so I have $167 more cash in my pocket every month for the next five years. I could put that money into long-term investments’. There are two main problems with this theory: 1

You could put that $167 per month for the next five years into investments, but you are financing this investment with a loan that doesn’t have tax-deductible interest. This means that you are paying off the loan (the $70.68 per week additional home loan repayments) with after-tax money, but interest and other income from the investment is fully taxable. You can’t deduct the interest on the additional home loan from investment income.

2

Although it sounds easy to simply divert that extra monthly surplus into an investment, it is often extremely difficult to do in practice. It requires superb determination and discipline. It’s too easy for most people to simply spend the extra money on day-to-day living expenses.

Here is a much better solution. The old $10 000 personal loan at 15 per cent costs you $238 per month. Pay out the $10 000 personal loan with a new loan from your lender at home loan rates, but over a very short period so that the repayments stay at the same at $238 per month. If the new loan is at home loan rates of, say, 7 per cent (because it is secured by the house and you are using the same lender that has your home loan), you can keep the payments at $238 per month and pay off the loan in 48 months. The total cost of the loan, therefore, is $11 424 ($238 × 48). That’s $2850 less than the total cost of the old loan, and you are out of debt in four years instead of five. An even better solution is to pay out the $10 000 loan by adding $10 000 to your existing home loan, but then increase the monthly payments on the entire loan by $238 per month in order to reduce the term on the loan by several years. This is very attractive because: 9

it converts the 15 per cent personal loan to the lower rate of 7 per cent

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9

total repayments on loans are kept at the same level

9

it pays the whole home loan off faster

9

it gets you out of debt (including the home loan) faster.

For example, let’s say your current loans are a $200 000 home loan at 7 per cent for 25 years, which works out to a total cash outlay of $424 200 ($1414 × 300 months), and a $10 000 personal loan at 15 per cent for five years, which works out to a total cash outlay of $14 280. Together, the repayments total $438 480. You pay out the $10 000 personal loan by increasing your home loan to $210 000, but you also increase the home loan payments by $238 per month. So the total cost of the loan is $384 916 ($1652 × 233 months). This way you pay the whole thing off faster and save over $50 000 in the process. Note, however, that this example assumes you have enough equity in your current home to add $10 000 to the home loan. In most cases where the home loan is more than a year or two old this should not be a problem because your equity increases over time as you make loan repayments. It also assumes that you keep the repayments on the home loan at the higher level for the rest of the life of the home loan. If you are making the $238 extra payment now, then there is no reason to think that you can’t keep making it for the rest of the 19-year period. After all, you have been making them ever since you took out the personal loan, and you can normally expect incomes to rise each year or so with inflation, while the repayments remain constant. The other thing to check is that the personal loans and other high interest rate debts can be paid out early. Some high rate loans have nasty penalties for paying out early. If you talk to the lender they will often waive some or all of these fees. On the other hand, other high interest rate debts, like credit cards, and many of the lines of credit for whitegoods (fridges and washing machines) and browngoods (TVs and furniture), have no early payout penalties — they can be paid off at any time.

Cut up the card! Don’t fall into the trap of getting back into debt straightaway. I have seen this happen many times. Some people do the right thing by reorganising their affairs to eliminate their high interest rate debts. After the debt restructure they still have their credit cards and lines of credits sitting there with nil balances, and it’s just too tempting! 103

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Don’t switch to fixed rates at the wrong time About 80 per cent of mortgages in Australia are ‘variable rate’, meaning that the interest rate varies as the interest rates in the economy change. Most lenders fund their mortgages out of money they raise at the official cash rate and the 30-, 60- and 90-day money markets. The other 20 per cent of mortgages are ‘fixed rate’, meaning that the interest rate and loan repayments are set at a fixed level for the term of the loan, which is usually one, three or five years. The main advantage of fixed-rate loans is the certainty they bring. But the certainty only lasts for one, three or five years. Then you will need to refinance (or ‘rollover’) the loan into another fixed-rate loan or change to a variable-rate loan. If rates have moved higher over the period, you will be hit with higher rates. The main advantage of variable-rate loans is that you can generally pay out the loan at any time with minimal penalties and make principal reductions without penalty. You also benefit if interest rates fall. The main disadvantage is that you will be hit when rates rise. Remember when mortgage rates were around 18 per cent in the late 1980s? I certainly do! In almost all cases, the worst time to switch to a fixed-rate loan is when everyone is talking about them — in newspapers, magazines and so on. Usually, the best time to switch is when the media are talking about doing the opposite. Also, don’t fall into the trap of switching to a fixedrate loan at the top of the interest rate cycle. If you want to switch to a fixed rate, the time to do it is when rates start to rise following a series of rate cuts — for example, as they did in early 2002 (rates were below 5 per cent), or late 1993 (also below 5 per cent). For most people, though, it is better to stay with a variable-rate loan and pay it off as quickly as possible.

Stay away from long-term loans Don’t be tempted to go for a 40- or 50-year loan term offered by some lenders — you’ll be paying it off forever! The longer the term of the loan, the lower the monthly repayments will be. By pushing the loan term out to 40 or 50 years, it reduces the monthly repayments so you borrow more money and buy a more expensive house. Remember this rule of thumb — if you need to reduce the repayments so the loan term goes beyond when you want to retire, then you can’t afford the house.

Don’t use your super to pay off your mortgage You’ll need your super to live off in retirement, so don’t be tempted to take on a bigger mortgage and plan to use your super to pay it off. You’ll probably live 10 or more years longer than your

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parents did, so you will likely need to fund over 30 years of retirement. You’re going to need every cent of super to live off in retirement. Superannuation is discussed further in chapters 4 and 5.

Make grown-up kids pay part of your mortgage If you have grown-up kids still living at home, get them to pay rent or board directly into your mortgage. Set up a direct debit from their bank accounts or a payroll deduction straight from their salary rather than trying to get cash from them each week or month. It’s a good way for them to learn how things work in the real world.

Downsize Downsize to a smaller, less-expensive house with a smaller mortgage. It may be the only way to finally get your grown-up kids to leave home! Have a garage sale (or use eBay) to get rid of all the leftover ‘stuff’. Use the cash freed-up by the downsizing to pay off the mortgage and enjoy life! I have a friend in Melbourne who has three kids in their mid to late 20s. (I use the term ‘grown-up’ loosely — they all had good jobs earning good incomes, but they were still bludging off the parents by living at home!). The parents had been trying for years to get them to move out, but the kids were always full of excuses. Finally, when all the kids were away temporarily, the parents sold their big house in the suburbs without telling the kids. By the time they all returned home the parents had moved into a small town house with no room for the kids. The kids got a rude shock, but desperate times call for desperate measures!

Avoid complex ‘debt-reduction’ schemes Don’t be tempted to get involved in complex schemes promoted by some mortgage brokers and financial planners including ‘debt-reduction’ schemes (involving lines of credit and credit cards), negative gearing into tax-based schemes (like tree plantations) or schemes to ‘get your hands on your super before age 55’ and so on. They are often riddled with hidden commissions and fees — paid out of your pocket. And they usually require extreme discipline to stick to the plan — often people end up in a worse situation than when they started. It’s usually better to stick to a simple plan and put whatever extra spare cash you do have towards permanent reductions in the principal.

If you get into trouble, stay in control If you’re having trouble making your mortgage payments, consider downsizing to a less-expensive house with a lower mortgage. If you get seriously into arrears the lender will charge you penalty interest plus legal fees, and chances are that the lender will repossess and sell your house at the 105

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worst-possible time in the market and get a low price. Also, it will damage your credit rating so it will be harder (or more expensive) to get a mortgage for another house. It’s better to take control of the situation and prepare to sell your house in your own time, on your own terms, and with your own solicitor and agent.

Refinancing your mortgage We’ve seen how you can save a lot of money by using extra cash to increase repayments or make lump-sum payments. But your particular loan might not allow you to do this. Also, it’s highly likely that you don’t have the best deal available. Your current lender is not going to recommend a lower rate — they’ll usually stitch you up for the highest rate they can get away with! So it’s up to you to find the best deal for your circumstances and what you want to achieve.

Refinancing costs Refinancing your mortgage is not without costs. Many lenders charge all sorts of ‘penalty interest’ for early repayments. The penalties are usually higher if the loan is repaid in the first year or so into the mortgage. Make sure you find out what the deal is when taking out a mortgage. The new lender will usually want to charge an application fee (around $500) plus legal fees and a valuation (around $200 each). In most states there is also mortgage stamp duty of several hundred dollars per $100 000 borrowed. If you are refinancing with the same lender there will not be any stamp duty and they should not charge fees for application, legal and valuation. If they try to charge these fees, threaten to go to another lender. If you are refinancing to another lender altogether you will not be able to avoid the mortgage stamp duty, so make sure the savings in interest more than outweigh the extra cost. For example, mortgage stamp duty of 0.4 per cent on a $300 000 loan is $1200. If you are reducing the interest rate by 0.5 per cent, that’s a saving of $1500 in interest each year. So the stamp duty is paid for by the lower interest rate in the first 10 months of the loan. Try to get the new lender to reduce or waive their other fees. Generally, the bigger the loan and the more other business you can offer them the more bargaining power you have. Lenders are under enormous pressure to make their monthly lending budgets so they are very eager to negotiate to get your business. If you ask for a discount and make it look like you are expecting to get one, often it will work.

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Mortgage brokers These days it seems there are mortgage brokers on just about every street across the whole of Australia. The mortgage broking industry didn’t really exist less than 10 years ago, but today there are probably about 20 000 mortgage brokers, working in about 2000 mortgage-broking firms. Nobody really knows how many there are because there is no licensing or registration system. Before mortgage brokers came on the scene, most people got their mortgages from their own bank, building society or credit union. There was not a lot of choice — all the products were the same and there weren’t many lenders in the market. Today, there are hundreds of new lenders offering thousands of different mortgage products, and nearly half of all mortgages are arranged by mortgage brokers. The banks are still lending the money, but they don’t actually deal with the borrowers much anymore. Borrowers deal with mortgage brokers, who organise all of the paperwork, and find the right mortgage and right lender for the borrower’s needs. Nearly all banks and other lenders in the market use mortgage brokers to find loans for them. But mortgage brokers don’t necessarily offer products from the full range of lenders. Some lenders refuse to sell through brokers, while others have no branches or other outlets and use only brokers to sell their loans. You can still walk into the local branch of your bank and get a mortgage, but the chances are that the local mortgage broker can still get you a better deal — in the form of lower rates and/or lower fees. Good mortgage brokers can also provide better service than the local bank branch because lending is no longer handled at the bank. All the paperwork and processing is done in huge centralised ‘service’ centres. (I use the term ‘service’ loosely). As mortgage brokers handle lots of loans all the time from a range of lenders, they usually have some bargaining power to get better deals for their clients.

Who pays the mortgage broker? Mortgage brokers are paid by lenders to find loans for them. They are paid a sales commission of around 0.5 per cent to 1 per cent of the amount of the loan initially, plus a ‘trailing commission’ of around 0.3 per cent of the loan for each year the loan remains on the lender’s books. When your mortgage broker arranges your $300 000 loan, she will be paid about $1500 to $3000 up-front by the lender, as well as a trailing commission of about $1000 per year. These sales commissions are not added onto your loan. The lender pays the commissions out of the interest and fees they receive from you.

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One of the problems is that different lenders pay different levels of sales commission for selling their loans. If your mortgage broker is faced with receiving a $3000 commission if he sells you loan A, but $4000 if he sells you loan B, most of the time the broker will try to sell you loan B, even if loan A is better for you. There is no regulation or law requiring the mortgage broker to disclose the commissions to you, or even to tell you about the alternatives. In fact, there is no legal requirement that they find the best product for your needs at all. That’s why it’s important for you to do your own research, so you know what questions to ask and what’s available. Avoid mortgage brokers who charge you a fee — even if they offer to ‘add it to the loan’. They are already receiving a sales commission from the lenders they act for, so they should not also charge you a fee for their service. By the way, this is the exact opposite of the rule when choosing a financial planner — and there are good reasons for this. I’ll discuss this later on.

How do you find a good mortgage broker? Mortgage brokers can make a great deal of money selling mortgages, so the industry attracts all sorts of cowboys and sharks. The industry is almost completely unregulated, meaning that anybody can put up a shingle and call themselves a mortgage broker. Some mortgage-broking firms are chains of thousands of little franchises and others are tiny one-man bands. There are some great mortgage brokers in the huge chains, and there are also some great ones in the tiny operations. There is no general rule about where the good ones are. It all comes down to the integrity, honesty and professionalism of each individual operator. The best way to find a good mortgage broker is to ask friends and family. A good mortgage broker can help you put into action many of the suggestions in this chapter for saving tens of thousands of dollars and cutting years off your mortgage. Just like in most other professions, the best operators get most of their new business through referrals from satisfied clients. They usually don’t need to advertise — their happy clients do this for them. As a general rule of thumb, beware of mortgage brokers who do a lot of advertising. If they have to spend a lot of time and money advertising, it means that either they don’t have a good base of clients referring new business, or they are new to the game and therefore probably don’t have a lot experience. Unfortunately, the other types of professionals out there — like accountants, solicitors, financial planners, stockbrokers and even your local bank managers — don’t generally know much about the ins and outs of the mortgage game. But your average mortgage broker really knows his or her stuff. You just need to find one that’s right for your needs by asking friends and family for recommendations.

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Action plan 1

Find out the Reserve Bank’s current cash rate target at .

2

Get out your last mortgage statement and check your current interest rate and balance. Is the interest rate on your mortgage more than 0.75 per cent above the cash rate? If it is, there is probably scope to reduce your rate and find a better loan.

3

Write down at least three things to do this week to get the plan underway.

4

Make a list of friends and relatives to call who might recommend a mortgage broker.

3.5 Your house as part of your wealth plan In Australia we have been lucky to have had some powerful factors working in our favour that have combined to make housing a relatively good way of building wealth over the long term. Several of the main factors driving housing demand (rising participation rates, fewer people per household, rising income levels and innovation in home lending) work in other countries as well, but Australia has some additional elements at work. Firstly, the overall population is growing — both through natural causes (although we are having fewer babies we are living a lot longer) and immigration. This is likely to continue into the foreseeable future. Secondly, our very small overall population compared with the sheer size of Australia has meant that we have tended to huddle in small concentrated areas. The building of infrastructure — like schools, universities, hospitals, factories, offices, ports, sporting facilities and so on — is very expensive and only makes sense if it is concentrated in a few densely populated pockets.

Overseas This pattern is in stark contrast to other developed economies like the United Kingdom, Europe and the United States, where larger populations, infrastructure and employment opportunities are spread much more evenly over the country. The UK, US and Europe are dotted with major centres every 100 kilometres or so, allowing people much more choice in employment, education and retirement. For example, London has been steadily falling in total population over the past 60 years. Demand for housing has been helped by real income growth and lending innovation, but

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the main driver of housing growth — population — has not been there. People living in the popular areas very close to the centre of London have seen rapid growth in values, but the average Londoner has not. As a result, housing in Australia is very expensive. Rental yields are much lower, and capital growth rates have been higher, and are more tax advantaged. You will be using this superior capital growth as a key part of your wealth plans.

Getting cash out of your house to invest and live on While owning your own house outright is the first and most important step towards financial freedom, it is only one step in the whole plan. It can provide freedom from rent and mortgage payments, and it can provide a great sense of security and peace of mind throughout your entire life. This financial and emotional security can allow you to do the things you want to do later in life. These are tremendous benefits, but the house you live in mortgage free doesn’t actually produce income to live off. However, there are several ways in which owning your own house outright can plan a key role in building your investment wealth: 1

Pay off the mortgage and free up cash to invest. The sooner you pay off the mortgage, the sooner you can begin putting extra cash into investments or super. This is the simplest and best way to arrange your finances in the early years of a mortgage.

2

Security to invest. The more equity you can build up in your house, the more it can be used as security for borrowings in other parts of your financial plan. Borrowing for investments can provide real acceleration in your wealth strategies. Interest on borrowings used to buy investments is generally tax deductible, but interest on your home mortgage is not. There are risks and costs as well, and these are covered in more detail in later chapters.

3

Reverse that mortgage. If you master the strategy of using your home to build wealth — that is, by maximising land value, paying off the mortgage, focusing on high-growth areas, and taking advantage of demographic and economic trends, and of the capital gains tax free status — you can build up a lot of wealth in your home. Over your working life you can end up owning your own home worth several million dollars debt free. You can use reverse mortgages judiciously to access some of the built-up equity and still live in your own home, and also have enough to leave a legacy. This can be a great supplement to your other investment strategies later on in life. Or it can be a useful fallback strategy if the other areas of your investments take a downward turn for some reason. 110

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4

Trading down. You can trade down to a cheaper house in order to free up some cash to invest. The more equity you have in your house the more cash you can free up by trading down. One of the biggest advantages of this strategy is tax. Profits made from selling your house are tax free if it is your principal place of residence. You can do this as many times as you want and pay no capital gains tax along the way.

In practice, due to the very high transaction costs of buying and selling houses, it is not generally something you can do every few months or even every year. I always allow for the costs of changeover to be at least 7 per cent to 8 per cent of the value of the house. It also means that you really need to add value to the houses in order for the value added to exceed the transaction costs. For most people it can work if done every few years over their working lives. However, be careful of the cycles! Trading down to free up cash from your house is easier said than done. Many people get used to the idea of bigger and better houses with each move. As their household income rises, so does their borrowing power, so the size of the mortgages tends to creep up each time. Also, people acquire more ‘stuff’ over the years and that all requires a bigger house in which to store it. As people move from their 20s into their 30s and 40s they also become more established and senior in their careers, and their standing in the community also rises. Aiming for a bigger and better house each time — befitting your increased standing in the community — is understandable. That’s just human nature. If you trade up, the key is to make sure that the mortgage is reducing (and eventually eliminated) over time, not increasing. In our case, my wife and I traded up for the first few houses by renovating and selling for profits, then with the last few houses we have traded down, freeing up cash to live on and invest.

That downsizing to the coast frees up cash is a myth One of the great Australian dreams is to downsize to the coast on retirement and free up cash to pay off the mortgage, buy a place on the beach and have money left over to live on. Let’s say you are in your 40s with a couple of kids and living in the suburbs. In about a dozen years’ time when you are ready to retire, the kids will be off your hands (hopefully!) and you won’t need the big house on the big block of land anymore. The problem is that a large number of the other baby boomers have exactly the same idea. Not many generation Xers (people born between 1965 and 1980) want to live in your large house in the suburbs. They’re generally sticking closer to the city and beaches, or renting. So, for every hundred boomers trying to sell the big suburban house to head for the coast,

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there may be only a handful of gen Xers wanting to buy them. They’re more likely to be competing for the same smaller houses and units near the city and coast that you will want to buy. Supply and demand will conspire to work against boomers and this will affect both the prices of suburban houses (down in relative terms) and coastal properties (up in relative terms). This is already occurring and it will continue to accelerate. Even now, for the price of a large family house in the suburbs, you can buy only a small apartment in one of the new blocks springing up along the coast. You may get $1 million or $2 million for your big house in Killara, Balwyn or Hamilton, but that will just buy you an averagesized new flat on or near the beach in Terrigal, Lorne or Noosa. If you want an actual beach house, forget it. They cost upwards of $3 million for a basic shack on the beaches within an hour or so of Sydney, Melbourne or Brisbane. They cost less near the other cities, but the values of the big suburban houses in those cities are also lower.

A winning combination You can’t fight the sheer weight of demographics (population and age trends), and supply and demand. You need to use them to your advantage. Following is a winning combination of strategies for using your home in your wealth-creation journey. It is not the only possible strategy, but it will maximise your chances of success in the long run. 9

Aim to own your house outright — that is, own a house and have a plan in place to pay it off as quickly as you can.

9

You can start out by buying an investment property, either by yourself or as a couple, or by pooling resources with friends.

9

You can start with a unit if you must, in order to get your foot on the first rung of the property ladder, but in most cases you will be much better off with a small, rundown semi or terrace for the same money.

9

In all purchases, make sure most of the value is in the land, not the buildings. This generally means houses on land, rather than units, town houses and apartments, which have less land value, less control and less ability to add value.

9

Gravitate toward locations close to the cities, beaches or emerging tree-change towns just outside the big cities, near desirable services and amenities, where land value growth is greatest. 112

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9

With each house you can add value and make improvements, but always remember that over the long term it is the land that is building wealth for you, not the renovations.

9

Use the wealth created in your house to support your other investment plans — as security for borrowing to buy investment properties and long-term share portfolios.

This strategy has worked for my wife and me, and it has worked for thousands of other people all over Australia. In our case, we started with a small unit in Sydney’s inner west. We then bought a series of run-down houses in Sydney and Melbourne, which we renovated while living in them. Gradually we moved closer to the city and where land value growth is greatest. To buy our first home we had what was then a huge mortgage — $180 000 at 16 per cent interest in 1986 when we were on salaries of $30 000 each. With every house we reduced the mortgage and we paid it off altogether 10 years ago, which was three houses ago. Since getting rid of the mortgage we have used the houses we renovated and sold to generate cash to put into other investments and to live off. We also used the equity in the houses to buy investment properties and other investments. We now live in a great house on Sydney Harbour, debt free and also have a beach house debt free, in addition to other investment properties rented out. Our property strategies have contributed about half of our total net wealth. There is no magic secret to it — we simply started early, chose houses carefully and paid off the mortgage as quickly as we could. It wasn’t easy living in sawdust and plaster dust — especially with young kids — and it wasn’t easy watching our mortgage interest rate reach 18 per cent in 1989. The houses we bought were not fashion statements, they were the opposite — many were unliveable wrecks. We had more house-wrecking parties than house-warming parties. But it has all paid off in the long run.

3.6 Key points 9

There are many benefits, besides financial, to owning your own home.

9

In theory it might be better to rent and invest the surplus cash, but in practice it is extremely difficult.

9

The main benefit of housing is that a mortgage is a great method of forced savings.

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9

In most property markets, land appreciates because of limited supply and rising demand — due to rising populations and incomes, falling number of people per household, but buildings almost always depreciate in value over time.

9

In most property markets, houses will appreciate in value more than units because they have a greater proportion of land value.

9

Land value growth will be in areas of increasing demand, so selecting growth locations is critical.

9

If you buy in a buying frenzy at the top of the market, it can take well over 10 years to recover in real terms. Timing is critical, so understand your market and the cycles.

9

The sooner you pay off your mortgage the sooner you can accelerate your investment plans. There are numerous ways to get rid of the mortgage much more quickly and save tens of thousands of dollars in interest.

9

Owning your house outright can greatly assist other aspects of your wealth-building journey. When you have finally paid off the mortgage, you will be a fair way down the path to wealth.

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Investments

Super

Protection House

Chapter 4

Step 3 — superannuation (part I): how to use super

Money sense

4.1 What is superannuation? Superannuation is the third step on the path to financial freedom. While you are working on a plan of attack for the first two steps you can also tackle step 3. Now, before you flick past this section because super is so complex and boring, consider the following questions: 9

Could you afford to live on the government age pension, which is about $13 000 per year for singles or $22 000 per year for couples?

9

Did you know there are things you can do this week that could help double your super balance when you retire?

Okay, now that I have your attention, let’s take a look at super.

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The government age pension is not an entitlement According to the Australian Bureau of Statistics, up to 80 per cent of Australians over 65 rely on the age pension. However, welfare is not an entitlement. Nobody is ‘entitled’ to live off taxpayers for the first third of their life, contribute to the tax base as a worker for the next third of their life, then expect to live off other taxpayers for the last third of their life. Welfare should be there for only the truly needy in society — the injured, disabled and destitute through no fault of their own. ‘But I paid taxes for 30 years, so I’m entitled to the pension!’ I hear you say. However, only a small proportion of the tax you pay goes towards funding age pensions. The majority is spent on schools, hospitals, roads, defence and so on. The tax you pay while you are working would probably entitle you a pension for only a year or two. This chapter outlines how you can use the super system to build wealth and self-reliance so you never have to rely on welfare.

Know your superannuation Can you answer the following questions off the top of your head: 1

Who is you super fund manager?

2

How much is the fund worth?

3

What was the investment return last year?

4

How much did you pay the fund manager in fees and expenses last year?

5

How much tax came out of your fund last year?

If you were unable to answer many, or any, of these questions, you are not alone. Most people wouldn’t be able to asnwer them even if they had a week to look for the answers. My wife and I were the same before we set up our own self managed super fund. In fact, finding out the answers to these questions was what prompted us to look after our fund rather than leave it in the hands of super fund managers. (I take a look at self managed super funds later in the chapter.) On the other hand, if you were to ask property investors the same questions about their property investments, they would probably be able to tell you all the details straightaway. They could tell you about the rental history on each property, the tenants, the repairs and maintenance each property needs, how much the agent is charging, the tax deductions for the interest and depreciation allowances; the list goes on. 116

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Most people have more wealth in their super funds than net equity in their property investments, but they know very little about how their super fund is going. Why? Because the whole subject is too complex and retirement is so far away. But if you take control of your super situation now, it can make a huge difference to the amount of money you will have later in life. I have tried to include enough of the details about superannuation to give you an idea of the system and how it works. The rules are constantly changing so it pays to check the current situation by searching the tax office website .

How superannuation works Superannuation is a system introduced by the federal government to help make people responsible for their own finances in their old age. The number of retirees is increasing at a much faster rate than the number of tax-paying workers needed to pay for the age pension, and the super system is intended to shift the burden of funding retirement from the government and onto employers and employees. The general idea of superannuation in Australia is this — you, your employer and the government can put money into your super fund, and while the money is in the fund you can’t get your hands on it. The money is invested and the tax rates are low, which means it can grow faster. When you retire you can take the money out to live on, tax free. Although this seems simple, the details are horribly complex. It’s no wonder people’s eyes start to glaze over whenever the subject of super comes up. There are two basic types of superannuation funds — defined benefit funds and accumulation funds. Defined benefit funds are where the benefit paid to the member is defined, regardless of the amount of money contributed and regardless of the fund’s investment performance. Usually the benefit is defined as a multiple of the final salary of the employee in the years before they retire. Accumulation funds are where the member is entitled to whatever money has been contributed to the fund over the years, plus investment earnings, less fees charged. You can find out which type of fund you are in if you look at the fund statement you receive each year. If it talks about the benefits being a multiple of salary, then you are in a defined benefit fund. If it talks about investment performance and returns, then you are in an accumulation fund. In the early days, defined benefit super was offered by most Australian federal and state government departments and several large companies, but over the years most of these have replaced defined benefit funds with accumulation funds. Generally, the only people left on those generous, old funds are judges, politicians and senior public servants.

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Most people are in accumulation funds and it is vital that you take control of it because what you do with it now will determine the level of retirement income you end up with.

Benefits of super The superannuation system has many benefits. Firstly, super funds generally pay lower tax rates than employees or companies. The company income tax rate is 30 per cent, and personal tax rates go up to a maximum of 46.5 per cent (including the Medicare levy of 1.5 per cent). Super funds pay a rate of only 15 per cent while in ‘accumulation phase’ and don’t pay any tax in ‘pension phase’, which is after you begin withdrawing money out of the fund. I will look at tax on super in more detail later in the chapter. Secondly, when you withdraw money from super when you are retired or have reached a certain age, the money you take out of the fund is either offset by tax breaks before age 60 and then completely tax free from age 60 (except in the case of the few remaining public sector defined benefit funds). Thirdly, you can’t get your hands on the money while it is in the super fund — which is perhaps the most important advantage of super. You can’t get hold of it to use as an emergency fund when you need the cash for some reason. There are rules that allow some people to access their super in cases of extreme hardship, but these are very rarely approved. Fourthly, super contributions are compulsory. Your employer can’t simply skip a contribution because the company is having a bad month. This makes super funds much more effective than people’s own individual investment plans, which can be very hard to stick to when money gets tight. Finally, money in your super fund is generally protected from creditors if things take a downward turn in your personal or business life.

Facts and figures At the time of writing, the total amount of money in super accounts in Australia was just over $1 trillion. That sounds like a lot of money, but in fact super is still hopelessly inadequate, even after 15 years of compulsory super and 20 years of industry super. Following are some worrying facts and figures sourced from industry statistics: 9

The $1 trillion total is less than $50 000 per head of the total population.

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9

The total super fund balance would only just pay out our total household debts, leaving nothing for the future. And household debt levels are rising just as fast as super, which means many people are not actually making any progress.

9

The average retirement payout from super is only about $80 000. The average payout for men is just over $100 000, but for women it is less than $40 000.

9

Seventy-five per cent of people aged between 45 and 60 have a super balance of less than $100 000.

9

About 20 per cent of working-age people don’t have any super.

9

About one-third of women have no super — largely because they haven’t worked or have worked only casual jobs.

9

A large portion of self-employed and small business operators have no super.

These figures are disappointing but they do point out the tremendous opportunity for you to put the system to good use as a key part of your wealth plans. Don’t just let your super drift along. You have to take charge of it and make it work for you. Fortunately, there are plenty of ways you can do this.

Action plan 1

Take the ‘know your super’ test. How long did it take to get all the answers and why?

4.2 Putting money into super There are three main ways money can get into your super fund — from your employer, you and the government.

Contributions from your employer Employers are the primary source of contributions into most super funds. If you are an employee, your employer should be making contributions to your fund unless you are over 70 or earning

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less than $450 per month. If you run a small business or a one-person operation where you are employed by your own company, contributions made by this company are also considered to be employer contributions. Before 1988, accumulation funds were offered by only larger companies and usually only to management and senior staff. From 1988 several union-based funds were set up under award provisions across several industries. From 1992 it became compulsory for every employer to pay a fixed percentage of salaries and wages into a super fund for each employee. This compulsory employer super contribution is 9 per cent of each employee’s salary or wage. If you are between the ages of 18 and 70, work more than 10 hours per week and earn more than $450 per month, your employer should be contributing 9 per cent of your salary or wage into a super fund on your account. It’s like getting an extra month’s pay — straight into your super fund for your old age.

Tax deductible but taxable Contributions made by employers into your super fund are tax deductible for the employer, just like salaries and other operating expenses. However, the contributions are taxed as they go into your fund. If a $1000 tax-deductible contribution is paid into your super fund, you will lose 15 per cent of it in contributions tax ($150) so only $850 is left in the fund to be invested and to grow. This 15 per cent tax is paid out of your super fund account, not by you or your employer.

Make sure you are getting what’s due There are some employees who may be missing out on employer contributions — for example, those who work in small- and medium-sized businesses (who account for a large proportion of the total workforce in Australia). Although employers should be making at least the compulsory 9 per cent contributions, in many cases the accounting and bookkeeping in these businesses is not up to scratch and they fail to actually pay the contributions. There have been some well-publicised cases of private business that got into financial difficulty and it was discovered that it had not been making super contributions into its employees’ funds. If the company is wound up, there may not be enough cash left to pay the super contributions owing. You should be receiving an annual statement (some are half yearly or quarterly) from your super fund that shows the balance and the contributions paid. If you are in any doubt, ask the payroll department at your work for the details of contributions paid and details of the super fund so you can check it as well. If you resign from a business or company, make sure the employer pays all the super it is required to pay up to the date of you leaving. This is a common problem and thousands of employees are short-changed each year. 120

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The other people who may be missing out are one-person businesses operating through a company structure. Many consultants and tradespeople operate this way. For many of these people making a super contribution is often a last-minute task rushed through at the end of June each year. For some there is very little money left to pay a salary and super contribution, and sometimes the contribution is simply forgotten in the rush. If you are paying yourself a salary out of a company, then you must also legally make a 9 per cent contribution to a super fund in your name. It is always best to make a super contribution each time you pay yourself a salary out of the company. That way you don’t run the risk of forgetting later on, or of not having enough in the tin at the end of the year for super.

Nine per cent is not enough Later in the chapter I take a look at what different levels of super contributions will result in levels of super balances at retirement and what retirement incomes they can produce. And unfortunately, the 9 per cent compulsory super contributions are not enough. Most developed countries rely on compulsory pension fund contributions (from government, employers and employees) of around 15 per cent to 20 per cent of salaries, with some being as high as 40 per cent and more.

Maximum employer super contributions For a person on a salary of, say, $70 000, the compulsory 9 per cent super contribution will be $6300 per year. At the time of writing, the maximum limit of tax-deductible employer contributions, regardless of salary, is $50 000 per year for people aged under 50 and $100 000 per year until 2012 for people aged over 50. (The $50 000 per year limit for under 50 year olds rises for inflation each year, so by the time you read this it may have drifted up a bit.) However, there is generally an upper limit to the amount of tax-deductible contributions and many employees are receiving well below this limit. For the current maximum contribution limits visit .

Action plan 1

Check that your employer is making the necessary compulsory contributions into your fund. If you haven’t been receiving statements, ask your employer for the name of the fund, the contact details and your account number, then check it yourself.

2

Make sure your super fund has your tax file number. If it doesn’t your fund will pay a penalty tax on contributions. Don’t just take your payroll manager’s word for it. Check with the actual fund yourself. 121

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Salary sacrificing How do you get your employer to put more than the compulsory 9 per cent into your super fund without costing them any more money? The answer is by salary sacrificing. The employer agrees to increase your super contribution but reduces your salary, so that the total cost to them is still the same. Let’s take a look at an example. John is on a salary of $70 000. The total cost to his employer is $70 000 plus the 9 per cent compulsory super contribution of $6300, which is $76 300. If John wants to salary sacrifice an additional $10 000 into super, his employer reduces the salary paid to him and increases the super contribution, so that the total cost to the employer remains the same. This is shown in table 4.1.

Table 4.1: difference in income and super if salary sacrificing Without salary sacrifice

With salary sacrifice

Total cost to employer

$76 300

$76 300



Less super contribution

$6 300

$16 300

+$10 000

$70 000

$60 000

–$10 000

Less income tax payable*

($17 400)

($14 250)

–$3150

Net cash in hand after tax

$52 600

$45 750

–$6850

Total super contributions

$6 300

$16 300

+$10 000

Less contributions tax (15 %)

($945)

($2 445)

+$1 500

Net increase in super fund

$5 355

$13 855

+$8 500

Total tax paid (salary and super)

$18 345

$16 695

–$1 650

Total benefit (net salary and super)

$57 955

$59 605

+$1 650

Salary to employee

Difference

Impact on super fund

Impact on employee

*Income tax is based on tax rates for the 2006 to 2007 year, the employee is in the 31.5 per cent tax bracket, including the Medicare levy of 1.5 per cent.

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John’s employer doesn’t mind doing this because the total cost is still $76 300. John’s salary has dropped from $70 000 to $60 000 for the year because the additional $10 000 has gone into his super fund. But because his salary is lower, the income tax payable is also lower. The result is that the net salary in John’s pocket after income tax is $6850 lower than if he didn’t salary sacrifice. The upside, however, is that he now has an additional $8500 in his super fund, after the 15 per cent tax on contributions has been paid out of the fund. So, if we take into account both the net cash in John’s pocket from his salary and the net increase in his super fund, he is better off by $1650 per year ($8500 – $6850).

‘Transition to retirement’ scheme From age 55 you can convert part or all of you super fund to a pension and pay yourself a tax-free super pension (between 4 per cent and 10 per cent of your super balance per year). Then you can salary sacrifice part or all of your salary (up to $100 000) back into super. Because your salary sacrifice is paid out of pre-tax income and your super pension is tax free, you can actually end up with more money in super, even though your net cash in your hand outside super stays the same. This is a popular way for over 55s to top up their super while they are still working. Talk to your accountant or planner about the details.

Not just for over-50s Salary sacrificing is usually most popular with people who are approaching their final five to 10 years of work and who haven’t contributed enough in their first 20 or so years of employment. Compulsory super contributions have only been at 9 per cent since 2003 — they started out at 3 per cent in 1992 — so older workers are at a disadvantage compared with younger workers who have had the benefit of compulsory super for all or most of their working lives. Workers in their 20s or 30s are usually in a better position because they have more time on their side, and they can use this extra time to create sizeable wealth by salary sacrificing — even if they do it by just a small amount. One great advantage of salary sacrificing into super is that it is another form of forced savings. It takes the money out of your pocket and out of temptation’s way. It’s simply not there to spend in the first place, so you are forced to make adjustments to your spending habits. One of the practical problems with salary sacrificing and other forms of salary packaging is that many small- and medium-sized businesses are simply not set up to do it. Often staff want to salary sacrifice different amounts, and some want to incorporate all sorts of things into their

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salary packages. Many small- and medium-sized businesses don’t have the support staff to do the extra work required. Talk to your employer and find out what is possible in your company. Also, talk to other staff and see if you can generate some interest in salary packaging (perhaps suggest they buy a copy of this book!). If several employees also want to do it, the employer is much more likely to start.

How much sacrifice? Take your current super balance and multiply it by it by 5 per cent to find the income it would produce per year (growing for inflation) if you retired tomorrow. Most people who are close to retirement have a super balance of between $50 000 and $100 000, which would provide them with incomes of between $2500 and $5000 per year for the rest of their lives — if they retired tomorrow. Even if you have $500 000 in super it would produce income of only around $25 000 per year (rising for inflation) for the rest of your life. These examples assume you don’t need your super fund to pay off the mortgage, or pay for kids’ education and so on. Scary stuff! Of course, you are probably not going to retire for many years yet, but this gives you a quick picture of the task ahead if you are counting on super to build a decent retirement income. Some people salary sacrifice everything they legally can into super, which results in them receiving very little or no actual cash in their pay packet. I have seen schemes in which people extend their home loans and/or switch the home loan to interest-only repayments in order to reduce monthly mortgage payments so they have enough cash to live on, while salary sacrificing their entire salary into super. There are too many things that could go wrong with the ‘salary sacrifice everything into super’ approach. Interest rates could rise dramatically, which would increase the interest-only mortgage payments leaving no money to live on. You or your partner could lose your jobs. You can’t access your super fund in the case of emergencies such as divorce, medical expenses and so on. Super should be an important part of your overall wealth-building plan, but it shouldn’t be your only plan.

What level of contributions is needed to build enough for retirement? The following examples demonstrate how different people in different positions could achieve the $1 million target required for a decent retirement through salary sacrificing. In each example I have made the following assumptions: 9

The employees have been receiving only the compulsory contributions each year. 124

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9

The employees are aiming to retire on an income of 70 per cent of their final salary.

9

The funds have been invested in a broad range of growth assets over the years, returning an average return of 12 per cent before taxes and fees.

9

The fund managers have been charging annual fees of 2 per cent per year.

9

Inflation is assumed to run at 2.5 per cent per year.

Let’s take a look at example 1.

Example 1: 45 year old on $70 000 salary Current age

45

Started working at age

20

Starting salary

$20 000

Current salary

$70 000

Employer contributions above 9% (past)

0%

Future salary growth p.a.

3%

Planned retirement age

60

Retirement income as % of final salary

70%

Current super balance (approx.)

$85 000 Plan A

Plan B

Plan C

Employer contributions above 9% (future)

0%

15%

30%

Super balance at retirement

$551 000

$751 000

$949 000

Equivalent in today’s dollars

$381 000

$518 000

$655 000

Money will run out at age

69

75

88

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Julia is 45 years old and on a salary of $70 000. Her employer has been contributing the compulsory super contributions over the years, but that’s all, and her current super balance is approximately $85 000. Julia plans to retire age 60 and wants a retirement income of 70 per cent of her final salary. Three different plans for Julia’s super are shown in the table. If Julia was to choose plan A, her employer would continue to make the compulsory 9 per cent contributions until she retired. Her super fund balance at retirement would be approximately $552 000 ($381 000 in today’s dollars) and it would run out at age 69, only nine years after she retires. Plan B is a bit better, with Julia’s employer contributing an additional 15 per cent of salary on top of the compulsory 9 per cent via a salary sacrifice agreement. This would produce a retirement balance of $751 000 ($518 000 in today’s dollars), which would run out at age 75. Salary sacrificing would leave Julia with about $7000 less cash in after-tax salary each year — painful but manageable. Plan C shows the amount Julia would need to salary sacrifice to build a super balance at retirement of $949 000 ($656 000 in today’s dollars), which would last until age 88. In order to achieve this Julia would need to salary sacrifice an additional 30 per cent of her salary ($21 000 initially, then rising as her salary rises from year to year) on top of the compulsory 9 per cent. She would have about $15 000 less in net cash after tax in her pay packet each year from now until retirement, or $300 less net cash per week. This would require a radical reduction of her living expenses and lifestyle from now until age 60. If Julia wanted to retire at 55 instead of 60, with a retirement income of 70 per cent of her final salary, she would need to salary sacrifice a whopping 65 per cent of her salary into super from now until retirement. This would give her a super balance of $855 000 ($668 000 in today’s dollars) and it would last until age 89. However, this would be almost impossible to do because the salary sacrifice would leave her with very little cash to live on. The only way this could work was if she had a partner who was also on a good salary and she lived off her partner’s income. On the other hand, if Julia was prepared to work until age 65 and still have a retirement income of 70 per cent of her final salary, the task becomes much easier. If she didn’t salary sacrifice at all and her employer kept contributing just the 9 per cent, then she would have a super balance at retirement of $937 000 ($572 000 in today’s dollars), which would last until age 83. If Julia salary sacrificed an additional 5 per cent of her salary into super, this would result in a super balance at retirement of $1 042 000 ($636 000 in today’s dollars), which would last her until age 89.

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Note, however, that these examples don’t count any part age pension that may be available. They also don’t allow for any extra money to be taken out of the super fund for things like paying off the mortgage, helping the kids buy a house, buying a boat, going on a big trip and so on. If you want to do any of these additional things with your super fund, you will need to build it into the amounts in these examples, or do it outside the super system. Nor is any allowance made for leaving a legacy for your family. In these examples the super fund is used purely to provide income to live off in retirement, and they assume that the fund is run down to nil. Let’s take a look at example 2.

Example 2: 35 year old on $100 000 salary Current age

35

Started working at age

20

Starting salary

$20 000

Current salary

$100 000

Employer contributions above 9% (past)

0%

Future salary growth p.a.

3%

Planned retirement age

55

Retirement income as % of final salary

70%

Current super balance (approx.)

$96 000 Plan A

Plan B

Plan C

Employer contributions above 9% (future)

0%

10%

18%

Super balance at retirement

$1 170 000

$1 471 000

$1 714 000

Equivalent in today’s dollars

$714 000

$898 000

$1 046 000

Money will run out at age

69

78

100

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The person in this example, Charlie, appears to be in a much better position than Julia, but he would still need to salary sacrifice an additional 18 per cent of his salary into super if he wanted to retire at 55 and have a retirement income of 70 per cent of his final salary. This would last Charlie until he was 100 years old, which would be plenty in most cases, but would still leave no balance at death. On the other hand, if he worked until he was 60, he would have a super balance on retirement of $1 960 000 ($1 057 000 in today’s dollars), which would last until he was 100 without the need for salary sacrificing. Of course, if Charlie wanted to use his super fund to do other things, like pay out the mortgage, help the kids buy a house, or leave a legacy after death, then he is back in the salary sacrificing game. Let’s now take a look at example 3.

Example 3: 50 year old on $60 000 salary Current age

50

Started working at age

20

Starting salary

$15 000

Current salary

$60 000

Employer contributions above 9% (past)

0%

Future salary growth p.a.

3%

Planned retirement age

60

Retirement income as % of final salary

70%

Current super balance (approx.)

$75 000 Plan A

Plan B

Plan C

Employer contributions above 9% (future)

0%

25%

50%

Super balance at retirement

$276 000

$453 000

$641 000

Equivalent in today’s dollars

$215 000

$345 000

$493 000

Money will run out at age

65

71

81

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Example 3 shows how tough it is to build a super balance for people currently aged 50 who have only been receiving the compulsory super contributions to date. The employee, Alice, would need to work until age 65 and salary sacrifice an additional 25 per cent of her salary into super to build a super balance at retirement of $765 000 ($528 000 in today’s dollars), which would last her until age 88. Let’s take a look at example 4.

Example 4: 25 year old starting out on $30 000 salary Current age

25

Started working at age

25

Starting salary

$30 000

Current salary

$30 000

Employer contributions above 9% (past)

0%

Future salary growth p.a.

4%

Planned retirement age

60

Retirement income as % of final salary

70%

Current super balance (approx.)

$0 Plan A

Plan B

Plan C

Employer contributions above 9% (future)

0%

5%

6%

Super balance at retirement

$892 000

$1 067 000

$1 102 000

Equivalent in today’s dollars

$377 000

$451 000

$465 000

Money will run out at age

80

99

Never

Example 4 is of an average worker, Ben. It shows that if he relied just on the 9 per cent compulsory super contributions, he would be able to retire on an income of 70 per cent of his final salary ($34 000 in today’s dollars) and it would last him until age 80. If Ben’s employer put another 5 per cent into super, the money would last him until age 99. 129

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This example also shows that the 9 per cent compulsory super is not enough to provide a decent retirement for an average worker, even for people starting out today and receiving the 9 per cent contributions their whole working life. This could be achieved only with contributions of about 13 per cent of their salary for their entire working lives — that is, 9 per cent plus an additional 4 per cent. It would only allow a retirement income of $34 000 in today’s dollars, which is very modest, but still more than double the age pension. For people starting out today who want a retirement income of today’s equivalent of $50 000 when they retire at age 60, this would require super contributions of 27 per cent of their salary — that is, 9 per cent plus an additional 18 per cent — throughout their entire working lives. However, this would be very difficult because the salary sacrifice of the additional 18 per cent of their income would take net cash of $100 per week out of their living expenses, making day-to-day living difficult on what was a modest income to begin with. The problem, of course, is that we are trying to fund what could well be 40 years of retirement (from age 60 to 100) from a working life of only 35 years (from age 25 to 60). It doesn’t make sense. The bottom line is that the compulsory super contributions are of a great benefit because they are a form of forced savings. But this money will only go so far.

Action plan 1

Ask your payroll manager whether the company has any salary sacrificing arrangements.

2

If the company doesn’t have arrangements for salary sacrificing, get support from other employees and put a plan to your company.

3

Take another look at the examples and estimate what your target level of contributions should be, based on your target age for retirement.

Contributions from yourself There are a couple of ways you can make contributions to your super fund.

Employee contributions If you work for an employer (and your employment income makes up more than 10 per cent of your total income), then you aren’t considered self-employed and any additional contributions to super will be classed as after-tax contributions and you won’t receive a tax deduction. After-tax 130

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contributions are also known as personal or individual contributions, undeducted contributions and non-concessional contributions. In this book I refer to them as after-tax contributions. Because these after-tax contributions don’t give you a tax deduction, they are not taxed again at the contributions tax rate of 15 per cent when they enter your super account. For example, if you make an after-tax super contribution of $10 000, the whole $10 000 goes into the fund. Because of this different tax treatment, after-tax contributions are not as tax effective as employer or self-employed (tax-deductible) contributions for people in the 31.5 per cent tax bracket — that is, those earning more than $30 000. I will get into the tax benefits of super in much more detail a little later. At the time of writing, the limit for after-tax contributions is $150 000 per person per year, or $450 000 over three years. This is useful if, for example, you sell an investment for, say, $450 000 because you can contribute the whole amount into the super fund in one go. It does mean, however, that you won’t be able to make after-tax contributions until three years later. Public servants who are members of the Public Sector Superannuation (PSS) and Commonwealth Sector Superannuation (CSS) schemes can generally have personal superannuation contributions deducted from their after-tax salary. Members of PSS can contribute between 2 per cent and 10 per cent of their salary. Note that these are after-tax contributions, so it’s not the same as salary sacrificing.

Work test You can still make contributions to super until age 65 whether you work or not. Between the ages of 65 and 74 you can make further contributions (tax deductible and after tax) to super only if you pass a ‘work test’, which means working a minimum of 40 hours over 30 consecutive days during the period.

Tax-deductible contributions for the self-employed Generally, you can make tax-deductible super contributions if you are self-employed. You are classified as self-employed for this purpose if you earn less than 10 per cent of your income from employers. These contributions are then subject to the 15 per cent tax on contributions — paid by the super fund to the tax office. For example, say you are self-employed and in the 31.5 per cent tax bracket. If you have earned a profit of $10 000 in a business venture you would pay 31.5 per cent or $3150 income tax on it, leaving you with $6850, after tax, from the venture. However, if you put the $10 000 into your super 131

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fund as a tax-deductible super contribution, this $10 000 would reduce your profit from the venture to nil, so you would save $3150 you would otherwise have paid in tax. The $10 000 contribution would be subject to the 15 per cent contributions tax, so your super fund would pay $1500 in tax to the tax office, which leaves you with no cash in hand, but $8500 in your super fund. The result is that you are better off by $1650 ($8500 – $6850). The downside is that, after making the contribution, the money is in your super fund, so you can’t access it until you reach preservation age (between 55 and 60 years old depending on your current age).

Spouse contributions Taxpayers can receive a rebate of up to 18 per cent of contributions of up to $3000 made into their spouse’s super fund if the spouse is not working or has income below about $14 000. The full rebate of $540 — that is, 18 per cent of $3000 — is offered if the spouse earns less than about $11 000 per year. Partial rebates are allowed if the income is up to about $14 000 per year. These types of contributions are considered to be after-tax or undeducted contributions so the fund doesn’t pay 15 per cent tax when it enters the super fund. You can always make spouse contributions of as much money as you like, up to the overall limit on undeducted contributions, but you only receive the tax rebate on the first $3000 and only if the spouse has income below the set levels.

Contributions from the sale of small businesses There are several special rules applying to contributions from the sale of small businesses. For example, if you are retiring and selling your small business, you are able to contribute up to $1 million from the proceeds of the sale into your super fund. Talk to your accountant for the details.

Contributions from the government Is there anyone in your family who: 9

is under 70

9

is employed (including casual and part-time work)

9

earns less than $58 000? 132

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If so, they can receive free money from the government. It’s not ‘free’ of course because you pay for it through your taxes, but you may as well get it back if they are offering it. People who have a total income of less than about $28 000 per year and who make personal (undeducted) contributions into their super fund can receive an additional co-contribution from the government straight into their super funds. For every $1 contributed by an eligible person up to $1000 in a tax year, the government will make a co-contribution of $1.50. That’s up to $1500 of ‘free’ money from the government! And you can do it every year! People earning between $28 000 and $58 000 can still receive a reduced co-contribution. The co-contribution is reduced by $0.05 for every dollar of total income over the $28 000 limit. These limits are increased each year for inflation and the government is constantly changing the rules, so visit the Australian Tax Office website for current information and search for ‘superannuation co-contribution’. The government co-contribution is available to anybody up to the age of 70 who receives at least 10 per cent of their income from employment as an employee.

Self-employed The self-employed are not eligible for the government co-contribution, but they can receive a tax-deduction for contributions. Small business operators who pay themselves a salary out of a company would be counted as employees and eligible for the co-contribution because they are technically employees of their own company. You don’t need to apply for the co-contribution. Your super fund will notify the tax office of any personal contributions received each financial year, usually by October. The tax office then makes the payment and sends you a notice informing you of this about two months later.

Action plan 1

If you are self-employed do you make regular contributions to a super fund?

2

How does your current super balance stack up against table 1.1 on page 8?

3

If you or your spouse earns less than $14 000, talk to your accountant about making spouse contributions.

4

Is anyone in your family entitled to the government co-contribution?

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4.3 Getting money out of super In the early days of super, people could access their super when they reached 55 years of age. However, the government has gradually increased this age. The minimum ages to access super (called ‘preservation age’), correct at the time of writing, are shown in table 4.2.

Table 4.2: preservation age Date of birth

Preservation age

Before 01 July 1960

55

01 July 1960 to 30 June 1961

56

01 July 1961 to 30 June 1962

57

01 July 1962 to 30 June 1963

58

01 July 1963 to 30 June 1964

59

Born on or after 01 July 1964

60

The increasing life expectancy of Australians is a continuing trend, so the government will probably continue to fiddle with the age rules in the future. Don’t be surprised if the age you can access your super drifts up in years to come.

Early access Money in approved super funds can be withdrawn before the specified ages usually only in very limited circumstances. These include cases of permanent disability preventing employment, severe economic hardship, compassionate grounds or where a person is leaving the country indefinitely. The grounds are very limited and there is a continuing trend towards further tightening of the rules. There are many schemes marketed via magazines and websites that promise access to super earlier than the rules allow. Many of these are outright scams, while others are legitimate processes to shift money into self managed super funds. Although moving money into a self managed fund is legitimate, you still can’t get your hands on it until you reach preservation age. All it usually achieves is putting a big chunk of it in the hands of the scheme promoters!

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Who can access super before age 60? People born before 1 July 1964 can access their super between preservation age and age 60. Income streams won’t be tax free, but they do get a 15 per cent tax offset.

Tax-free after age 60 At the time of writing, you can take money out of your super fund at age 60 tax free (except for the old defined benefit government schemes, where you get a 10 per cent tax rebate). This money is not included in your tax return, so you still have your tax-free threshold and other tax offsets to reduce tax on your other income. You don’t even pay the 1.5 per cent Medicare levy on this tax-free cash from your super account.

Lump sum or pension You can take money out of your super account in the form of a super pension (which is a regular income stream) or a lump sum. The superannuation system was intended to encourage people to opt for a pension, but it has become a lot easier to take a lump sum. Under the current rules, you can take the whole amount of your super fund tax free at age 60, pay off the mortgage, blow it all on a big world trip or at the races, then go on the government age pension for the rest of your life! If you want to pay yourself a pension from your super fund there are rules limiting the amount you can take out each year. The minimum amounts are shown in table 4.3.

Table 4.3: minimum distribution Age

Minimum distribution (% of fund balance)

55 to 64

4

65 to 74

5

75 to 79

6

80 to 84

7

85 to 89

9

90 to 94

11

95+

14 135

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These minimum amounts are there to ensure that the money is paid out and doesn’t accumulate in the fund once it is in pension mode. Remember, while the fund is in accumulation phase it pays income tax on fund earnings at the rate of 15 per cent, but as soon as the fund goes into pension phase its earnings are tax free. There is no obligation to switch from accumulation mode to pension mode. You can keep it in accumulation mode until death, but earnings will be taxed.

Death of a member When a super fund member dies with a balance remaining in the member’s fund, that money is distributed according to the terms of the fund trust deed, not the terms of the deceased’s will. Some benefits paid to beneficiaries will be tax free, but some will be taxable. The rules are very complex and are constantly changing. For example, some benefits originating of after-tax contributions, from the proceeds from the sale of businesses, and from pre-1983 contributions can be tax free when passed on to beneficiaries. Other benefits paid can be taxable in the hands of the beneficiaries when they receive the benefit after the death of the member if the beneficiaries are not ‘dependents’ of the member. Dependents include the spouse, dependent children and adult children with a disability. At the time of writing, the ‘death tax’ is paid at the rate of 16.5 per cent of the value of the inheritance, payable by the beneficiary when the benefit is received.

4.4 Key points 9

The main advantages of super are that it’s compulsory and it’s locked away for several decades.

9

Super has several tax advantages including tax deductions for contributions, lower taxes within the fund and lower tax when paid out to members.

9

The performance of the super system to date has been poor, but there are lots of opportunities for you to maximise the benefits as part of your overall wealth plan.

9

The earlier you start the greater the impact of additional contributions on your super.

9

Nine per cent compulsory super is not enough to generate a comfortable income in retirement. Most people will require at least double or triple that, depending on their age now and planned retirement age.

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Step 3 — superannuation (part I): how to use super

9

Make best use of rebates for spouse contributions and government co-contributions.

9

Your super is your money so you need to take control of how it is invested. Most people can choose how their money is invested, and most super funds offer a wide range of investment options.

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Protection House

Chapter 5

Superannuation (part II): maximising super performance

Money sense

5.1 Maximising performance When it comes to super, the most important job you have is to make sure your employer is paying the compulsory contributions to your super account or, if you are self-employed, making sure that you are paying the appropriate contributions. The next two important jobs are to make sure the money is invested in the right types of assets and that it is done at the lowest cost.

Asset allocation Here’s a simple way that the majority of Australians can double their super balance and retirement income with very little time and effort. It’s all about ‘asset allocation’. The term ‘asset allocation’ refers to how your money is spread over the different types or classes of investment assets. In chapter 2 I introduced the four main asset classes — shares (also called equities), property, bonds (also called fixed interest) and cash.

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Each of these asset classes performs in a different manner and your choice of asset allocation will make a huge difference to your super fund balance and your retirement income. If you are using your super fund to build wealth over the long term (that is, over several decades), then your fund should be invested primarily in growth assets — shares and property. Each super fund and fund option will have a different mix of these four asset classes, but it’s not always easy to tell from the fund names what particular mix of assets each fund has. The only way to find out is to look at the product disclosure statement (PDS) for each fund. You can download the major fund managers’ PDSs from their websites. Funds with a high proportion of shares and property are often called ‘aggressive’ or ‘highgrowth’ funds. At the other end of the spectrum are ‘conservative’, ‘stable’ or ‘secure’ funds, which consist mainly of cash and bonds. In the middle are ‘balanced’ or ‘moderate-growth’ funds. The mistake many people make is choosing for a ‘conservative’ option for their super fund, thinking that their money is safe and sound. This may be so, but it will go backwards after tax and inflation. The more aggressive growth funds may be more volatile from year to year but, over long periods of time, they will outperform conservative funds and stay well ahead of inflation.

Tale of three funds Let’s take a look at what would happen to $100 000 if it was sitting in three super funds with different mixes of assets. In these examples, super fund earnings are taxed at 15 per cent, inflation is assumed to run at 2.5 per cent per year (which is the average inflation rate for the past couple of decades), and fees of 2 per cent per year are charged. The rates of return and tax treatment of each asset class are shown in table 5.1 (overleaf). Table 5.2 (overleaf) shows how three different funds with very different asset allocations would perform over 10 and 20 years. On page 141 figure 5.1 shows how $100 000 would grow in the three funds over a period of 30 years. You can see that if you chose plan C, the ultra-conservative fund that invested in cash and bonds, your $100 000 would only barely keep pace with inflation. That $100 000 turns into just $114 000 in today’s dollars in 20 years after inflation, taxes and fees. If you were relying on this fund to provide an income to live off in 20 years, the income at the rate of, say, 5 per cent on your $114 000, would be only $5700 income per year. Switching from plan C to plan B would give you double the super balance in 20 years and double the income every year for the rest of your life. If you chose plan A, the high-growth fund with 90 per cent of the assets in shares and property, your $100 000 would turn into $365 000 in today’s dollars in 20 years, after inflation, 139

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taxes and fees. That’s more than three times the super balance of plan C and more than three times the income every year for the rest of your life — $18 000 per year in today’s dollars versus less than $6000 per year.

Table 5.1: rates of return and tax treatment assumed for each asset class Shares

Property

Bonds

Cash

Growth rate p.a.

8.0%

6.0%

1.0%

0.0%

Income yield p.a.

4.0%

6.0%

5.0%

6.0%

Total pre-tax return

12.0%

12.0%

6.0%

6.0%

Normally taxed income

10%

60%

80%

100%

Discounted gains

10%

10%

10%

0%

Tax free/deferred

10%

20%

0%

0%

Fully franked dividends

70%

10%

10%

0%

Break-up of distributions within the funds

Table 5.2: performance of $100 000 in super funds with different asset allocations Plan A High growth or aggressive

Plan B Balanced or moderate

Plan C Conservative or stable

Shares

60%

35%

0%

Property

30%

25%

0%

Bonds

5%

20%

50%

Cash

5%

20%

50%

100%

100%

100%

Asset allocation

Total

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Superannuation (part II): maximising super performance

Plan A High growth or aggressive

Plan B Balanced or moderate

Plan C Conservative or stable

Return before fees and tax

11.4%

9.6%

6.0%

Return after fees and tax

9.4%

7.3%

3.2%

Balance after 10 years

$244 000

$202 000

$137 000

Balance in today’s dollars

$191 000

$158 000

$107 000

Balance after 20 years

$598 000

$407 000

$187 000

Balance in today’s dollars

$365 000

$248 000

$114 000

Income after 20 years (p.a.)

$29 900

$20 300

$9400

Income in today’s dollars (p.a.)

$18 200

$12 400

$5700

Figure 5.1: impact of asset allocation on super balance ($100 000 invested with no further contributions) Balance Balance

30 years

$1,600,000 $1 600 000

$1,461,197 $1 461 197

$1,400,000 $1 400 000

$1 200 000 $1,200,000 $1,000,000 $1 000 000

High-growth, aggressive (60/30/5/5) Hi Growth, Aggressive (60/30/5/5) Balanced, Balanced,Moderate moderate (35/25/20/20) (35/25/20/20) Very (0/0/50/50) VeryConservative conservative (0/0/50/50)

years 2020years: $597 685 $597,685

$800 000 $800,000

$821,014 $821 014

$600 000 $600,000 $406,974 $406 974

$400 000 $400,000 $187,144 $187 144

$256,014 $256 014

$200 000 $200,000 $0

0 1 2 3 4 55 6 7 88 99 10 10 11 12 13 13 14 15 16 16 17 18 18 19 20 20 21 21 22 23 23 24 24 25 25 26 26 27 27 28 29 29 30 30 Years

Years

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Asset allocation drives performance In table 5.2, plan C is invested in cash and bonds. The fund return before fees and tax is 6.0 per cent and the return after fees and tax is 3.2 per cent. Cash and bonds have little or no capital growth, few tax advantages and offer poor protection against inflation. Sixty per cent of plan B is in shares and property, and therefore will achieve more capital growth and more tax advantages than plan C. In plan B the fund return before fees and tax is 9.6 per cent and the return after fees and tax is 7.3 per cent. Ninety per cent of plan A is in shares and property, and therefore will achieve even more capital growth and tax advantages than plan B. In plan A the fund return before fees and tax is 11.4 per cent and the return after fees and tax is 9.4 per cent. The key number in each case is the return after fees and tax. Switching from plan C to plan B increases the return after fees and tax by 4.1 per cent, which more than doubles the fund size and retirement income after 20 years. Moving from plan B to plan A increases the return before fees and tax by 1.8 per cent, but it increases the return after fees and tax by 2.1 per cent. The change in return after fees and tax is greater than the change in return before fees and tax because there is more capital growth and more tax advantages in plan A. This switch also takes the fund from 60 per cent shares and property to 90 per cent shares and property. This results in another 50 per cent higher fund balance over and above plan B, and another 50 per cent more income for the rest of your life. The longer the money is in the fund, the greater the impact of asset allocation.

Choose your own retirement income and lifestyle These examples use a fund with just $100 000 in it. If you had, say, $500 000 in your fund, plan A would produce income after 20 years of $91 000 per year in today’s dollars, plan B would produce $62 000 per year, but plan C would produce only $28 000 income per year. Think for a moment about what your life would look like on $28 000 per year for the rest of your life and compare it with what it would look like on $91 000 per year for the rest of your life. You don’t have to work harder, save more or get a second job to achieve this. All you need to do is switch from a plan C fund to a plan A fund.

Eighty per cent of people don’t exercise their right to choose a fund The amazing thing is that more than 80 per cent of employees don’t exercise their right to choose their fund, or to choose their fund option within their existing fund. These people stay in the ‘default’ fund option that the fund manager offers people who don’t choose a particular option.

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Each fund has its own default option with its own mix of assets. Generally, this option is somewhere between plan C and plan B. For example, if your super is run by AMP, its default fund only has around 11 per cent shares and property in it, which is much closer to plan C. The bottom line is this — unless you have filled in a form to choose a particular fund option, you are in the default option. You are on the ‘low road’ because your asset allocation would most likely have only between 10 per cent and 30 per cent growth assets. By simply switching from the default option into a higher growth option you could double your super balance after 10 or 20 years and also the amount of retirement income the fund would produce for rest of your life. This will get you off the low road and onto the high road. It is critical that you find out what fund option you are currently in and make an informed decision about which option to choose. Most funds allow members to make one free switch per year. Once you are in a fund option with an appropriate asset mix that should normally do it for several years. Remember, growth assets are volatile so they should be left alone for several years to do their work. Don’t be tempted to change the allocation choice each year. Also beware of ‘reweighting’ or ‘rebalancing’. This is the practice of changing the asset allocation each year, or sometimes even quarterly, based on how well each asset class is doing. The theory is that if, for example, shares have done very well and property has done poorly in one particular year, money should be transferred out of shares and into property so that the overall asset mix stays on target. While this makes sense, it is too often used as an excuse to generate switching fees for the fund managers and sales commissions from the planners who recommend the change. In addition it triggers capital gains tax in your fund.

Don’t get too cute Most super fund managers offer a variety of fund options with varying levels of growth assets in them. When faced with a choice of half-a-dozen options with names like ‘aggressive growth’, ‘moderate growth’, ‘balanced’, ‘stable’ and ‘conservative’, many people try to split their fund into several parts and put a portion of their fund into each option. All this achieves is to make the fund more complex and costly. You would end up with a number of different subfunds and your overall asset allocation would be the same as the ‘balanced’ option in the first place. As long as you are happy with the fund manager and the fees, it is usually more effective and efficient to pick just one or two options. Another area where people get into trouble is choosing too many subclasses of assets. Many fund managers go beyond the basic options and include a range of smaller funds that specialise in things like small companies, emerging markets companies, international bonds, commodities, 143

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listed property, enhanced cash, hedge funds, private-equity funds, high-yield credit funds and a host of specialist areas. For most people it is generally better to stick to the broader funds because their existing super fund will have invested a portion of the fund into these specialist funds already.

Get the basics right, take action I have seen cases where people procrastinate while they debate the pros and cons of various smallcompany funds, commodities funds or hedge funds for their super fund allocation. Meanwhile, their money is sitting in a low-growth default fund incurring huge fees of up to 2.5 per cent per year. It’s important to get the basics right first; you have plenty of time to think about the optional extras later.

How aggressive is ‘aggressive’? It is important to note that descriptions like ‘very high growth’ and ‘aggressive growth’ usually do not mean the fund manager is going to be very aggressive and aim for crazy returns by taking unnecessary risks. It usually means that nearly all of the assets are invested in shares and properties. Even if their share and property investments are very broad and ‘boring’ — like investing in passive index funds — these funds would still be called aggressive because of the high proportion of shares and property in the fund. So check the PDS to find out exactly what your super fund is invested in.

Volatility and risk With a high-growth fund the value of the investments will rise and fall from year to year. In every decade there will be a ‘down’ year or two, but over the long term growth funds will beat conservative and balanced funds by a good margin. The difference in performance can mean the difference between a comfortable retirement and living at subsistence level. Even if you consider yourself to be conservative with money (like me), if you are under 45 or 50 years of age and intend to work for at least another decade, then you would be much better served by having most of the money in growth assets.

Beware of ‘churning’ If you ask financial planners for advice on super, there is a good chance that they will just sell you their own in-house fund (most planner groups are just sales arms of the fund management groups 144

Superannuation (part II): maximising super performance

that own them) or they will sell you another fund that pays a nice sales commission. Every time planners switch your fund — ‘ka-ching!’ — they get another sales commission. So, if you are going to change funds make sure it is for a very good reason, and don’t be afraid to get a second or third opinion. After all, this is your future lifestyle we’re talking about here. Every year hundreds of planners are wrapped over the knuckles by the Australian Securities & Investments Commission for switching funds for no valid reason and without demonstrating clear benefits to the client. Unfortunately, not enough planners are fined or jailed for this type of misconduct. In many cases the planners don’t even bother to investigate the merits of the fund the client is in before ‘recommending’ the one they want to sell. In addition, many planner groups aren’t even allowed to recommend the low-cost super funds (‘industry funds’) because they don’t pay sales commissions. Don’t get me wrong — there are some great planners out there. But the industry is riddled with conflicts of interest and hidden agendas, which makes it difficult to get good, unbiased, independent advice.

Action plan 1

Find out whether you are eligible for choice of funds.

2

Find out if you are in your fund’s default option.

3

Find out the asset allocation between the four asset classes.

4

Start to think about what your ideal asset allocation should be.

Fees After the asset allocation, the other important factor that determines how your fund grows is fees. There are a number of different types of super funds: 9

retail funds — the largest group

9

corporate funds — set up by companies to take contributions from their employers

9

public sector funds — for government employees

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$1 Million for Life

9

industry funds — initially for award employees but now accept public contributions

9

self managed super funds — set up by people who want to run their own super fund.

Most personal after-tax contributions and small business contributions go into retail funds. There is a whole range of annual fees, including: 9

investment management fees — 1.5 per cent to 3.0 per cent per annum (the average retail fund fee is 2.3 per cent per annum)

9

platform administration fees — 0.70 per cent to 1.8 per cent per annum (depending on the platform and fund balance)

9

adviser fees and trail commissions — 1 per cent to 2 per cent per annum.

This means the average investor who invests in shares via a financial planner into retail super funds (which is where 80 per cent of undeducted contributions go) is paying annual fees totalling 3 per cent or 4 per cent, often even more, in addition to an initial up-front fee of between 2 per cent and 4 per cent. Annual investment management fees charged by industry funds and many corporate funds average about 1 per cent or less.

Fees have a huge impact It’s important not to underestimate the impact fees can have on the overall fund performance over long periods of time. It’s easy to fall into the trap of saying, ‘It’s only a couple of per cent, so what’s the big deal?’ Let’s take another look at the investor who had $100 000 in a high-growth fund in the example used on page 139. For that example I assumed annual fees of 2 per cent, which would be pretty normal for retail funds. Table 5.3 and figure 5.2 show the affect of fees of 1 per cent, 2 per cent and 2.5 per cent on the fund. All the other assumptions are the same — asset allocation, growth rates, tax treatment, inflation and so on. As table 5.3 shows, the differences caused by different levels of fees are enormous. In a standard retail super fund with 2 per cent annual fees (fund B) $100 000 would be worth $598 000 after 20 years, or $365 000 in today’s dollars. If you were to rely on this fund to provide an income to live off in 20 years, income at the rate of, say, 5 per cent on your $365 000 would be $18 200 per year in today’s dollars. That’s about the same as the government age pension for couples.

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Table 5.3: fund performance with various levels of fees Fund A

Fund B

Fund C

1% p.a

2% p.a

2.5% p.a.

Balance after 10 years

$271 000

$244 000

$232 000

Balance in today’s dollars

$211 000

$191 000

$181 000

Balance after 20 years

$732 000

$598 000

$540 000

Balance in today’s dollars

$447 000

$365 000

$329 000

Annual fees

Figure 5.2: impact of fees on fund performance 30 years

Balance Balance

$1,981,446 $1 981 446

$2,000,000 $2 000 000 $1,800,000 $1 800 000 $1,600,000 $1 600 000

1% fund fund fee 1% fee

$1,400,000 $1 400 000

2% fund fund fee 2% fee

$1,200,000 $1 200 000

2.5% fund 2.5% fundfee fee

$1 461 197 $1,461,197 $1,253,328 $1 253 328

years 2020years: $732 242 $732,242

$1 000 000 $1,000,000 $800 000 $800,000 $600,000 $600 000

$539 564 $539,564

$400,000 $400 000

$200 000 $200,000 $0

0 11 22 33 4 5 6 7 88 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 29 30 30 Years Years

That same $100 000 in a retail super fund with 2.5 per cent annual fees (fund C) would be worth just $540 000 after 20 years, or $329 000 in today’s dollars. The additional 0.5 per cent in fees knocks 10 per cent off the super balance after 20 years. If you were to rely on this fund to provide

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an income to live off in 20 years, income at the rate of, say, 5 per cent on your $329 000 would be reduced to $16 500 per year in today’s dollars. In contrast, $100 000 in an industry fund or low-fee corporate fund with 1 per cent annual fees (fund A) would be worth $732 000 after 20 years, or $447 000 in today’s dollars. So, by dropping fees by just 1 per cent, there is 22 per cent more in the fund after 20 years! If you were to rely on this fund to provide an income to live off in 20 years, income at the rate of, say, 5 per cent on your $447 000 would be $22 300 per year in today’s dollars. It’s a simple as that. By having $100 000 in a 1 per cent fee fund instead of a 2 per cent fee fund, you end up with $100 000 more after 20 years. The two funds invest in exactly the same assets and are subject to the same tax rates, inflation and so on. The longer the fund is running, the greater the negative impact of fees. The lesson is this — there are plenty of large, reputable super funds on the market with fees of less than 1 per cent per year, achieving returns just as good, or better, than the expensive super funds charging over 2 per cent fees.

Exit fees In addition to entry fees and annual fees, many funds also have exit fees to lock you into their fund. Exit fees are given other names to disguise them such as termination fees, withdrawal fees and deferred entry fees. Most of the newer funds (introduced in the past five years) have either entry fees or exit fees, but some have both. Many older funds tend to have much higher exit fees than the newer funds. Many funds have exit fees that amount to a significant chunk of the fund balance — often up to 10 per cent or 15 per cent or more of the total fund. If your fund has huge exit fees, it may not make economic sense to switch out of the fund into a new one. In that case, the best course of action is probably to leave the existing fund in place, but select a growth option. Then open a new account with a new super fund that has low entry fees and low annual fees, and start making contributions into the new fund. On the other hand, if the exit fee is ‘only’ a per cent or two of the balance, it generally makes sense to switch out of a fund with a high annual fee (2 per cent or more) into a new fund with lower annual fees. The cost of the exit fee will be more than made up for by the lower annual fees in the new fund. The sooner you are in a low-cost industry fund or a self managed fund, the better. You can invest in exactly the same assets as the expensive retail funds but at a much lower cost.

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Action plan 1

Find out the annual fees your fund pays, including administration fees, platform fees, investment management fees and any other fee.

2

Use the examples in this chapter to estimate how much you can save by switching to a fund with lower fees.

Choosing a super fund Unless you have enough money in your super fund to make it cost-effective to run your own self managed fund — which normally requires at least $100 000 — your super fund will be in the hands of super fund managers. These days, an increasing proportion of employees are legally able to choose their own funds. Even if you don’t have this choice, your existing fund is almost certain to offer different investment options. For more information about choice of funds see . Having made decisions about asset allocation and fees, the next step is to choose a fund manager. I will look at each type of super fund manager in turn.

Industry funds There are more than four million Australians in industry super funds. Although they were originally intended for award-based employees, most are now ‘public offer’ funds and will accept new members from anywhere. Industry super funds are not run for profit — all the benefits go to members. Because of their lower fees they regularly outperform the active managed funds. Their boards are made up of representatives from unions and business communities.

Fees The fees for industry super funds are much lower that for the active fund managers because they pay no commissions to financial planners and have no external shareholders to pay. Management fees differ depending on the asset allocation selected, but are usually about 0.70 per cent or 0.80 per cent per year for growth options, which is about one-third of the fees of retail super funds. In addition to annual fees, industry super funds tend to also charge a flat weekly fee — between about $1 and $2 per week. This flat fee makes industry funds more expensive if you only have a small balance, as shown in table 5.4 (overleaf).

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Table 5.4: small balance versus large balance in an industry fund Small balance

Larger balance

$10 000

$100 000

Investment fee of 0.70%

$70

$700

Flat admin fee of $1.50 per week

$78

$78

Total fees per year

$148

$778

Fees as a percentage of the balance

1.48%

0.778%

Fund balance

Table 5.4 shows that for small fund balances (the average account balance in industry funds is only $15 000), the total cost in percentage terms is still well below that of the retail super funds. The larger the balance, the lower the total costs in percentage terms.

Choosing an industry fund If you are currently in an industry fund, there should be no need to switch to another industry fund manager because all industry fund managers offer a wide range of investment options and asset allocations, as well as a range of low-cost insurance products. If you are currently in a retail fund or no have fund at all, industry funds offer a low-cost alternative. They can take contributions from anybody who is entitled to make super contributions, including sole traders, self-employed, small businesses, and even spouse contributions. There is no need to choose the fund catering to your particular industry, but for practical purposes you will find that your employer probably already has a member relationship with your relevant industry fund, so that’s a good place to start looking. Some of the larger industry funds are listed in table 5.5. There are several other smaller industry funds. For details on these visit .

Corporate funds Corporate funds are run by large companies that employ thousands of people. Most charge relatively low fees (from about 1 per cent per year) and are generally not open to non-employees. Fees are kept low because the costs are usually subsidised by the employer.

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Superannuation (part II): maximising super performance

Table 5.5: major industry super funds Super fund

Industries

Size

Australian Super

Diverse range

$25 billion

1300 300 273

Sunsuper

Multi-industry

$10 billion

13 11 84

Cbus

Construction and building

$9 billion

1300 361 784

HESTA

Health and community services

$9 billion

1800 813 327

HOSTPLUS

Hospitality, tourism, recreation and sporting

$5 billion

1300 363 895

MTAA Super

Motor trades

$4 billion

1300 362 415

Care Super

Administrative, managerial, professional and service

$2 billion

1300 360 149

TWUSUPER

Transport

$2 billion

1800 222 071

Westscheme

Mining

$2 billion

1800 198 327

Catholic Super Fund

Catholic schools

$2 billion

1300 550 273

AGEST Super

Australian government employees

$2 billion

1300 724 378

Asset Super

Multi-industry

$1 billion

1800 805 981

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Most offer a wide range of investment options and low-cost insurance to members. One advantage is that they can usually arrange all sorts of complex salary packaging and salary sacrifice structures because they work hand in hand with the company’s payroll department. If you are in a corporate fund, the chances are that you can select good-quality growth assets at around a similar total annual cost as the low-cost industry funds. One option is to leave your existing corporate fund in place and make additional deducted or undeducted contributions into a new account at an industry fund, but be aware of the impact of the flat weekly fees on the performance of an industry fund with a small balance.

Public sector funds Public sector funds offer a range of investment options and good benefits especially in terms of indexed pensions on retirement. If you need additional flexibility to make further contributions and/or salary sacrificing structures that your existing fund doesn’t handle, you may want to set up another super fund account with an industry fund.

Retail funds Retail funds are where the largest share of super money is held and they are by far the most expensive funds. Most people working for small- and medium-sized companies in non-award industries would have their contributions paid into retail funds. Also, about 80 per cent of nondeductible after-tax contributions — that is contributions made by employees over and above their employer contributions — are made into retail funds. Retail funds are run by commercial fund managers and they have much higher fees than industry and corporate funds. They charge high fees because they have additional costs to bear: 9

sales commissions to financial planners (about half the up-front and annual fees charged by the funds are paid out in sales commissions to planners)

9

returns to the fund manager’s shareholders (the fund managers are owned by banks or insurance companies)

9

advertising and marketing (retail funds are the ones with all the expensive advertising such as Macquarie, MLC, Clearview, BT, Westpac and Zurich).

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If you are already in an industry fund or corporate fund there is little or no reason to switch into a retail fund. Industry and corporate funds offer a wide range of investment options and asset allocations at much lower costs than the retail fund managers.

Action plan 1

Find out what type of fund are you currently in — retail, industry, corporate, public sector.

2

Find out the fees your fund charges.

3

Find out the different fund options your super fund offers.

5.2 Tax advantages of super for after-tax contributions On the surface, superannuation looks like it has some great tax advantages compared with other forms of investment. During your working life, the super fund’s investment earnings are taxed at only 15 per cent and after you retire and the fund starts paying you a super pension or lump sums, super fund earnings are tax free from age 60. On top of this, any money you take out of super after age 60 is tax free (except for the few remaining defined benefit plans for senior public servants). These tax breaks may sound fantastic, but the reality is actually quite different. Even taxpayers in the highest marginal tax bracket (46.5 per cent and earning more than $150 000 per year), would build wealth more quickly by investing outside super rather than by making additional undeducted contributions to their super fund. How is this possible? Surely paying 15 per cent tax or no tax on investments inside a super fund is much better than paying 46.5 per cent tax on investments outside super? The answer is fees. The tax advantages offered by the super system are more than outweighed by the heavy fees charged by super fund managers. The only circumstances in which taxpayers would be better off with super is if they had a self managed super fund and kept the costs very low.

Capital gains tax Individuals can contribute $150 000 per year to their super fund as undeducted after-tax contributions. Three years can be grouped together each three-year period, which means you can contribute up to $450 000 every three years — for example, from the sale of a business or investment

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property. Households with two adults can therefore contribute up to $900 000 to their super every three years as undeducted contributions. Now, before you start selling assets and putting the proceeds into super think about capital gains tax and transaction costs. If you have owned investments, such as properties and shares, for several years, you will lose a substantial amount of the sale proceeds in capital gains tax if you sell now.

Adding spare cash to super as undeducted after-tax contributions Even if you don’t sell assets and incur capital gains tax, think twice about putting surplus cash into super as undeducted after-tax contributions. Investors even in high marginal tax brackets generally end up paying very low tax rates on investment returns outside of super. In chapter 2 I noted that investors in Australian shares that paid fully franked dividends end up paying between 0.75 per cent tax and 8 per cent tax. The example in that chapter used a broad range of Australian shares producing average returns before tax of 12 per cent per year over the long term, consisting of 8 per cent capital growth and 4 per cent fully franked dividends. I will now look at how this performs over time both inside and outside a super fund. The total after-tax returns for investors in different tax brackets are shown in table 5.6.

Table 5.6: total returns after tax for different types of investors (fully franked Australian shares) Total returns after tax (% p.a.)

Effective tax rate on total return (%)

Super fund before retirement paying 15% tax

12.86

–7.2

Super fund after retirement paying 0% tax

13.71

–14.25

Direct investor in 31.5% marginal tax bracket

11.91

0.71

Direct investor in 41.5% marginal tax bracket

11.34

5.5

Direct investor in 46.5% marginal tax bracket

11.06

7.9

Table 5.6 shows that even investors in the highest marginal tax bracket of 46.5 per cent pay an effective tax rate of only 7.9 per cent of total returns and achieve a total investment return after tax of 11.06 per cent per year. For working Australians in the 31.5 per cent tax bracket, their investment in the same range of shares outside super would pay an effective tax rate of less than 1 per cent on total earnings, and would produce total returns of 11.91 per cent per annum. This is less than 1 per cent lower than the 154

Superannuation (part II): maximising super performance

total returns after tax that their super fund would be achieving during their working lives (11.91 per cent versus 12.86 per cent on the table). You will notice that the total after-tax returns achieved by different types of investors and super funds is very similar. The returns are all between 11.1 per cent and 13.7 per cent, even though the tax rates vary from 0 per cent in the case of a super fund in pension mode, to 46.5 per cent tax paid by investors in the highest tax bracket. The reason the after-tax returns are so similar is that you only pay tax on income, and income makes up only a small part of the total return. With growth assets, most of the returns come from growth in value of the investments and you only pay tax on growth if and when you sell the shares, which may be never. In a long-term fund like this example, the shares are not going to be sold. When you retire, you don’t need to sell shares, you can live off the income while the shares continue to grow.

Different mixes of investments The previous example used a simple portfolio made up of a handful of Australian shares all paying fully franked dividends. In real life the mix of assets and income would not be this neat and tidy. A typical growth fund with a mix of shares, listed property and a small proportion of fixed interest and cash, should produce pre-tax returns over the long term similar to the following:

Unrealised capital growth

7 per cent per annum

+ income yield

5 per cent per annum

= total investment return before tax

12 per cent per annum

The break-up of income distributions would vary each year but over the long term would average something like this:

Percentage of distributions Normal taxable income (including undiscounted capital gains, unfranked dividends, rent, interest)

40%

Discounted realised capital gains

10%

Tax-free or tax-deferred income

10%

Fully franked dividends

40%

Total

100% 155

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If both the direct investment fund outside super and the super fund had this same mix of investment assets, they still achieve similar results when their total after-tax returns are compared, as shown in table 5.7.

Table 5.7: total returns after tax for different types of investors — mix of assets Total returns after tax (% p.a.)

Effective tax rate on total return (%)

Super fund before retirement, paying 15% tax

12.08

–0.67

Super fund after retirement, paying 0% tax

12.86

–7.2

Direct investor in 31.5% marginal tax bracket

11.25

6.25

Direct investor in 41.5% marginal tax bracket

10.74

10.5

Direct investor in 46.5% marginal tax bracket

10.48

12.7

Killer fees The total after-tax returns in table 5.7 are before fees. As I have mentioned, what kills super is the hefty fees charged by super fund managers. In comparison, if you invest directly in the same assets you pay no annual fees. The initial cost of purchasing the shares would be about 0.1 per cent for brokerage, but there are no annual fees after that. I will show how easy and inexpensive it is to invest directly in shares and other types of investment assets in later chapters. Table 5.8 shows that the average direct investor will beat super funds in terms of total returns after taxes and fees. Even a direct investor in the highest tax bracket will achieve better total returns after taxes and fees than a tax-free super fund that charges a 2 per cent fee per year. You may notice that the difference between returns before fees and after fees is a fraction more than the 1 per cent and 2 per cent fee charged by the fund. This is because super funds charge their fees on the balance at the end of the year, not on the balance at the start of the year, but returns are calculated based on the balance at the start. This means that a ‘2 per cent fee’ ends up being about 2.2 per cent of the opening balance and a ‘1 per cent fee’ ends up being about 1.1 per cent.

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Table 5.8: total returns after tax — before fees and after fees Total investment returns after tax Before fees (% p.a.)

After 1% fees (%)

After 2% fees (%)

Super fund before retirement, 15% tax

12.08

10.96

9.84

Super fund after retirement, 0% tax

12.86

11.73

10.60

Direct investor in 31.5% tax bracket

11.25





Direct investor in 41.5% tax bracket

10.74





Direct investor in 46.5% tax bracket

10.48





The difference adds up over time Let’s take a look at another example. Say you are a 40 year old in the 31.5 per cent tax bracket. You have a spare $20 000 and you can either put it in your super fund, which charges a 2 per cent fee per annum, or invest it directly into the same investments. Table 5.9 shows what the two alternatives will look like after 10 and 20 years, assuming both alternatives were invested in the same mix of assets as the previous example.

Table 5.9: investing directly at 31.5 per cent tax versus investing in a super fund at 15 per cent tax with a 2 per cent fee Invest direct

Super with 2% fee

Advantage of direct over super

Total return before tax and fees

12.00% p.a.

12.00% p.a.



Total return after tax, before fees

11.25% p.a.

12.08% p.a.

–0.83% p.a.

Total return after tax and fees

11.25% p.a.

9.84% p.a.

+1.41% p.a.

Balance after 10 years

$58 072

$51 111

+$6961

Balance after 20 years

$168 618

$130 618

+$38 000

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As you can see, even though you are in the 31.5 per cent tax bracket while the super fund pays just 15 per cent tax, and even though both options hold exactly the same investments, by investing directly rather than in the super fund, you will end up ahead — after taxes and fees — by nearly $7000 after 10 years and by $38 000 after 20 years. The tax advantages of super are more than outweighed by the 2 per cent annual fee. Even if you invest in an industry fund or corporate fund with a low fee of ‘only’ 1 per cent per year (including the flat weekly fee), the tax advantages of the super fund would still be killed by that fee, as shown in table 5.10.

Table 5.10: investing directly at 31.5 per cent tax versus investing in a super fund at 15 per cent tax with a 1 per cent fee Invest direct

Super with 1% fee

Advantage of direct over super

Total return before tax and fees

12.00% p.a.

12.00% p.a.



Total return after tax, before fees

11.25% p.a.

12.08% p.a.

–0.83% p.a.

Total return after tax and fees

11.25% p.a.

10.96% p.a.

+0.29% p.a.

Balance after 10 years

$58 072

$56 573

+$1499

Balance after 20 years

$168 618

$160 024

+$8594

The super fees kill the investment because they are calculated on the entire balance of your fund, not just on the income, whereas the income tax benefits of the super fund apply just to the income, which is a minor part of the overall return. So each year you pay a fee based not just on the past year’s growth, but also on the growth in every previous year as well. And you pay for it again the following year and each year into the future. Remember, too, that the previous examples assume super fund fees of 1 per cent and 2 per cent per year. At the time of writing, the average retail super fund fee is 2.25 per cent per annum, and many retail investors are paying up to 3 per cent, including platform fees, administration fees and advice fees.

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What about a super fund paying zero tax in retirement? Remarkably, the advantage of investing directly applies after the super fund pays zero tax when you start drawing a pension from it. The fund fees still outweigh the tax breaks. Table 5.11 sets out the performance of the same $20 000 in the zero tax super fund after retirement compared with investing it directly in the same assets. Assume again that the investor is in the 31.5 per cent tax bracket.

Table 5.11: investing directly at 31.5 per cent tax versus investing in a super fund with zero tax but a 2 per cent fee Invest direct

Super with 2% fee

Advantage of direct over super

Total return before tax and fees

12.00% p.a.

12.00% p.a.



Total return after tax, before fees

11.25% p.a.

12.86% p.a.

–1.61% p.a.

Total return after tax and fees

11.25% p.a.

10.60% p.a.

+0.65% p.a.

Balance after 10 years

$58 072

$54 775

+$3297

Balance after 20 years

$168 618

$150 014

+$18 604

So, even a super fund paying no tax on earnings will end up with a smaller balance than if you invested the money in the same underlying assets yourself, because of the hefty fees in the super fund.

What about retirees’ tax-free super income in retirement? Aside from the super fund tax rates, another advantage of the super system is that money paid out to members after age 60 is tax free. This also sounds good but don’t forget that the Senior Australian Tax Offset means that couples of ‘pensionable’ age can have investments outside super and can earn more than $40 000 before paying any tax. This would allow them to have investments outside super worth, say, $800 000 earning income at the rate of, say, 5 per cent basically tax free. Retirees don’t pay the Medicare levy, either.

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What about people in higher tax brackets? The previous examples are based on somebody in the 31.5 per cent tax bracket (earning an income of between $30 000 and $75 000), which is most working adults. The same exercise could be done for somebody in a higher tax bracket and similar results obtained. Table 5.12 compares the investment performance of somebody in the highest tax bracket of 46.5 per cent (earning an income over $150 000).

Table 5.12: investing directly at 46.5 per cent tax versus investing in a super fund at 15 per cent tax Invest direct

Super with 2% fee

Advantage of direct over super

Total return before tax and fees

12.00% p.a.

12.00% p.a.



Total return after tax, before fees

10.48% p.a.

12.08% p.a.

–1.60% p.a.

Total return after tax and fees

10.48% p.a.

9.84% p.a.

+065% p.a.

Balance after 10 years

$54 195

$51 111

+$3084

Balance after 20 years

$146 854

$130 618

+$16 236

Only after the super fund switches to zero tax mode on retirement does the super option start to perform better than direct investment, as shown in table 5.13.

Table 5.13: investing directly at 46.5 per cent tax versus investing in a super fund with zero tax Invest direct

Super with 2% fee

Advantage of direct over super

Total return before tax and fees

12.00% p.a.

12.00% p.a.



Total return after tax, before fees

10.48% p.a.

12.86% p.a.

–2.37% p.a.

Total return after tax and fees

10.48% p.a.

10.60% p.a.

–0.12% p.a.

Balance after 10 years

$54 195

$54 775

–$580

Balance after 20 years

$146 854

$150 014

–$3160

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Table 5.12 shows that for somebody in the top tax bracket with $20 000 invested for 20 years before retirement, direct investment beats super by more than $16 000. But as table 5.13 shows, after retirement $20 000 invested in super for another 20 years will beat direct investment by about $3000. So the small advantage of the super in retirement doesn’t make up for the disadvantage during 20 years before retirement. And remember, the direct investor will have more at retirement in the first place because of the higher returns after tax and fees outside super.

The bottom line The bottom line for undeducted contributions is this — if you have additional money to invest and the choice is between investing direct outside super or making undeducted after-tax contributions into your super fund, the tax advantages of super funds are more than eaten up by super fund fees even if: 9

the money is invested in exactly the same underlying assets

9

you are in a low-cost industry or corporate fund

9

you are in the highest marginal tax bracket.

Not only do you achieve higher returns and end up with more money by investing directly in the same types of assets yourself, you also avoid the other disadvantages of super — that is the uncertainly, complexity, lack of control and lack of access. If you are in a position to take advantage of the tax rebate on spouse contributions or the government co-contribution, then it is certainly worthwhile. Aside from these circumstances, the only way to access the tax advantages of super while avoiding the high cost of fees is to set up your own self managed super fund. This is generally not viable unless you have a super balance of, say, $100 000 to $200 000 to start with, so this is out of reach of many Australians. In later chapters I explain how you can start an investment plan outside the super system and beat the returns you would get from ‘professional’ super funds after taxes and fees. The bottom line for tax-deductible contributions is this — if you are able to make a tax-deductible contribution to super, such as if you are self-employed or via salary sacrificing with your employer, you would also obtain the tax deduction from the contribution. This puts you ahead of investing outside super, especially if you are in a high tax bracket. But it is still important to choose your asset allocation carefully and to minimise fees in your fund.

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5.3 Self managed super funds Most of the $1 trillion in super funds is managed by the big super fund managers on behalf of the members. But a growing share is managed by members themselves in their own super funds. At the time of writing, there were 350 000 self managed super funds in Australia and they held a total of $250 billion, which is about a quarter of the total funds in the superannuation system in Australia. That’s an average of around $700 000 per self managed super fund, but most are much smaller. It is a rapidly expanding sector, with about 1000 new self managed super funds being set up each week. These ‘self managed’ funds generally consist of mum and dad who are the trustees and also the members, on whose behalf they are managing the money. The legislation and regulation of super funds is too complex for most ‘mums and dads’ to manage, so they usually have an accountant to help and an auditor to check the books each year. In addition, many self managed super funds also have the administration and paperwork done by a professional administration firm, and some people also hire a financial planner to help invest the money.

Costs There are two types of costs involved — initial set-up costs and ongoing annual costs. Most accounting firms will charge about $1000 for the initial cost of the super fund and another $1000 for a company if a new company is required to be formed to be the trustee. Many people use an existing family company as the trustee, while others simply have the members as trustees. The ongoing annual fees include audit, accounting and lodgement of returns, which usually total about $2000 per year. If you were paying a super fund manager to manage your fund, you would be paying an annual management fee ranging from about 1.0 per cent to 2.5 per cent of the fund asset value. For a fund worth, say, $200 000 this would amount to management fees of between $2000 and $5000 per year, but a self managed super fund would cost about $2000. On the other hand, for a fund worth $1 million a fund manager’s 1.0 per cent to 2.5 per cent would end up costing $10 000 to $25 000, while the self managed super fund would still cost the same $2000, or 0.2 per cent of the fund value. It follows that a sum of about $100 000 to $200 000 is about the break-even point for making an self managed super fund a viable alternative, as long as the fixed cost of around $2000 for audit and accounting is the only cost. It is common for people with large super funds to set up an self managed super fund, then put the money straight back into an expensive ‘platform’, ‘master trust’ or ‘wrap account’ with 162

Superannuation (part II): maximising super performance

their planner. This adds another layer of costs and completely defeats the purpose of having a self managed fund. If you’re going to do this you may as well just use a public offer fund, like an industry fund, and avoid the additional $2000 it costs to run a self managed fund. Most public offer funds have the same range of investment options as most of the expensive ‘platforms’. Having a self managed super fund only makes sense if you are going to avoid managed funds and platforms, and invest the money directly using investments like those outlined in this book.

Why set up a self managed super fund? The main reasons people have for setting up self managed super funds are greater control, poor performance of fund managers and cost savings. The overwhelming benefit is the ability to directly control your money. The government may change the rules, but at least you can control what happens to your money.

Managing the fund The trustees of the fund are ‘fiduciaries’, which means they are subject to very strict and onerous rules and duties regarding what they can and can’t do with the money and assets in the fund. The tax office is fond of saying that while the fund may be managed by trustees who are also members of the fund, the assets are ‘not theirs yet!’ There is a ‘sole purpose test’, which means the fund must be run for the sole purpose of providing retirement benefits to its members. The members must not receive any kind of benefit before retirement. For example, if the super fund owns a property, members are not allowed to benefit from it such as by staying in it free of charge. The fund is allowed to buy things like artworks, but they cannot be hung in the home unless you pay the fund a market-based rent for it. Likewise the fund is allowed to buy things like cars, but you can’t drive them unless you pay the fund a market rental. You would also need to demonstrate that the fund bought the items with the intention of using them to provide retirement benefits, for example, from resale at a profit from receiving rental income. This gets very tricky and you are bound to get a tax audit, so make sure to be careful and keep detailed records. The fund must have its own separate bank and investment accounts. All records must be kept separate from those of the members. It’s also important to ensure that all dividends, interest, rent and other distributions from super investments go straight into the super fund account, not into your personal accounts. The money is not yours yet! If your fund breaches the strict rules it will become a ‘non-complying fund’ and it will be taxed at the top marginal tax rate and lose other benefits, so it’s extremely important to dot every ‘i’ and cross every ‘t’. 163

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Property Self managed super funds generally cannot buy a residential property from a member or related party, nor can it accept residential property as a contribution from a member or related party. This means that you cannot transfer your house or investment property into your super fund. These restrictions do not apply to business properties or farms owned by members. If you do decide to transfer in a non-residential property you or your business owns, you are still liable for capital gains tax on any gains, plus, in some states, stamp duty on the transfer. Also, the business property can’t have any borrowings on it. Super funds are not allowed to borrow money, so any loan must be paid off before the property is transferred into the fund. Self managed super funds can, however, buy and hold residential properties from independent third parties as investments as long as they are rented out at commercial rents and as long as there is no borrowing.

Derivatives and trading One area of significant activity in many self managed super funds is the use of derivatives — that is contracts for difference (CFDs), options, futures and warrants. Subject to a few exceptions with various types of warrants, self managed super funds are allowed to trade these types of derivatives as long as you put up cash, not other financial assets, as security for the margin accounts. This appears to be a very generous approach by the tax office, and it seems to me that it would be much too tempting for a lot of people to get into derivatives trading with their super funds. Be extremely careful with this — trading is not investing. In most cases, sticking to a ‘buy and hold’ strategy for a long-term fund will beat part-time derivatives traders every time. Even experienced traders would allocate no more than, say, 5 per cent of their super portfolio to derivatives trading. If anybody told me that they wanted to try trading using their super fund, I would advise them in the strongest possible terms not to do it. Your super fund is there to build wealth to provide financial security for the rest of your life. It’s not there to tinker with and take a punt, despite what the rules might allow you to do. Derivatives are covered in more detail in chapter 8.

Disadvantages of self managed funds Along with the many advantages of self managed super funds there are a number of disadvantages:

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9

Many people tend to carry too much cash in their self managed funds because they don’t get around to investing it. At the time of writing, over 20 per cent of self managed super funds were held in cash, which is far too much for long-term funds.

9

Many invest in a single asset — like a single residential property or the family’s business property. This is too concentrated, especially when the members’ main asset outside super is probably also property — in the form of the family home.

9

Many investors are tempted into trading. This needs to be specifically permitted in the trust deed. The investment strategy should include a trading strategy, risk-management strategy, and may also need to be signed off by the auditor.

9

Some people regard their super fund as cash to play with. This money is not there for speculation or trading — it’s money that you will be relying on when you are old.

9

Expert help is needed to run self managed super funds, including a good accountant to keep the books, prepare the accounts, take minutes of meetings, do the tax returns, organise the auditor, and look after other necessary returns and filings.

How to set up a self managed super fund Your accountant can set up the main components of a self managed fund in a few days. It generally takes a substantial amount of time for your fund managers to transfer your existing fund balance into your new self managed super fund. But there is no excuse for any delay — they are just doing it to get hold of more fees. I had an old National Mutual (now AXA) retail fund that I set up in the mid 1980s that took four years to transfer into our self managed super fund in the 1990s! There are lots of rules, regulations and paperwork involved in running your own fund. You’ll need a written investment policy, accounts, bookkeeping, transaction records, minutes of meetings of trustees, tax returns, Business Activity Statement returns, compliance reports, annual returns and an annual audit. It all seems rather daunting but, in practice, your accountant will organise everything and it’s not any more work for you than running your other investments outside super.

Action plan 1

If you have an accountant, ask how many self managed super funds he or she looks after.

2

Ask your accountant to outline the main costs — both initial and ongoing. 165

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5.4 Lost super It’s very easy to lose track of your super funds if you’ve changed jobs several times because each employer will generally put money into a different super fund. It’s not uncommon for some people to have half a dozen super accounts from past jobs. In 2006 the amount of money sitting in ‘lost’ super accounts was $8 billion in 5.4 million accounts. Only one year later this has grown to $10 billion in 5.7 million accounts. That’s an average of $1000 for every worker in Australia, just sitting there waiting to be found! There are several services that can help you track down lost super. A couple of years ago I saw an article about lost super in the paper and decided to give it a try. My wife and I have had all sorts of jobs over the years, so I filled in a few forms for both of us and sent them off. A couple of months later the service wrote back and said that it had found some lost super for my wife from 20 years ago, and she was sent a cheque for $658. Sounds crazy I know, but it actually happened. It is estimated that around one-third to half of all working Australians have money in lost super accounts, so it’s well worth making the effort to track it down. Try these services: 9

SuperSeeker — or 13 28 65

9

Lost Member Register — or 13 10 20

9

Find My Super — or 1800 333 713

9

AUSfund — or 1300 361 798

9

MLC ‘Find Your Lost Super’ — .

Consolidate your super In Australia there are almost 30 million super accounts but only 10 million account holders, which means there are nearly three super accounts per person. In certain circumstances it can make sense to have more than one account, but in most cases it just costs you more fees. If you do find that you have more than one super fund, it’s worth consolidating them into one fund. It will be easier to look after, and there will be less paperwork and lower fees. Many funds charge monthly or annual fixed fees on top of an annual fee based on the size of the fund, so consolidating will eliminate this doubling up on fees.

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Action plan 1

Find any lost super in your family.

5.5 Disadvantages of super The main disadvantages of super are: 9

Long time to wait. It’s getting longer as the rules change and the population ages. And if you suddenly need the cash because of a change in your financial circumstances, you are unlikely to be granted approval to access it.

9

Uncertainty. Governments are constantly fiddling with the rules. You never know what rules they will fiddle with next.

9

Complexity. There are thousands of pages of rules and regulations. Further, the increasing burden of super fund regulation always means increasing costs for fund managers, which means lower returns for members.

9

Can’t borrow. Given the long-term time frames, borrowing can be used effectively to build wealth using assets like shares and property, there are few geared investments that super can invest in and these are usually very expensive.

9

Super death tax. Non-dependent heirs (such as adult children) who receive benefits following the death of a super fund member pay an immediate tax of 16.5 per cent of the value of the assets received, excluding a proportion that represents after-tax contributions and pre-1983 contributions to the fund. Spouses are deemed to be dependents, so they do not have to pay the death tax.

Overall, super has some great advantages but also some real disadvantages. Therefore, super should be a key part of your wealth-building plan but it shouldn’t be your only strategy.

5.6 Super as part of your wealth plan Don’t plan to use your super as a way to pay off the mortgage, buy that boat or help the kids buy a house — you’re probably going to need all the money yourself! 167

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Government age pension There are many experts predicting the demise of the government age pension, due to the shrinking base of taxpayers and the increasing numbers of retirees. My personal view is that there will always be a minimum age pension. With the rising number of elderly there are simply too many votes at stake. It would be political suicide for any government to reduce welfare for the two million voters who rely on it and who see it as a ‘fundamental human right’. This is the fastest growing segment of the population, so politicians aren’t going to make them angry. Many baby boomers, however, are locked into the notion that they have some sort of entitlement or automatic right to 30 or more years of taxpayer-funded age pensions, tax-free super incomes and a host of other welfare benefits, tax rebates and perks for the aged. They haven’t saved enough themselves, and the financial planning industry seeks to milk every last cent out of the poor taxpayers who have to fund the ageing boomers’ retirement lifestyle. In contrast, for gen Xers and gen Ys, the age pension will probably be seen as a bare minimum fallback position if all else goes wrong. And that’s the way it should be. Where does super fit into the picture? The compulsory employer contributions are generally not going to be enough to build a fund that will provide a comfortable retirement. Even if you increase contributions to, say, 15 per cent to 20 per cent of your income over your entire working life it will only provide an adequate level of income and lifestyle.

Create an income beyond work You might not be retired — after all you can’t ‘retire’ for 30 or 40 years. These are the years you will be doing the things you really want to do with your life. Perhaps pursuing a hobby, turning your hobby into a small business, going back to university, living overseas learning about a new culture, or doing volunteer work here or in the outback or overseas. Or a combination of these things. Your future lifestyle will need funding. You don’t want to have to work just to make ends meet.

$1 million can generate $50 000 per year for life Your lifestyle and required income beyond work will need a capital sum. If you want to use your super fund for retirement income, $1 million would be sufficient for most people. A capital sum of $1 million can be expected to provide a tax-effective income of around $50 000 per year after tax, that will rise to keep pace with inflation and still have money left over at the end, even if you live for 10 or 20 years longer than the tables of statistics say you should. 168

Superannuation (part II): maximising super performance

Find out your current super balance and think about what needs to be done to get it on track for the $1 million target at 60 or 55 or whatever age you plan to retire. You will probably need to undertake many of the things outlined in this chapter including salary sacrificing, spouse contributions, government co-contributions, refining the asset allocation, reducing fees and so on. The good news is that you have time on your side. Adjustments made now can make a huge difference over time — even if you have only five or 10 years left before you plan to leave your current work. The general maximum limits for contributions to your super fund are very generous — $50 000 for tax-deductible employer or self-employed contributions plus $150 000 for undeducted after-tax personal contributions — and you can make these contributions each year. When it comes to amounts like this, a self managed super fund can be a real help. If you have several hundred thousand dollars in the fund you can run it very cheaply and you have much more control over the investments.

Future trends My guess is that future governments will start putting restrictions on getting tax-free lump sums out of super. It only makes sense because the aim of super is to get people off welfare. The ability to take your super balance as a tax-free lump sum at age 60 will probably prove to be too tempting for more and more people. In a time when they should be paying off the mortgage and investing for the future, many 40 to 50 year olds are borrowing more money (which feeds straight into rising house prices) with a view to using the tax-free lump sum to pay it out at age 60. Housing affordability is a hot issue and future governments are sure to start cracking down on this unintended consequence of the generous super rules. Therefore, don’t plan to always be able to get your hands on your super as a lump sum. Governments are also gradually lifting the age of access to super. This is especially likely to affect generation Xers and younger — that is, people born since about 1965. Always bear in mind that the rules relating to super and tax are constantly changing. There are many other areas of super that I have not covered in this book and it pays to check the current situation by visiting the tax office website . Of all the strategies covered in this book, the areas of super and tax are probably the most critical and complex, so make sure you get professional advice about your particular circumstances before taking action.

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Action plan 1

Go through the action plans in this chapter and create a list of things you can do to start taking control of your super.

2

Prioritise the list and highlight the things you can do this week.

5.7 Key points 9

Asset allocation is the mix of different classes of assets in your fund. Getting this right can double or triple your fund balance at retirement. Most people don’t choose the investment allocation in their super fund and end up being in the fund’s ‘default’ option, which is usually conservative, low-growth asset allocation.

9

If you are planning to use your wealth over time frames of 20, 30 or 40 years you should be invested primarily in growth assets — that is, shares and property.

9

Super’s high fees more than eat up the tax advantages of making personal after-tax contributions into super. Most people — even those in high tax brackets — are better off investing surplus cash outside super.

9

Salary sacrifice arrangements are very attractive for people in high tax brackets because the benefit of the tax deduction from the contribution exceeds the 15 per cent contributions tax.

9

The level of fees can make a huge difference to your fund performance over the long term. By reducing annual fees by just 1 per cent you can end up with over 20 per cent more in your fund after 20 years and 35 per cent after 30 years.

9

Self managed super funds can be much more cost-effective than even the cheapest industry fund. Self managed super funds starts to become economically viable if you have at least $100 000 to $200 000.

9

There is up to $10 billion sitting in more than five million ‘lost’ super accounts. Some of it is probably yours — all you need to do is find it and claim it.

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Super

Protection House

Chapter 6

Step 4 — invest outside super (part I): shares

Money sense

It’s time get into the engine room that generates most of the wealth in Australia — investment outside the superannuation system. Take a look at BRW’s Rich 200 list, or any wealthy people you know or know of in your local area. The chances are they made their wealth through businesses and/or property — the two main types of growth assets — and they probably did it outside super.

6.1 Share basics The primary source of growth for long-term investment is company shares. The terms shares, stocks and equities mean the same thing — investing in the ownership of companies and businesses. By owning shares in a company you become a part-owner or equity partner with all the other shareholders in the company. The sharemarket, stock market and equities market also mean the same thing — the market in which people buy and sell shares in companies. A ‘share’ in a company is just a tiny piece of ownership of the company.

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The Australian Stock Exchange The Australian Stock Exchange (ASX) is a service that lets investors buy and sell shares in companies easily, quickly and cheaply. There are around 2000 companies that have their shares ‘listed’ on the ASX. As well as being able to buy and sell company shares on the ASX, you can also buy all sorts of other investments, including property trusts, share trusts, preference shares, hybrids, cash funds and many more. But the main function of the ASX is to provide a market for investors to buy and sell company shares. The ASX is open for business for buying and selling shares between 10 am and 4 pm on business days. You can log onto the ASX website or your online broker account during the day to watch the prices of the shares change as they are traded.

A company’s share price can change constantly Every day (and every minute of every trading day) the share price of each listed company can change. There is no guarantee offered by the company, the ASX or anyone else that you will get back the money that you put in when you bought the shares, or that you will get back any money at all. We have all heard about companies like One.Tel and HIH and many other companies that simply went broke and ceased to exist. Their shareholders lost all of their money. Hopefully, of course, you will invest in companies that grow in value over time. This is very different from ‘income’ or ‘debt’ investments like cash, bonds, term deposits, debentures and mortgage funds. With those investments you get a guarantee that you will get back 100 per cent of your capital, either ‘on demand’ — that is, whenever you want it (like in a cash account) or at the end of a specified term (like in a term deposit or debenture). Shares are not like this — there are no guarantees that you will get any or all of your money back.

Choose from many companies Many of the 2000 listed companies you can invest in are well-known household names, including: 9

retailers — Woolworths (WOW), Coles (CGJ), David Jones (DJS), Harvey Norman (HVN), JB Hi-Fi (JBH), The Reject Shop (TRS), Super Cheap Auto (SUL)

9

banks — National Australia Bank (NAB), Commonwealth Bank (CBA), ANZ Bank (ANZ), Westpac (WBC), St George (SGB), Macquarie Bank (MBL) 172

Step 4 — invest outside super (part I): shares

9

media — News Corporation (NWS), Fairfax (FXJ), Ten Network (TEN), Seven Network (SEV)

9

communications — Telstra (TLS), Unwired (UNW), Engin (ENG), Reverse Corp (REF)

9

insurance — QBE (QBE), AMP (AMP)

9

transport — Brambles (BIL), Toll Holdings (TOL), Qantas (QAN), Cirgin Blue (VBA), CabCharge (CAB)

9

building materials — CSR (CSR), Boral (BLD), James Hardie (JHX)

9

mining and resources — BHP (BHP), Rio Tinto (RIO), Beaconsfield Gold (BCD), BlueScope Steel (BSL)

9

food and beverages — Coca Cola Amatil (CCL), Fosters (FGL), Goodman Fielder (GFF)

9

oil and gas — Caltex (TTX), Woodside Petroleum (WPL), Santos (STO), AGL (AGK)

9

health and medical — Blackmores (BKL), Resmed (RMD), Cochlear (COH), Ansell (ANN)

9

clothing — Billabong (BBG), Globe (GLB), Country Road (CTY).

For information about these companies visit and type in the three-letter stock codes. There are listed companies operating in most sectors of the Australian economy. The sectors that aren’t covered by Australian listed companies — like car manufacturing, computer hardware and software, and electronics — are dominated by foreign companies listed on international stock exchanges. Investing in foreign countries is covered later in the chapter.

Dividends Companies don’t pay interest to their ordinary shareholders like debt or income investments. Most companies listed on the ASX pay their shareholders income in the form of ‘dividends’ on their shareholdings. Dividends are a share of the profits that the company has made from running its businesses.

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Dividends are usually paid every half year. There is an ‘interim’ dividend paid halfway through the company’s financial year, and a ‘final’ dividend paid at the end of the company’s financial year. Most companies have a financial year ending in June, but some use December or September as the end of their financial year. But most use June, which lines up with the June tax year. The dividends paid by companies don’t necessarily stay the same from year to year. Sometimes a company will reduce the dividends but most of the time it will increase them as the business grows. Sometimes a company will stop paying dividends altogether. Usually the shareholders get very annoyed when this happens! You can find out the dividends each company is paying by using the three-letter stock code on the ASX website or any online broker account website — or look it up under the ‘dividends per share’ column in the share listings in the back of newspapers.

Franking credits If companies pay tax on their profits and then distribute some or all of the profits to the shareholders as dividends, it would be unfair if the shareholders had to pay tax again on their dividend income after the company has already paid income tax on it. Where companies pay Australian company tax on profits and then pay dividends to shareholders, the shareholders receive a credit for the income tax already paid by the company. These credits are called ‘franking credits’, and they reduce the effective tax rates on dividend income for most investors in Australia. If you held a broad portfolio of Australian shares paying fully franked dividends, you could expect that over the long term they would produce dividends of about 4 per cent per year and that they would produce capital growth averaging about 8 per cent per year. If that were the case, the total return before tax would be 12 per cent (4 per cent dividend yield plus 8 per cent capital growth). The net effect of franking credits on effective tax rates and total returns after tax will be different for shareholders in different tax brackets. This is shown in table 6.1, which is based on the tax rates for the 2007 to 2008 financial year. Table 6.1 shows that, even for taxpayers in the highest tax bracket, a total return before tax of 12 per cent from a portfolio of shares paying franked dividends would still achieve a total return after tax of more than 11 per cent per year. Even though they are in a very high tax bracket, the impact of tax on their overall return is very minor. This is how investors pay much less tax than salary earners, as noted in chapter 2.

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Table 6.1: impact of franking credits on effective tax rates and total returns after tax Tax bracket

Types of taxpayers

Net effective tax rate on dividends

Dividend yield after tax

Total return after tax

0%

Super funds in pension phase and individuals earning below $11 000

–42.9%

5.71%

13.71%

15%

Super funds in accumulation phase and individuals earning between $11 001 and $30 000

–21.4%

4.86%

12.86%

31.5%

Individuals earning and $30 001 and $75 000

2.1%

3.91%

11.91%

41.5%

Individuals earning between $75 001 and $150 000

16.4%

3.34%

11.34%

46.5%

Individuals earning more than $150 001

23.6%

3.06%

11.06%

Negative tax rates The table also shows that taxpayers paying no tax or who are in low tax brackets — like super funds and perhaps low-income spouses — actually achieve negative tax rates, meaning they receive tax refunds each year. For these taxpayers, the negative tax rate means that the return after tax is actually higher than the return before tax. Those tax refunds can be put back into the fund to make it grow even faster.

How to use dividends in the plan While you are building your investment funds in your working years, the dividends should be reinvested so the investment fund multiplies faster. Even though you won’t receive the dividends in cash, the dividend income still needs to be included in your tax returns, but this income is largely offset by franking credits. If you are investing in shares through a managed fund, you can instruct the fund manager to automatically reinvest all dividends and distributions into the fund to buy more units. When you need to rely on the dividend income, there is no need to sell the shares and invest in other shares or other income investments. The dividend yield generated by the shares should be enough to provide income for life. If you retain the same shares you pay no capital gains tax, and the dividends will keep rising in value over the long term, to keep ahead of inflation. 175

$1 Million for Life

Investment returns from shares The Australian stock market has been generating great returns for investors for more than 100 years. It consists of nearly 2000 listed companies and each company has its own story and its own performance. When you hear on the evening news or read in the newspaper that ‘the market was down 1.5 per cent today’ or ‘up 13 per cent last year’ that just means that the overall market, averaged across all the listed companies, was up or down by that amount.

All Ordinaries Index There are various methods used to measure the overall market — the most well known is the All Ordinaries Index or All Ords. The All Ordinaries Index measures the level of the prices of the largest 500 or so listed companies on the ASX. The other 1500 or so listed companies are very small and don’t influence the overall average. When the All Ordinaries Index is ‘down 1.5 per cent today’ this means that the market average was down 1.5 per cent in value. The share price of some companies may be up 20 per cent or more, others may be down 20 per cent or more, and the share prices of many companies may not have moved at all. But the weighted average of all the companies in the index was down 1.5 per cent on that particular day.

All Ordinaries Accumulation Index While the All Ordinaries Index measures the capital growth from the sharemarket, the All Ordinaries Accumulation Index measures total returns from the sharemarket including capital gains plus income. It assumes that all income is reinvested (hence it ‘accumulates’). This is a much better measure of total returns from share investing over time. Over long periods, some companies have generated returns of over 20 per cent per year, and some companies have produced very poor returns or even gone backwards. Some companies collapse and go into liquidation (go broke and close up shop) and the shareholders lose some or all of their money. But overall, the general market has been generating pre-tax returns of between 10 per cent and 14 per cent over several decades. After-tax returns vary depending on the tax status of the shareholder. In a super fund or for low-income shareholders the after-tax returns will be about 1 per cent higher than the pre-tax returns. For shareholders in high tax brackets, the after-tax return will be about 0.5 per cent lower than the pre-tax returns.

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Ups and downs each year Although the total returns from shares have provided good long-term returns over long periods, there have been a lot of ups and downs along the way. Figure 6.1 shows the total returns each calendar starting from when records first began in 1875 until the end of 2006.

Figure 6.1: Australian stock market performance between (1875 and 2006) — All Ordinaries Accumulation Index

Most of the time when you hear economists and market commentators say that returns are more volatile than in the past, they are scaremongering and trying to get you to buy their managed funds. Figure 6.1 shows that the returns in the past decade have been more stable than they were between the 1950s and the 1980s.

Key findings Over the 131-year period from 1875 to 2006: 9

there were 27 negative years — that is, one in nearly every five years was a negative year. The rest were positive 177

$1 Million for Life

9

the best year was 1983 with a return of over 66 per cent

9

the worst year was 1930 with a loss of almost 30 per cent

9

the longest run of positive returns was 13 years, from 1902 to 1914 when the First World War broke out. After the war there was a 12-year run of positive returns from 1917 to 1928. The crash of 1929 put an end to that

9

but the longest run of negative returns was only two years. Even during the Great Depression only 1930 and 1938 were negative years, all the other years in the 1930s were positive.

Decade by decade Table 6.2 shows that each decade in the history of the stock exchange in Australia has produced positive total returns.

Table 6.2: past returns from Australian shares by decade Decade

Average return

Negative years

Best year

1880s

+14.0%

1

1883

+29.0%

1889

–1.1%

1890s

+6.2%

2

1895

+25.6%

1891

–10.4%

1900s

+11.7%

1

1903

+21.9%

1901

–3.2%

1910s

+7.9%

2

1919

+18.7%

1915

–3.5%

1920s

+13.3%

1

1922

+21.3%

1929

–5.3%

1930s

+8.5%

2

1933

+25.6%

1930

–29.6%

1940s

+8.6%

1

1942

+18.4%

1941

–5.5%

1950s

+13.2%

2

1959

+44.3%

1952

–13.3%

1960s

+11.6%

2

1967

+42.5%

1965

–8.2%

1970s

+6.6%

4

1975

+54.6%

1974

–26.2%

1980s

+17.7%

4

1983

+66.8%

1982

–13.9%

1990s

+11.1%

3

1993

+44.1%

1990

–17.5%

2000s*

+12.9%

1

2004

+27.8%

2002

–8.1%

(* 2000s is to the end of 2006.)

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Worst year

Step 4 — invest outside super (part I): shares

Although past returns are no guarantee of what will happen in the future, some general observations can be made: 9

Over the long term, total returns from the Australian sharemarket have averaged around 12 per cent per year.

9

There are a lot more good years than bad years — about one in every four or five years is a negative year, but all the rest have been positive years.

9

There are often periods of up to a decade or more of consecutive positive years. The negative runs are very short by comparison. In the 130 years since 1875 there have been six negative runs lasting two years. There have never been three negative years in a row. That doesn’t mean that it won’t happen in the future, but so far it hasn’t — even in the worst depressions and through two world wars.

9

The ‘good’ years more than make up for the ‘crash’ years. In the 131 years since 1875 there have been only three years with returns worse than –25 per cent (–30 per cent in 1930, –25 per cent in 1973 and –26 per cent in 1974). Even the so-called crash of 1987 was a loss of only 8 per cent for the 1987 calendar year, and the great crash of 1929 was only a loss of 5 per cent for the 1929 calendar year.

9

But in that same 131-year period there have been 21 years with positive returns of 25 per cent or better. Do we remember them as well as we remember the two ‘crashes’? Of course not. Humans are programmed to remember negatives more than positives. We don’t remember the years with positive returns of more than 25 per cent because there were simply so many of them. The 21 years with much bigger positive returns than the worst of the ‘crash’ years were: (

60 per cent+ positive returns in 1983

(

50 per cent+ positive returns in 1975, 1986

(

40 per cent+ positive returns in 1959, 1967, 1980, 1985, 1993

(

30 per cent+ positive returns in 1950, 1968, 1972, 1979, 1991

(

25 per cent+ positive returns in 1883, 1887, 1888, 1895, 1933, 1963, 2004 and exactly 25 per cent in 2006.

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The great crashes that you hear about were actually just tiny bumps on the road to wealth via the sharemarket. Figure 6.2 shows the performance of the All Ordinaries Accumulation Index since records began in 1875.

Figure 6.2: Australian stock market performance from 1875 to 2006 — All Ordinaries Accumulation Index

100,000.0 100 000.0

10,000.0 10 000.0

NB: Uses uses logarithmic scalescale for Y-axis NB. logarithmic for Yto show exponential (compound) axis to show exponential growth. (compound) growth.

1,000.0 1000.0

Index based 1000 Index is is based onon 1000 as atas at 31 December 1979.

100.0 100.0

31 December 1979.

10.0 10.0 1.0 1.0

2005 2005

2000 2000

1995 1995

1990 1990

1985 1985

1980 1980

1975 1975

1970 1970

1965 1965

1960 1960

1955 1955

1950 1950

1945 1945

1940 1940

1935 1935

1930 1930

1925 1925

1920 1920

1915 1915

1910 1910

1905 1905

1900 1900

1895 1895

1890 1890

1885 1885

1880 1880

0.0 0.0

1875 1875

0.1 0.1

I have used a logarithmic scale on the Y-axis for this chart to show the effect of exponential (compound) growth over the period. The index is based on 1000 points as at 31 December 1979. (In my first book, How to Give Your Kids $1 Million Each!, I go through in more detail rates of return and how to construct logarithmic charts.)

Spot the hiccups Figure 6.2 shows that there were three minor hiccups in the long road to wealth via Australian shares: 9

a serious recession in the early 1890s

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Step 4 — invest outside super (part I): shares

9

the Great Depression in the 1930s

9

a major recession in the mid 1970s.

These depressions and recessions might have appeared serious and severe for people caught in the middle of them at the time (especially if they borrowed to invest in shares and then lost their jobs, as many did). But figure 6.2 shows that, in the broad scheme of things, they were really just minor hiccups for long-term investors. In each case the stock market recovered and marched on to bigger and better things after only one or two negative years. Throughout the entire period there were never more than two years in a row of negative returns. Now, past returns are no guarantee of what will happen in the future, with more than a century of history to look at, there is a good chance that this pattern will continue into the future. It has remained constant throughout the past century — through two world wars, depressions, recessions, countless boom-and-bust cycles, and through a host of dramatic economic, social and technological upheavals. If the market can survive all this, then there is a good chance that it will survive just about anything over the next 50 years.

Don’t panic For your investment fund you should not be worried about the fact that shares have fallen in one particular year or a few years here and there. If your share portfolio is down 10 per cent or 20 per cent one year, don’t panic and sell the shares and put everything into property investments or cash or anything else. History shows that the sharemarket will recover and more than make up for the losses in future years.

What is driving growth? When using investments to fund the rest of your life I’m talking about periods of 30 to 50 years. Over any given period of 30 to 50 years Australian shares have produced returns of around 12 per cent or more per year averaged over the period. You can be confident that the sharemarket will do this over the long term because it is driven by several factors: 9

steady population growth, which means more people to buy the products produced by listed companies

9

productivity growth, which means increasing profits by doing this smarter and better

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9

good education system, and a good environment for investments in technology and innovation

9

strong global demand for Australian products and services from growing companies especially Asia

9

stable legal and tax systems

9

capable management of the economy by the Reserve Bank and other government departments.

These factors will ensure that Australian companies (and therefore the sharemarket as a whole) will continue to provide great returns over the long term, just like they have done in the past.

6.2 Different ways to invest in shares This chapter is all about the different ways you can invest in shares — either outside your super fund, or inside super if you run your own self managed super fund. The same principles apply to both. If you don’t run your own self managed super fund, your super fund will be in the hands of a super fund manager, but you still need to know what the manager is investing in and where the money goes. There are five major ways to invest in shares: 9

exchange-traded funds

9

index funds

9

listed investment companies

9

active managed funds

9

direct shares.

I will explore in detail each of these methods in a moment, but first let’s take a look at tables 6.3 to 6.6, which provide comparisons of their mechanics, investment performance, strategy, and advantages and disadvantages.

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Mechanics The mechanics of each method are shown in table 6.3.

Table 6.3: mechanics of the five investment methods

Mechanics

Exchange-traded funds

Listed investment companies

Index funds

Active managed funds

Direct shares

Listed or unlisted

Listed on ASX

Unlisted

Listed on ASX

Unlisted

Listed on ASX

Type of entity

Unit trust

Unit trust

Company

Unit trust

Individual companies

How to buy

Buy on ASX through broker or online broker

Apply to fund manager to buy and sell

Buy on ASX through broker or online broker

Apply to fund manager to buy and sell

Buy on ASX through broker or online broker

Minimum initial investment

$500

$5000 for most

$500

Varies — most $2000 to $5000

$500 per company, but should have $10 000 to $20 000 minimum

How to make regular contributions

Salary deduction to broker cash account, then invest when ready

Salary deduction direct to fund manager

Salary deduction to broker cash account, then invest when ready

Salary deduction direct to fund manager

Salary deduction to broker cash account, then invest when ready

Investment performance Performance varies greatly between the five methods (as shown in table 6.4, overleaf), largely because of the different levels of fees and commissions, but also because of the tax effectiveness, which is due to different levels of activity and turnover (buying and selling) in each method.

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Table 6.4: performance of the five investment methods

Performance

Exchange-traded funds

Index funds

Listed investment companies

Low — buy/sell spread (about 0.2%)

Low to very low — min $20 brokerage

Active managed funds

Direct shares

Entry fee

Low to very low — minimum $20 brokerage

Annual fees

Very low — 0.20% Low — 0.35% to to 0.30% 0.70%

Investment performance

Almost matches market index consistently over long term

Almost matches market index consistently over long term

Varies — selection of three or four would perform close to index over long term

Most underperform the index over long term; patchy over short term

Broad ‘passive’ portfolio can match the index over long term, patchy over short term

Tax effectiveness Good, because of low turnover of shares

Good, because of low turnover of shares

Good, because of low turnover of shares

Poor, because of high turnover of shares

Varies, depending on selection and turnover of shares

High — often up to 3% to 4%

Very low — 0.10% High to very to 0.30% high — often up to 2.5%

Low — minimum $20 brokerage per parcel Nil

Strategy With each method you are trying to achieve different things, and this affects how you can use them in your investment plans. Strategies for the five methods are shown in table 6.5.

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Table 6.5: strategies for the five investment methods

Strategy

Exchange-traded funds

Listed investment companies

Index funds To match the market index

Active managed funds

Direct shares

Aim

To match the market index

Approach

Passive — buy and Passive — buy and Older, larger LICs hold for the long hold for the long are more passive term term than active

Active — frequent Active or passive, buying and selling depending on your style

Choice

Decision based on Decision based on Choose three or costs — you’re costs — you’re four from a dozen buying the market buying the market of the older, larger passive LICs

Up to 8000 to choose from; patchy research

Choose from 2000; good research on largest 300

To beat the market To beat the market To beat the market. You are your own fund manager

Level of ongoing Set and forget investor involvement

Set and forget

Choose initially; monitor occasionally

Monitor and take action depending on performance

Monitor and take action depending on performance

Holding period

Indefinitely

Indefinitely

Monitor and take Older, larger passive LICs can be action depending held long term to on performance indefinitely

Monitor and take action depending on performance

How to use in portfolio

Use as core of share Use as core of share Can use three to portfolio portfolio four as core of portfolio, or as optional extras

Can use as optional extra — with small portion of portfolio

Can use as core, or as optional extra — with small portion of portfolio

Advantages and disadvantages The main advantages and disadvantages of each method are shown in table 6.6 (overleaf).

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Table 6.6: advantages and disadvantages of the five investment methods Advantages and disadvantages

Exchangetraded funds

Listed investment companies

Index funds

Active managed funds

Direct shares

Main advantages

Very low cost; tracks the market index; very tax effective

Low cost; tracks the market index; very tax effective

Older larger passive LICs are very low cost and tax effective

Some beat the index in some years (but don’t over long term)

Total control; flexibility

Main disadvantages

In Australia only tracks the main index, not individual sectors

In Australia only tracks the main index, not individual sectors

Performance of each LIC varies from the index. Need to have more than three LICs

High costs and low tax effectiveness drag down performance over long term

Need to diversify; need larger sum to be effective — e.g. over $50 000

Exchange-traded funds In your long-term investment plan you should be aiming to achieve the returns provided by the overall sharemarket — using the lowest cost, the most tax-effective, ‘set-and-forget’ method. Exchange-traded funds (ETFs) are the ideal way to achieve this; even the smallest investors can buy ETFs with as little as $500. ETFs are a relatively recent arrival in Australia but are well established in North America and Europe. There are two types of EFTs — index and active. The difference between these ETFs is just like the difference between index managed funds and active managed funds. Index ETFs aim to match the performance of the index and their fees are very low, whereas active ETFs try to beat the index but their fees are higher. They are like unlisted active managed funds except they are listed on the ASX. In this book when I talk about ETFs I am referring to index ETFs. Index ETFs are what you need to concentrate on for your long-term fund because their fees are much lower, and they provide good returns over the long term. They are essentially index funds that are listed on the stock exchange. There is only one major global fund manager in the Australian market, State Street Global Advisors, and it has two main share funds, shown in table 6.7.

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Table 6.7: State Street Global Advisors’ share funds Name

ASX code

Size

Annual fee (%)

Started

SPDR S&P/ASX 200 fund

STW

$1.2 billion

0.29

2001

SPDR S&P/ASX 50 fund

SFY

$1.0 billion

0.29

2001

State Street Global Advisors has been around for over 200 years in the United States and around 20 years in Australia, with over $60 billion managed here. These funds used to be called StreetTracks funds in Australia until they were renamed SPDR funds (known as ‘Spiders’), as they are known in the US. The SPDR 200 fund follows the index of the top 200 listed companies, while the SPDR 50 fund follows the index of the top 50. Both of these funds have matched the overall market very closely (because they are essentially index funds), and they have very low fees — just a fraction of the fees of active managed funds. Over time there are likely to be more index ETFs in the market because they are sure to take off just as they have done in the US. If you decide to invest in these funds, first read the product disclosure statement, which can be downloaded from the State Street Global Advisors website or you can call the company (on 02 9240 7600) and request that one be mailed to you.

Advantages and disadvantages of ETFs Index ETFs have no entry fees, no exit fees and have annual management fees of only 0.29 per cent per year, which is a fraction of the annual fees of active managed funds or even unlisted index funds. The main disadvantage of ETFs is that the only funds offered cover the sharemarket as a whole. Unlike in the US and Europe there are no funds covering specific sectors — like health care, resources, banks and so on. (The only other sector ETF in Australia is the SPDR property fund, which I will look at in chapter 7.) However, as you are aiming to get exposure to the overall sharemarket at the lowest cost and least hassle, this is not really a disadvantage. The overall market ETFs are fine for this purpose. More information on ETFs can be found on the ASX website or and type ‘ETF’ in the search box.

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Performance of ETFs There is little need to diversify across funds and across fund managers because all they are doing is ‘buying the index’. They are not trying to do anything fancy to beat the index. As long as the fund manager is a well-known global group and the fund is a decent size, you can be reasonably sure that you will go pretty close to matching the performance of the overall market index year after year, decade after decade. If and when the sharemarket has a bad year or two, don’t panic and start looking at other strategies. Just stick to the index-based funds and you will achieve the overall market performance.

How to invest in EFTs Financial planners generally won’t recommend ETFs (or other types of passive funds such as index funds or listed investment companies) even though they may be better value and better performers with lower costs than active managed funds, because the passive funds don’t pay sales commissions. Most financial planning groups are owned by active fund managers and all of their information and research is provided by the fund manager, so it’s hard for a planner to go out on a limb and recommend a product that doesn’t pay a sales commission. Listed ETFs can be bought through the ASX using an online broker account in parcels of around $500 — just like shares and listed investments. You will need to set up an online broker account (I discuss how to do this in chapter 11). All distributions from the ETFs go into the broker cash account or can be automatically reinvested into the funds. Set up salary deductions or direct debits from your bank account to go straight into the broker cash account and buy new units in the EFT each time the cash balance builds up to a suitable size. In practice you will probably buy new ETF units a couple of times each year. There is no need for extra involvement. ETFs will practically match the performance of the overall stock market year after year. All you need to do is read the annual reports, keep the distribution statements and use them to do your tax return each year, or give them to your tax agent or accountant.

Index funds Index funds do exactly the same thing as the index ETFs, except they are not listed on the ASX. They are often called ‘passive’ or ‘tracker’ funds because they don’t actively trade shares all the time. They

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just ‘buy the index’ by buying the shares in the main companies that make up the index. Every now and then they make minor adjustments as the make-up of the index changes. But they are passive in their level of activity compared with the active funds. Warren Buffett, the world’s second richest person, is generally regarded as the greatest investor and stock picker of the past 40 years. He is quoted in the Berkshire Hathaway 1996 annual report as saying, ‘Most investors, both institutional and individual, will find that the best way to own common stocks (shares) is through an index fund that charges minimal fees’. Also, Benjamin Graham, widely regarded as the grandfather of share analysis and the author of the ‘bible’ of share investments, The Intelligent Investor, wrote, ‘Hold an index fund for 20 years or more, adding new money every month, and you are all but certain to outperform the vast majority of professional and individual investors alike’. As these funds are not listed on the stock exchange, you don’t buy into them through the stock exchange like you do for ETFs and company shares. The funds are offered directly by the fund manager and you invest by completing an application form at the back of its product disclosure statement.

Costs and fees Index funds are not always buying and selling shares so their costs are low — much lower than for active funds, but a fraction higher than the ETFs in Australia. There are no up-front entry fees and no exit fees. The annual costs of index funds are generally around half a per cent per year, which is about one-quarter to one-third of the fees in active managed funds. Index funds pay much lower salaries than the active funds, and they don’t employ teams of research analysts to study hundreds of listed companies. They don’t need to pay big salaries to whiz-kid fund managers and dozens of analysts because they’re not trying to beat the index. They just buy the shares that make up the index and hold on to them.

Who does it? Index funds are huge in the US and Canada, where they were first took off in the 1970s. The largest index fund manager in the world is Vanguard; it is also the largest index fund operator in Australia. The main index fund managers in Australia are: 9

Vanguard Australia — or 1300 655 101. Minimum investment size is $5000, and management fees range from 0.35 per cent to 0.75 per cent.

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9

AXA offers its Barclays Australian Equity Index Fund . Minimum initial investment is $2000, and annual management fee is 1.2 per cent.

9

Equity Trustees offers its State Street Global Advisors’s Tax Enhanced Index Fund . Minimum investment size is $5000, and annual management fee is 1.0 per cent.

The Vanguard Index Australian Shares Fund is the largest and lowest cost general market index fund. The annual management fees are: 9

0.75 per cent for the first $50 000

9

0.50 per cent for the next $50 000

9

0.35 per cent for balances over $100 000.

These annual fees are well above the EFT annual fees, but they are still a fraction of the fees of active managed funds. There is also an initial entry fee of 0.20 per cent in the form of a ‘spread’, which is essentially a cost of buying units in the fund. You can reinvest the distributions back into new units in the fund, and you can set up an automatic regular transfer from your salary or bank account into new units.

Set and forget Index funds are an ideal way to invest in shares since they are low-cost, low-maintenance, ‘set-and-forget’ investments. Over the long term they will provide almost the same returns as the overall stock market — which historically has been around 12 per cent returns per year averaged over several decades. They aren’t trying to do anything fancy so you don’t need to diversify across several different index fund managers — using a huge global group like Vanguard should be fine.

Listed investment companies Listed investment companies (LICs) are companies that are listed on the stock exchange and use their money to buy shares in other companies also listed on the stock exchange. When you buy

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shares in a LIC, it’s almost the same as buying shares in each of the companies the LIC has shares in. So you can get exposure to lots of companies just buy buying shares in one LIC. LICs are different from index funds or ETFs because they don’t try to mirror the All Ordinaries Index. They each have their own portfolios and their performance does not necessarily match the All Ords each year. But unlike active managed funds, many LICs have demonstrated a strong and consistent performance over long periods of time — some have good track records of 50 years and more, and they have much lower fees.

Two types There are two basic types of LICs: 9

older, larger, passive LICs — these are what you should use in your plan

9

newer, smaller, active LICs — these are less tax effective and less reliable. Most are only a couple of years old and are more like active managed funds.

Whenever I refer to LICs in this book I am referring to the ‘passive’ LICs. The active LICs should be seen as very similar to active managed funds.

Diversify If you are going to use LICs in your plan, make sure you spread your risk across a few different LICs. You probably don’t need to use a dozen different LICs, just pick three or four of the larger ones to spread the risk. LICs have been in Australia for many decades; certainly much longer than any of the active managed funds. LICs have a number of advantages: 9

Low fees. LICs have no up-front fees that the active managed funds have. There are no annual management fees, but LICs do have staff who manage the investments and this costs money. However, the management cost of most LICs are a fraction of the fees charged by active managed funds, and are even lower than the index funds. LICs have no exit fees, unlike many ‘active’ managed funds.

9

Low minimum size of investment. Unlike unlisted index funds and active managed funds, you can invest in LICs with as little as $500, which is the minimum parcel size for buying listed shares. 191

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9

Higher investment performance than active managed funds. If exactly the same management team ran a managed fund and a listed investment company, the LIC should do better over the long term because it charges much lower fees. Fees eat into your capital and reduce returns.

Table 6.8 shows the passive listed investment companies in Australia.

Table 6.8: passive listed investment companies Name

ASX code

Size

Annual fee (%)

Started

Australian Foundation Investment Company

AFI

$5 billion

0.12

1936

Argo Investments

ARG

$4 billion

0.14

1947

Milton Corporation

MLT

$2 billion

0.18

1958

Djerriwarrh Investments

DJW

$1 billion

0.25

1995

Choiseul Investments

CHO

$500 million

0.12

1990

Carlton Investments 02 9373 6732

CIN

$500 million

0.12

1990

Whitefield

WHF

$300 million

0.31

1923

Sylvastate

SYL

$65 million

0.34

1924

This list will change from time to time; however, most of these LICs have been around for many decades and it is likely that they will be around for a long time in the future. Always check their current details on the ASX website, or on your online broker service or on the company websites.

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Performance All of the LICs in table 6.8 have been around for many years and all hold a broad spread of investments. The performance of each LIC varies from year to year — some beat the index and others underperform because they don’t just ‘buy the index’ like the index funds and exchangetraded funds.

Low fees Look at the annual fees charged by the LICs in table 6.8. There are several with fees less than 0.20 per cent per year, which is even lower than the ETFs and the index funds, and less than onetenth of the annual fees charged by most active managed funds. They don’t charge entry or exit fees either. A portfolio consisting of just the larger listed investment companies is an easy, low-cost way of investing in the overall sharemarket for small investors. The portfolio will need very little maintenance — each of the LICs owns a good spread of investments and you can be reasonably sure that the overall returns will keep track with the whole market index over the long term. You don’t need to check the share price daily, or even weekly or monthly or quarterly. If your portfolio consists of three or four LICs, you can be confident that your fund is well on the way to reaching $1 million. All you need to do is keep up the salary deduction or direct debits, every now and then increase the investments in the LICs from the broker cash account as it grows, and read the half-yearly and annual reports that will be sent in the mail. Keep the dividend statements and use them to do your franking credit refund application or tax return each year.

Managed share funds — ‘active’ versus ‘passive’ Your long-term investment plan is based on obtaining returns from the overall sharemarket averaging around 12 per cent per year tax effectively. If you are happy to achieve these returns, all you need to invest in are index ETFs, unlisted index funds or a spread of passive LICs. These are all passive strategies because they are not always buying and selling shares attempting to beat the index. On the other hand, fund managers who try to ‘beat the index’ are called ‘active’ fund managers. The majority of managed funds in Australia are active managed funds. Active fund managers aim to beat the market or beat the index — that is they aim is to beat the All Ordinaries Accumulation Index. If they can’t beat the index, then investors would be better off just buying

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the index using an index ETF or unlisted index fund, or doing it themselves by buying shares in the biggest companies and not paying fund managers to do it for them.

Thousands to choose from Managed funds (also called ‘unit trusts’) are pools of money contributed by investors and managed by a fund manager. Some managed funds are very large, with several billion dollars in total funds, and others are very small, with only a few million dollars in the pool of money. Some funds are dedicated to buying shares, others to buying properties, others to buying fixed interest or bonds and so on. There are managed funds that invest in pretty much any type of investment asset, including racehorses, vineyards, hotels and art. Some managed funds buy a mix of different asset classes. At the time of writing, there were over 8000 active managed funds offered by hundreds of different fund managers. You can use managed funds to invest outside your super fund as well as inside super using managed super funds, which are usually offered by the same fund managers as the non-super managed funds. Fund managers generally offer several different managed funds to suit different types of investors. Often they are labelled balanced, growth, aggressive, conservative, blended, lifestyle and so on. Take a look in the back pages of the Australian Financial Review (weekend edition) — there are hundreds of the larger managed funds listed.

Advantages of active managed funds If all you wanted was exposure to the sharemarket over the long term, you would invest in index ETFs or unlisted index funds. You wouldn’t use active managed funds because they are far more expensive and less tax effective. However, investing in active managed funds can be a useful way to target particular areas that it would be difficult to do directly — for example, overseas shares, hedge funds, credit derivatives, commodities and a host of other specialist areas of investment. Keep in mind though, that most of these areas are much too specialised and unnecessary to build a $1 million fund for life. They are just overkill and an unnecessary diversion from the main game.

Fees, fees, fees The main problem with active managed funds is the level of fees and sales commissions. Fund managers charge several different fees for managing the money in the funds: 9

Up-front fees. These fees range from around 3 per cent to over 5 per cent. If you invested $10 000 in a fund with a 4 per cent up-front fee (which is pretty standard), then the fund 194

Step 4 — invest outside super (part I): shares

would take $400 and invest the rest. So you have lost $400 before you even start — that’s a big chunk of your investment. Around half of this up-front commission is used to pay the financial planners who sell the managed funds. Most online brokers offer direct access to a range of managed funds and they rebate part of all or the up-front fee. 9

Annual fees. These fees are charged as a percentage of the fund balance each year. Annual fees of most funds available to small investors start at around 2 per cent or 3 per cent of the amount in the fund each year. If you were to invest $10 000 in a managed fund with annual fees totalling, say, 2.5 per cent, then you would be paying $250 each year. If the value of the fund increased each year (as you would be hoping), the annual fee would also increase. A portion of these fees are generally paid in sales commissions to the financial planner who sold you the managed fund (it’s called their ‘trailing commission’).

9

Exit fees. Some managed funds also charge exit fees for taking your money out (what’s left of it anyway!). Exit fees are also called ‘deferred entry’ fees.

9

Performance fees. Some managed funds also charge performance fees if the fund performance exceeds a set target level. Performance fees can be as high as 25 per cent or more of the performance above a set benchmark.

The higher the fee, the higher the risk The level of fees charged by a fund represents the level of incentives and enticements the fund manager has to pay the financial planners to sell their fund. The harder a fund is to sell on its merits, the more the fund manager has to pay, and the more slick advertising and marketing they need. Funds with lower risk (like index funds) are easy to sell because they make sense — they just track the index and are tax effective because they are passive (they don’t constantly buy and sell shares). They don’t need to pay high sales commissions, and advertising and marketing costs, so their fees are low. Active funds try to beat the index by doing all sorts of weird and wonderful things and are less tax effective, so they have to offer high sales commissions and they need lots of advertising and marketing. For example, Westpoint funds paid up to 18 per cent sales commissions to planners. High fees in a fund indicate that the fund manager can’t sell the fund on its merits. ‘High fees’ mean any sort of up-front fee or exit fee, or any annual fee above about 0.5 per cent per year. Many planners have admitted to me off the record that index funds, exchange-traded funds and listed investment companies are far more cost effective and tax effective than active funds, but they don’t recommend them because they need the sales commissions to make a living! 195

$1 Million for Life

Small amounts attract higher fees Generally, the larger the amount of money you have to invest, the smaller the percentage fees will be. For example, if you have $10 000 to invest you would generally pay about 4 per cent in up-front fees plus around 2 per cent to 3 per cent per year in annual fees. That’s up to 7 per cent or $700 you’ve lost in the first year alone! But if you had $100 000 to invest you could pay around 2 per cent up-front and, say, 2 per cent per year in annual fees. It might be a smaller per cent, but it’s still $2000 you’ve lost. The problem with these fees is that it they put a real drag on performance, which means it will take a lot longer to reach the $1 million target. Even ignoring up-front fees, if you have to pay annual fees of, say, 2.5 per cent on your investments, it knocks 2.5 per cent straight off your investment returns each year. If shares were generating 12 per cent returns per year and you were paying 2.5 per cent annual fees on managed share funds, your investments would only earn 9.5 per cent per year. Table 6.9 shows the impact of fees on $100 000 over time. This investment generates pretax returns of 12 per cent per year, and all distributions are reinvested in the fund. It compares a passive fund charging an annual fee of 0.30 per cent, and an active fund charging 2.3 per cent (the average annual fee charged by retail managed funds at the time of writing). The fee difference is therefore 2 per cent.

Table 6.9: impact of fees on $100 000 invested in active and passive funds Gross return (% p.a.)

Annual Net return fees p.a. after (% p.a.) fees (%)

Fund balance after year 5

10

20

30

Passive fund

12.0

0.3

11.7

$173 886

$302 365

$914 247

$2 764 364

Active fund

12.0

2.3

9.7

$158 867

$252 387

$636 990

$1 607 677

2.0

–2.0

–8.6%

–16.5%

–30.3%

–41.8%

$ difference

–$15 020

–$49 979

–$277 257

–$1 156 687

$ difference in today’s dollars (after inflation @ 2.5% p.a.)

–$13 275

–$39 043

–$169 202

–$551 442

% difference

Figure 6.3 shows how the two investments perform over time. 196

Step 4 — invest outside super (part I): shares

Figure 6.3: impact of annual fees on managed fund balance $2 764 000 $2,764k

$3 000 000 $3,000k $2 500 000 $2,500k $2 000 000 $2,000k

Passive fund with 0.3% Passive Fund withannual 0.3%fee annual fee: Active fund with with 2.3% annual Active Fund 2.3% fee anual fee

$1 500 000 $1,500k

$1,608k $1 608 000

$914 000 $914k

$1 000 000 $1,000k $500 000 $500k $0 $0k

$100 000 $100k $100k $100 000

start Start

$174 000 $174k $159 000 $159k

55 years years

$302 000 $302k

$637k $637 000

$252 000 $252k

10 10 years years

2020years years

30 30years years

As you can see, if you have $100 000 invested over 10 years, you will have almost $50 000 (or $39 000 in today’s dollars) less in an active fund than if you invested the money in a passive fund. After 20 years you would end up with $277 000 (or $170 000 in today’s dollars) less in an active fund than if you invested the money in a passive fund that invested in exactly the same underlying shares. That’s 30 per cent less in your pocket. Remember, the longer the time period, the better off you are in a passive fund. I’m talking about building wealth for the long term here, to fund your lifestyle for 30 to 50 years. These differences are massive and can mean the difference between a great lifestyle for the rest of your life, or a modest one. A similar illustration of the impact of fees on low-cost industry super funds versus high-cost retail super funds was included in chapter 4. It’s the same problem and the same culprits (the active fund managers) are responsible. A couple of further notes on table 6.9. Firstly, it doesn’t include up-front fees (or exit fees), which would further reduce the active fund performance. Secondly, it doesn’t include the impact of tax. (Active funds are almost always less tax effective than passive funds because they trade shares far more frequently inside the funds.) This would pull down the relative performance after tax of the active funds even further.

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Performance of active managed funds Are active fund managers worth the extra fees? Can they beat the index consistently over the long term? Despite costing Australian investors around $20 billion per year in fees paid to fund managers, there is no independent long-term study in Australia or anywhere else in the world that has found that ‘active’ fund managers add value and perform better than the index of a whole market over the long term. Rather, numerous studies conducted in many markets over many years — sometimes going back several decades — have demonstrated that active fund managers have never consistently outperformed or even matched the market index. While it is true that in any given year there will be some funds that perform better than the index, there will also be many more funds that perform worse than the index. Usually when all of the funds are taken together, the average active managed fund will, at best, match the index before fees. But when you take into account their fees, the average active fund will always do worse than the index over the long run, because of the impact of their fees. This has been demonstrated time and time again in many markets around the world including Australia.

Active fund managers don’t need your money You’ve got to really feel for active fund managers. Life’s tough for them. Each year one of the magazines catering to the active fund managers (Institutional Investor’s Alpha magazine) reports on the pay levels of active fund managers. In 2006 the top 25 highest paid individual fund managers in the world were each paid an average of US$540 million. The top three individuals received more than US$1 billion each, and the top guy got US$1.7 billion. Not bad for a year’s work! Of course, our local Australian fund managers don’t get paid that much — ‘only’ a few million dollars each.

Tax effectiveness Active managed funds tend to buy and sell more often than index funds and most private longterm investors. Passive funds only adjust their holdings when the weightings of companies in the index changes. Long-term investors generally choose their companies carefully then stick to them for long periods. For example, there are many shares that my wife and I have held for over 15 years and will probably never sell. Active fund managers are very different — they are always buying shares that come into fashion and selling shares in companies that go out of fashion. Fund managers spend their lives trying to pick the latest investment fashions and trends so they can buy and sell shares to try to beat the index. They read every piece of daily financial and economic news

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from around the world and try to adjust their holdings to beat all the other active fund managers doing the same thing. All of this activity results in greater transaction costs (which causes higher annual fees) and less tax effectiveness. After the end of each year many investors in active managed funds get a rude shock when they read the fund’s annual tax statement and discover that there is a big chunk of fund earnings described as ‘undiscounted capital gains/losses’ (which are gains and losses from selling shares owned less than one year) and discounted capital gains/losses (shares sold after more than one year). Both of these figures are often much larger than what you would find in most long-term investors’ funds and it is caused by the active fund managers constantly altering their holdings in the endless quest to beat the index. In contrast, passive funds and long-term private investors buy and hold for decades, and incur little or no capital gains tax along the way.

Style Then you have to worry about what ‘style’ your fund manager is. Is it a ‘value’ or ‘growth’ style? Is it ‘buy and hold’, ‘strategic’ or ‘tactical’? Is it ‘big cap’, mid cap’ or ‘small cap’? ‘Geared’ or ‘ungeared’? ‘Fundamental’ or ‘technical’? ‘Long-only’ or ‘long–short’? ‘Top–down’ or ‘bottom–up’? You need to understand what the fund manager is trying to do because it’s your money he or she is playing with.

Chasing performance each year In any given year the best managed share funds produce returns well above the market index, but most underperform the index; the worst ones often go backwards. So how do you pick the great funds and avoid the duds? The problem in most cases is that the great funds in one year often turn out to be poor performers the next year. One year will be great for the ‘value’ style managers but the next year might be great for the ‘growth’ style.

Short-term focus Active fund managers are driven by quarterly performance figures. Over short periods (three months or even a year) share prices can do pretty much anything — they could drop 20 per cent or more, or they could jump 20 per cent or more. It’s anybody’s guess what share prices will do over the short term. All sorts of things seem to cause share prices to jump around — war in the Middle East, oil prices, the gold price, interest rates, inflation numbers and so on. Fund managers are constantly looking at these factors and adjusting their portfolio to try to stay ahead of the game.

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The most important number in the life of every fund manager is the quarterly performance return for their fund. If the number is down for that quarter for whatever reason, people will stop putting their money into the funds (or worse still — take their money out), which means their fees will fall, so fund managers will do everything possible to get the quarterly performance number up. Everything is focused on the next quarterly performance result. Once they reach the end of this quarter they all take a deep breath and start concentrating on the next quarter. And so it goes on quarter after quarter, year after year.

‘After lunch’ Active fund managers define ‘short term’ as being ‘after lunch’, and ‘long term’ as three or five years at most. Most performance figures in newspapers, magazines and on websites show performance over three or five years. They call that ‘long term’ because most managed funds have only been around for that long or less. For your investments, ‘short term’ is defined as one year or so, and ‘long term’ is 30 or 40 years, so we’re talking a completely different language here. All active managed funds are expensive, and none of them can beat the index consistently over the long term. Simple as that — end of story.

You still need to diversify Buying one active managed fund is not good for your portfolio because you never know from one month to the next what shares they are going to pick. If you are going to use active funds in your investment plans you would need to diversify across several different funds and several different fund managers. How do you know whether a particular managed fund is any good? It may have been a star last year but it could be a dud next year. The staff in fund managers come and go every year or so, so you never know who is managing your money or how good they are. If you switch managed funds every year to chase the best performers, all you end up doing is paying capital gains tax and more fees. Therefore, if you are going to buy active managed funds you should: 9

conduct research into the managed fund and fund manager to see what their performance, training, expertise, management systems and so on are — to satisfy yourself that they know what they’re doing that they are likely to perform well for many years into the future

9

diversify your risk across several managed funds and several fund managers.

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It’s often much harder to conduct research into fund managers than it is to research companies you are looking to invest in. Instead of spending a lot of time trying to research into various fund managers, you may as well spend that time researching into companies and invest in them directly — and save on all the fees and commissions that fund managers will charge.

Master trusts Master trusts are also known as ‘master funds’, ‘funds of funds’, ‘multi-manager’ funds or ‘pooled master funds’. Instead of investing your money directly into shares and/or property, the master trust just takes a fee and invests your money in other managed funds, which take a fee as well. Just more layers of unnecessary fees!

Who are the active fund managers? Some of the major active fund managers operating in Australia are: 9

ABN Amro (Dutch) —

9

Advance (St George) —

9

AMP —

9

AXA (French) —

9

BT (Westpac Bank) —

9

Challenger —

9

Colonial First State (Commonwealth Bank) —

9

Goldman Sachs JBWere (US) —

9

ING (Netherlands) —

9

MLC (National Australia Bank) —

9

Perpetual Trustees —

9

Zurich (Swiss) — .

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Visit a few of these websites and take a look at some of the funds. Each offers dozens of different funds.

The power of money Each year up to $20 billion in fees is siphoned off investors’ funds by the fund managers and all that money buys a lot of influence and advertising. Everywhere you go you see advertisements for active managed funds. Most newspapers, magazines, TV stations and almost all other forms of ‘independent’ information are sponsored by the active fund managers. The whole financial planning industry is funded by fees and commissions siphoned off from your investments, so commission-based planners are hardly independent ‘advisers’. You need to learn to ignore all the advertising and the sales spiels and stick to the basics.

6.3 Direct shares Many Australians already have some experience with direct shares by taking part in ‘floats’ or ‘de-mutualisations’. There have been some good ones such as CBA, Tabcorp and Woolworths. Some have been flat, such as Qantas, AXA, IAG and Singtel (Optus), while others have gone downhill such as AMP and Telstra T2. Some of these are probably sitting in a bottom drawer with other things you’re not sure what to do with. What you need to do now is take the next step and make direct investing a part of your overall plan to build wealth for the long term.

Advantages of investing in shares directly There are two main advantages of buying shares directly rather than indirectly using even the low-cost ETFs, index funds or LICs. The first is cost, especially with larger funds. If you have, say, $50 000 to invest in shares, you can buy into a dozen different companies for a total brokerage of about $250 (0.5 per cent initial cost), and then have no ongoing costs at all (apart from the normal cost of fund audit and accounting if it is inside your self managed super fund). The second advantage of owning stocks directly is control. You can pick your own stocks depending on your area of expertise. You can also choose your own timing for buying and selling to minimise tax. There are additional advantages of owning direct shares, including access to shareholder discount cards, dividend reinvestment plans and share purchase plans that often offer shares at a discount to the market price and no brokerage costs.

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Step 4 — invest outside super (part I): shares

At the same time, there are also responsibilities — you need to take an active interest, stay informed and make decisions. This usually takes years of practice, so the best plan would be to start out using ETFs, index funds and/or LICs for a few years and during this time learn about shares and develop a direct share strategy.

How much do you need? The minimum transaction size for buying shares on the Australian Stock Exchange is $500 per parcel. The lowest brokerage rates charged by online brokers is about $19 for small parcels, which equates to 4 per cent of a $500 parcel, so the minimum amount per company you should aim for is at least $1000 per parcel. Ideally, you should aim to invest in at least 10 to 15 companies, spread across a number of different industries. So, if you were to have a minimum of a dozen or so shares in your portfolio in the early stages, and, if you didn’t buy parcels less than $1000 each, then you would need a fund of at least $20 000 before it became economic or wise to start investing directly in individual companies.

Why do it? Long-term investors use shares to provide tax-effective returns of around 12 per cent per year. You could achieve this using ETFs, index funds and/or achieve passive LICs. You could buy into these, sit on them for decades and never have to worry about them again. These would generate the returns you need to get to the $1 million target. You would reinvest the earnings during your working years so the fund grows faster, and then when you need the investment income you could live on the income generated by those same investments for the rest of your life. But you would only use direct share investing if you were sure you could do better than the overall sharemarket returns that could be achieved with ETFs, index funds and/or LICs.

Direct share strategies There are a number of different strategies you could adopt using direct shares to build long-term wealth, including: 9

buying the index — running your own index fund

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9

running your own ethical fund

9

picking stocks.

Following stock ‘tips’ from mates at the pub, neighbours over the back fence, or from astrological charts are not approved strategies! Nor am I talking about trading, which is frequent buying and selling in order to generate income. This is covered in chapter 8. What I’m talking about is investing to build wealth over the very long term.

Run your own index fund Rather than buy into an ETF or index fund, you can achieve very similar results with no annual fees. In Australia there are very few really big listed companies, so it is pretty easy for a medium-sized investor to simply ‘buy the index’ or ‘buy the market’ — meaning buy a group of shares that would more or less mirror the whole market. The 20 largest stocks on the Australian Stock Market, at the time of writing, are shown in table 6.10. There’s no magic to this list — these are just the largest listed companies ranked in order of size. You can find them in the finance pages in the back of just about every city newspaper in Australia. Anybody could create their own index fund with a portfolio of $50 000 by buying the largest couple of dozen stocks in proportion to their relative size. Because there are only a few really big companies on the ASX, by buying the largest 20 stocks you would have bought more than 50 per cent of the market index. Your fund will more or less match the return from the overall market year after year. The more stocks you have in your portfolio, the closer the performance will be to the market average. About once each year you would need to look at how the shares have moved and make minor adjustments. This is exactly what the ETFs and index funds do. The size rankings change from time to time, but the same old ‘usual suspects’ have been around for years, some for over a century.

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Table 6.10: the 20 largest stocks on the ASX Company

ASX code

Market capitalisation

News Corp

NWS

$140 billion

BHP

BHP

$102 billion

National Australia Bank

NAB

$74 billion

Commonwealth Bank

CBA

$71 billion

Telstra

TLS

$64 billion

ANZ Bank

ANZ

$58 billion

Westpac

WBC

$50 billion

Rio Tinto

RIO

$40 billion

Westfield

WDC

$39 billion

Woolworths

WOW

$35 billion

Woodside Petroleum

WPL

$28 billion

QBE Insurance

QBE

$27 billion

Macquarie Bank

MBL

$24 billion

Coles

CGJ

$21 billion

Brambles

BIL

$20 billion

AMP

AMP

$20 billion

Suncorp

SUN

$20 billion

St George Bank

SGB

$20 billion

Rinker

RIN

$17 billion

CSL

CSL

$16 billion

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Cost savings The initial brokerage is around $19 to $29 per company (depending on what broker you use) per parcel of shares. If you are buying parcels of $1000 per company, this equates to about 2 per cent of the value of the shares, which is not cheap. It’s like a 2 per cent entry fee in a managed fund. Most direct investors would buy minimum parcels of around $10 000, so the same $19 to $29 would effectively cost only 0.2 per cent. Note that most brokers charge the minimum fee for trades up to about $20 000 or $30 000, so a $20 000 or $30 000 parcel still costs the same $19 to $29 in brokerage. For larger parcels, most online brokers charge about 0.1 per cent of the value of the parcel. Savings can also be found in the annual fees. Let’s say you had a portfolio worth $50 000 invested in a dozen stocks. The annual fee on an ETF would be 0.29 per cent or $145, and the annual fee on an index fund would be 0.75 per cent or $375. My view is that the $145 or $375 annual fees on ETFs or index funds is money well spent dealing with all of the paperwork that comes from owning a dozen listed companies. In order to make it worthwhile, I would want the direct investing strategy to save me at least several hundred dollars in annual fees, so I wouldn’t do my own direct index fund with less than a couple of hundred thousand dollars. If all you are trying to do is buy the index more cost effectively than the ETFs or index funds, it would not make sense with less than about $100 000. Below that amount, stick to ETFs, LICs or index funds.

Action plan 1

Take a look at the Weekend Australian and check the list of largest 20 stocks against table 6.10. How much have the rankings changed?

Run your own ‘ethical’ fund Until a few years ago, owning shares was seen as the preserve of the rich, and a chapter on ethics would not appear in books on investing. However, now that owning shares has become much more widespread, more people have started to think more deeply about what they are actually investing in when buying shares. Companies are not charities and they are not run by saints. They make hard-nosed decisions in order to survive in a tough, competitive world full of compromises

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and grey areas. What is right or ethical is a very personal thing. Everyone has the right to their own views about the ethics of different companies. For example: 9

When the Australian Wheat Board (AWB) paid over $200 million in ‘incentives’ to Saddam Hussein’s regime for the sale of wheat, did this amount to illegal bribes that helped finance a corrupt and murderous regime, or was it simply following accepted market practice in securing wheat sales for struggling Australian wheat farmers?

9

When James Hardie (JHX) moved its head office and corporate base from Australia to the Netherlands and set up a fund that was far too small to cover all of the claims, was it avoiding its moral and ethical responsibilities to do everything it possibly could for the victims of its asbestos products, or was it merely taking appropriate action to protect the interests of its owners, the shareholders?

If you are an investor in any ETF or index fund, you are effectively an owner of both AWB and James Hardie shares, so you are partially responsible for the decisions and actions of the company. You can’t morally or ethically wash your hands of the issue and simply say, ‘I can’t be held responsible for the decisions of management, I’m just a shareholder!’ You are a part-owner and it’s your company and your responsibility, regardless of the fine legal distinctions. You are benefiting financially from its activities and its profits. These two examples point out a couple of the more obvious ethical dilemmas, but there is a range of factors you could consider when picking companies for your portfolio, including the following: 9

environmental impact and sustainability

9

tobacco

9

alcohol

9

gambling

9

workplace diversity and affirmative action

9

monopoly pricing and exploitation

9

employment of cheap foreign labour

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9

carbon emissions and renewable energy

9

level of CEO pay compared with the workers.

These are just some of the issues you could consider, but there are many others — each person is different. What one investor sees as unethical, another may have no problem with. Not only do opinions on what is ethical vary from person to person, but attitudes are constantly changing. For example, uranium mines were once considered evil, but in a few years my guess is that uranium mines could be seen as the ‘clean, green saviours’ as public opinion and world politics change.

Performance ‘karma’? Some ethical investors say their approach is based on some type of karma — that ‘what goes around comes around’, that if they invest only in ‘ethical’ companies then fate will reward them over the long term. There are problems with this. The first is that the time horizon may be too long. Fate could take hundreds or thousands of years to reward an ethical investor, but you may need the money to retire in 10 years. Another problem is that the reverse seems to be true — that is, that the companies promoting the ‘vices’ seem to have provided above-average financial returns in the past, for example, businesses based on the vices of alcohol, tobacco and gambling. There is an economic basis for the fact that the ‘evil’ industries have provided superior financial returns. The vices in society tend to be regulated. Governments often regulate their industries with mechanisms like restrictive licensing and quotas, which result in artificial barriers to entry into the industries and artificial protection, which in turn result in abnormally large margins and profits for companies in these industries. One way to approach ethical investing is by deciding that you are happy to accept lower investment returns (which may mean a less expensive lifestyle in retirement) in return for peace of mind knowing that you did your best to avoid promoting unethical companies. You can’t take the extra money with you when you die, so you may as well use it to do as much good in the world as you can while you are here. The long-term performance of any diverse ethical portfolio is probably not going to vary much from the market average returns. This is supported by the modern portfolio theory, one of the principles of which is that any broad basket of stocks (say 30 or more) picked at random will

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pretty much match the general market in the long run. That's why the dartboard or school student or astrologist often wins the stock-picking contests in the Sunday newspapers. There are a couple of way you can approach ethical investing.

Use ethical fund managers Think about that concept for a second — all jokes aside there are some active fund managers that actually sell themselves as being ethical. Despite this they charge the same huge sales commissions and fees as the other active fund managers — often even higher. Ethical funds started about 10 years ago and took a long time to take off. There are now quite a few unlisted active managed funds as more and more fund managers jump on the bandwagon and discover their ‘ethical side’. They all have different interpretations of what is ethical. They argue that their performance will be better than regular funds. Certainly in the early days of ethical managed funds (say, the past 10 years) this hasn't been true.

Do it yourself Rather than searching around for ‘ethical’ companies to invest in (it will probably take years and you may not find any!), you can do the reverse. You will need a broad spread of shares to build a diversified fund, so take the list of the largest 20 stocks as a starting point. Just by looking at the names of the companies you will probably see companies that are against your personal principles and ethics. It may be a bad experience you had with the company, or it may be an event or disaster the company caused. Cross those companies off the list. If you want to do more research on any company, you can download annual reports and other documents from the ASX website or any online broker site. Over the next few years, take some time to continue researching and refining your views about what is unethical or unacceptable. As you find good companies you can add them to your portfolio and as you discover bad ones in your portfolio you can sell them. That way, you end up with a list of companies that fit your own view of what is ethical. You also get to sleep at night, knowing that you have eliminated all of the companies you weren’t happy with.

Action plan 1

Run through the list of largest 20 stocks and test them against your own view of ethics.

2

Look at your current stocks (or those owned by your managed fund) — how ethical are they? 209

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Picking stocks — develop your own style If you are investing in direct shares you can try to compete with the active fund managers and pick stocks to ‘beat the index’. Analysing stocks takes time and developing a winning method takes years of practice. You may save on managed fund fees, but don’t forget to factor in the cost of your time, which is often considerable. I believe that unless you have some natural advantage by way of special skills or industry knowledge and insight, then trying to pick stocks is pot lock. You’ll do no better than the thousands of fund managers out there trying to do exactly the same thing. Active managed funds are run by committees who are terrified of going out on a limb and doing anything too different, so their overall performance pretty much ends up in line with the overall market over the long term — except they charge huge fees along the way, so they fall short of the market index. At least the index or passive fund managers (including exchange-traded fund managers) don’t try to beat the market index. So we know that, over the long term, managed funds are going to provide, at best, around the same returns as the overall stock market. It will be a fraction lower for exchange-traded funds, index funds and listed investment companies, but a good deal lower for active managed funds because of their much higher fees and commissions. Remember also that you can could pretty much match the performance of the overall market yourself by simply buying the index — that is, simply buying the largest 30 or so stocks in the index. However, buying an ETF, index fund or LIC is a lot more convenient.

Avoid the ‘dud’ companies Performance varies greatly from company to company. The overall market contains a lot of great companies that produce tremendous growth over many years. But the market also contains some real duds — companies that go nowhere or, even worse, collapse altogether. Wouldn’t it be good to just avoid the duds — your returns would beat the overall market year after year. Hindsight is a great thing. We can look back and see which companies are the stars and which are the duds. But it is not easy to see this in advance. If you had just avoided, say, Telstra (TLS) and News Corp (was NCP but now NWS) for example, you would have beaten the ETFs and index funds and the active managed funds by a good margin every year over the last decade. Telstra has dropped from over $9 per share in 1999 down to around $4 in 2007. And News Corp had a brief burst in the ‘tech boom’ of 1999 to 2000 but has been mostly falling ever since. Because Telstra and News Corp had such large weightings in the index (they were once the two biggest listed companies in Australia), investors would have achieved returns of probably a couple 210

Step 4 — invest outside super (part I): shares

of per cent per year better than the overall market and the index funds simply by avoiding Telstra and News Corp. But, because Telstra and News Corp were practically the biggest companies in the index for most of the time, the fund managers (not just the index fund managers) were dutifully buying them up because they were terrified of going out on a limb and straying too far from the index. As a small investor you don’t need to buy into companies that you don’t like. In my family we have had some great growth companies over the years like Macquarie Bank (MBL), ANZ Bank (ANZ), Westfield (WDC), BHP Billiton (BHP), Woodside Petroleum (WPL), Wesfarmers (WES), Woolworths (WOW), Perpetual Trustees (PPT), Billabong (BBG) and Toll Holdings (TOL). Each of these has produced returns of over 20 per cent per year averaged over the past decade. We have had only one dud — Qantas, which has gone sideways most of the time. Fortunately, we avoided Telstra and News Corp altogether because we didn’t like them. Then again, we also missed out on several other great growth companies out there. Generally, we stick to the biggest 100 or so companies. Here’s the problem — how can you be sure that the great growth companies of the past decade or so will continue on the same path for the next decade? And what if Telstra or News Corp or Qantas turn out to be great growth companies in the future? That’s the beauty of buying shares direct — you can take your time to have a look at each company and take a very long-term view. You’re not bound by committees and indexes and quarterly return targets. You’re in it for the long haul. In 30 or 40 years you should still be in the game and still own many of the shares you bought when you started.

Find the ‘next big thing’ All the great companies around today started out as small struggling start-ups. Many of today’s great companies started out in the 19th century or early 20th century, but most of the others were just tiny specs on the horizon only 20 or 30 years ago. The biggest growth in the next 30 to 40 years is probably going to come from companies that are very small today. What you need to do, as long-term investors, is find those companies that will turn into the Westfields, Billabongs, Toll Holdings and Perpetuals of tomorrow. One of the great advantages of buying shares direct, rather than paying fund managers, is that you can invest in small companies where the fund managers often can’t, because of their size. Fund managers run big funds — hundreds of millions of dollars each, sometimes billions. They do this

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to get ‘economies of scale’. They are geared toward making big investments in big companies. They tend to concentrate on the top 100 or so listed companies. There are several ‘small cap’ funds that specialise in small companies (‘small capitalisation’ means small market value) — but these also have tens of millions to invest and cannot buy very small parcels in very small companies. Fund managers simply can’t afford to have their staff looking at the other 1000 or so very small listed companies. There are just too many to cover. Even if they found a great small company, the sorts of dollars they deal with would be far too big to buy a meaningful stake. They are not going to be bothered putting a few thousand dollars into a tiny company — even if it had great products, great management and great growth prospects. But small investors are different. You are not rushing to reach this quarter’s performance target. You are not going to be sacked or retrenched if your fund’s performance is a bit off this month. You have plenty of time to get to know the types of companies that interest you. Of course, for every great growth company, there are a dozen or so others that don’t make it. So take your time and do plenty of research.

Use your own experience and expertise Another approach to picking stocks is to specialise in a particular area that you have knowledge of. If you have spent 10 or 20 years working in a particular industry, then you certainly know more about the companies in that industry than any fund manager ever will. Put this detailed knowledge to good use by finding the best companies in your industry and buying shares in them. In my case I have had senior roles in several Australian and international banking and finance groups. I ran various departments and divisions including branch operations, lending and credit, product design and profitability, systems, marketing, funds management and insurance, accounting and finance, back office operations, internal audit and control, funding and capital management, corporate finance, and mergers and acquisitions. There are about a dozen listed banks in Australia and also a few dozen other companies in related financial services. Over the past 15 years I have used my knowledge of the inside workings of the industry to pick and choose different stocks, and it has worked very well. Other industries like gold mining, retailing or energy I know very little about so I don’t invest in them. I own companies in these industries via my ETFs because they are in the index, but that’s enough for me.

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This can work in any industry. For example, if you are working in the medical or health field, you would know a bit about the industry. So you can start to look at a few listed companies in your industry, using your online broker service or the ASX website. From your existing base of knowledge about this industry you can get a feel for companies that are onto something and could have good growth prospects. There is plenty of time. You might just find the next Cochlear (COH), world leader in ear implants for the hearing impaired, Ventacor (VCR), world leader in heart implants to prevent heart failure, or CSL (CSL), world leader in bioplasma and blood products. If you can find great growth companies like these were 20 years ago, you can get in years before the fund managers even notice them.

How much to invest? These types of investments are long-term punts. You should only do this with a very small portion of your overall share portfolio, say, 5 per cent in total. You should also have a rule limiting your exposure to one particular stock of, say, 1 per cent of the whole share portfolio. Only buy when you are confident in your selections. Never buy on ‘hot tips’ without doing your own research first. Small high-growth companies are where you should be looking to get the big gains. But these companies are also where you will make losses on many investments. You can only lose 100 per cent of your investment but your gains can be thousands of per cents. Don’t sell too soon just because a stock has doubled or tripled in value — hold onto the winners. Perhaps sell down enough to pay for, say, double the purchase price, making the rest ‘free money’.

Different ways to analyse stocks In the business of analysing stocks there are two main camps — technical analysis and fundamental analysis. Technical analysis looks primarily at the historical price and volume data of a company’s share trading over various periods of time — from minutes to years. Technical analysts (also called chartists) look for ‘head and shoulders’ patterns, ‘support and resistance lines’, and follow ‘candlestick charts’. This form of analysis is used mainly by short-term traders, who buy and sell stocks, currencies, commodities and derivatives over periods from minutes to days or perhaps a few weeks.

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Fundamental analysis is used by long-term investors to understand what is going inside a company. This method looks at balance sheets, profit and loss statements, cash flows, management skill, industry dynamics, competitive positioning and many other factors. There are two main approaches: 9

Top–down — starts from the top (that is, the global economy), then looks at which countries, sectors and industries are achieving superior growth due to factors like demographics, industry structure or protection and regulation (for example, retirement accommodation, health care and funds management). Within those chosen industries, good companies are selected.

9

Bottom–up — looks for great individual companies, regardless of the industry, sector or country they are in. So, even a dying industry may have superior companies. Most stock pickers are either top–down or bottom–up, or a combination of both.

Style There are two styles of fundamental share analysis: 9

‘Growth’ investing mainly looks at growth in earnings per share, margins, sales, market shares and so on. Growth investors are looking for the next Macquarie Bank, Perpetual, Billabong and ABC Learning — companies that may be expensive now but have the potential to produce above-average growth for the long term.

9

‘Value’ investing concentrates on finding companies that are undervalued or misunderstood by the general market. Various value investors have different theories, but most look at the following factors: (

financial strength — usually measured by a range of factors, including returns on equity, debt levels, profitability ratios, balance sheet ratios, dividend cover and the like

(

good value — usually measured by things like high dividend yields, low price earnings ratios and share prices trading at a discount to the net tangible asset backing per share

(

strong management — measured by things like earnings per share growth, returns on assets, and often looks at qualitative factors like management depth and skill.

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Value investors recognise that companies go in and out of fashion in different parts of the economic cycle and that many companies could be ideally placed to rebound back into fashion. There is also an approach called growth at a reasonable price (GARP), which is a combination of growth and value investing principles. There are hundreds of books on share investing that cover the whole spectrum of theories, and it’s up to each investor to discover what works for them. Some investors just want to be told what to buy or sell and when. Others want to understand what they are buying and why. Some useful books are included at the end of this chapter. Different people have different tolerance to risk and volatility. For example, how would you react if the share price of a company in your portfolio dropped by 50 per cent? Would you: 9

buy more shares because it’s cheap

9

sell the lot because it’s a dog

9

wait and hold on for the long term and hope things turn around

9

focus on what the company is doing rather than worry about the share price?

There are no right or wrong answers, but your answer will tell you a lot about the kind of investor you are and your tolerance to risk. Remember, in trying to pick stocks you are up against all the ‘professional’ active fund managers and private investors out there trying to do exactly the same thing. Unless you have a natural advantage by way of particular skills or industry knowledge, then you’re better off using ETFs, index funds or LICs for your share strategy.

Measure your performance One common mistake most private investors make is that they don’t compare their stock-picking ability with the general market. For example, let’s say I had a great year picking stocks — one was up 16 per cent, one up 24 per cent and another up 12 per cent. I would be pleased with my efforts and I would talk all about it at the pub. The problem is that the All Ordinaries Accumulation Index was up 25 per cent over the same period, so I actually went backwards! That’s why it’s important to have most of your money (the core of you portfolio) in the general market via EFTs, index funds, or LICs. That way most of your money is achieving the overall market returns and you can easily use that to benchmark your performance with direct shares. 215

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6.4 International shares So far we have looked at various ways of investing in shares in Australian companies. We started out with Australian companies listed on the Australian Stock Exchange because they are closest to home and easiest to research. While there are large companies and large stock exchanges overseas, most are in countries with different languages and different currencies, and they operate under different legal systems and customs. And they are far away, so it’s not easy to find out on the street what’s happening inside the companies. You can’t ring them up and talk to management, or walk into their shops, factories or warehouses and have a look. International sharemarkets often work in different cycles to the Australian sharemarket, so investing some of your funds in international shares can add to the diversification and lower the variability of returns to your overall portfolio. Generally, it’s best not to take up this option until your portfolio reaches around $50 000 in total size. At that point, you could set a target of having, say, 10 per cent or 20 per cent of the fund in international shares. Most active fund managers have a component of international shares in their growth, high-growth and aggressive funds, often up to 20 per cent or 25 per cent of the total portfolio size.

Picking companies and picking countries When it comes to picking international companies to invest in, do you start at company level and say, ‘Toyota or Shell or Apple are great companies — should I own them regardless of what countries they are listed in?’ Or do you start by saying something like, ‘The US economy (or Chinese economy) is looking strong and I want to invest in it. Should I pick individual companies in the US (or China) or just buy index funds?’ Or should you pay an active fund manager to invest in companies in just one country or maybe a range of different countries? You can do all of these things from here in Australia. Just about anything is possible online with a few mouse clicks these days.

Currency risk When you invest in foreign companies (whether through index funds, active funds, or directly) you are taking on not only the risk of the share price moving up and down, but also the risk of the currency moving up and down. For example, it is all very well for shares in General Motors (the US car maker) to rise from US$20 per share to US$30 per share, but if the Aussie dollar has risen from

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US 50 cents to US 80 cents over the same period, the share price gains would have been more than wiped out by the currency move. Some of the international funds are ‘hedged’ (meaning that they have reduced or eliminated the currency risk) and some are unhedged. This will be explained in the product disclosure statement for each fund.

Different taxes There are different tax rules in different countries. For example, most dividends received from Australian companies come with ‘franking credits’, which can be used to reduce tax or even get tax refunds. Dividends from foreign companies don’t carry this franking credit benefit. Many countries take out withholding tax before remitting dividends to Australian shareholders, and investors can then offset these against tax in Australia, but it is different in each country. Your tax agent or accountant will assist you in completing your tax return each year.

How to invest in international shares There are a number of ways to invest in international shares, including the following: 9

unlisted (passive) index funds of international indices

9

active ASX-listed managed funds investing in international shares

9

unlisted active funds investing in international shares

9

foreign-listed index funds

9

direct international shares

9

Australian listed shares with international operations and profits.

Unlisted (passive) index funds of international indices For most investors, unlisted index funds of international indices is probably be the best place to start for exposure to the international sharemarkets. The lowest cost index fund manager is Vanguard and it offers two unlisted share international index funds in Australia: 9

Vanguard Index International Shares fund — tracks the Morgan Stanley Capital International World (ex Australia) Index. Minimum investment is $5000. Entry fee is a 0.30 per cent buy 217

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spread (cost). Annual management fees are 0.90 per cent for the first $50 000, then 0.60 per cent for the next $50 000, then 0.35 per cent for the balance over $100 000. 9

Vanguard Index Hedged International Shares fund — tracks the same MSCI World (ex Australia) Index but hedges the exposure in Australian dollars. Minimum investment is $5000 and it has almost the same fees as the unhedged fund.

You can download information and PDSs from . These funds track the MSCI World (ex Australia) Index, which comprises representative stocks in the following regions:

North America Europe (ex UK) United Kingdom Japan Asia (ex Japan) Total

55 per cent 20 per cent 11 per cent 12 per cent 1 per cent 100 per cent

This provides broad exposure to the mature, developed markets, but does not provide entry to the emerging or developing ‘BRIC’ region (Brazil, Russia, India and China), or other countries in Latin America, South-East Asia, Middle East or eastern Europe. Low-cost, broad index-based exposure to these types of markets is only available with funds on foreign stock exchanges.

Active ASX-listed managed funds with international shares This is a very new sector in Australia, although this type of listed fund has been around for a couple of decades in the US and Canada. Being listed investments, their fees are generally lower than unlisted managed funds (and they have no entry or exit fees), and you can buy into them with a minimum of $500 each. Some of the main ones are shown in table 6.11. The performance of these active funds has been patchy. All have underperformed the Australian market since their introduction. The main problem is that the fund managers are sitting in Sydney or Melbourne and trying to pick stocks in overseas companies, so they probably have no better chance of succeeding than you or me.

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Table 6.11: ASX-listed international share funds Name

ASX code

Description

Size

Started

Hunter Hall Global Value Fund

HHV

Mainly Asia (India) banking

$350 million

2004

Platinum Capital

PMC

Diverse

$270 million

1994

Templeton Global Growth Fund

TGG

Mainly Europe, US

$220 million

1987

Bentley International

BEL

US and Europe

$16 million

1986

Active unlisted funds for international shares Many of the major Australian active fund managers also offer funds that include foreign shares. Generally, they don’t run the international funds themselves, they just pass on the money to other overseas-based fund managers to invest it. The list of major active fund managers in Australia was provided earlier in the chapter. As these fund managers operate in Australia you can buy into their funds with Aussie dollars and deal with local staff in their local offices, which is convenient. The unit prices of many of these funds are listed in the back pages of the weekend edition of the Australian Financial Review in the ‘investment trust’ section. Similar super funds are listed in the ‘superannuation funds’ section.

Minimum sizes These funds have minimum initial investment amounts of around $5000. Unless you stuck to the international index funds, you would want to diversify your risk over at least two or three international markets or active fund managers. And because you wouldn’t normally have more than, say, 10 or 20 per cent of the portfolio in international shares, you would probably have to wait for the fund to reach around $50 000 or $100 000 or so before buying two or three active international funds. These managed funds are unlisted, which means you can’t buy and sell them on the stock exchange through your online broker account. You buy them by completing an application form

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at the back of their PDS, which can be downloaded from the fund manager’s website or you can call and ask for one to be sent in the mail.

Foreign-listed index funds or ETFs Most online broker services in Australia offer access to the major overseas markets. Most can access the main US markets and several can access the London, Hong Kong and Singapore markets. This is particularly useful for investors who want to access some listed ETFs. You will recall that there is only one major ETF provider in Australia (State Street Global Advisors) and it has only two Australia share ETFs (the SPDR 200 fund and the SPDR 50 fund). They only cover the general Australian market, not other sharemarkets. The picture is vastly different when you can access the US markets using an online broker. There are hundreds of index-style ETFs listed in the US. Many are also listed in other exchanges like London, Hong Kong and Singapore. The main players are: 9

Barclays Bank — has more than 100 US-listed ETFs called ‘i-Shares’, see

9

State Street Global Advisors — offers a number of ETFs covering the US and foreign markets, but is not as strong as i-Shares in international markets, especially emerging markets, see .

Each of the hundred or so Barclays ‘iShares’ funds tracks a particular index. The range of i-Shares ETFs is mind-boggling. There are: 9

32 ETFs tracking various US general market indices, including the Dow Jones (IYY), S&P 500 (IVV) and Russell 2000 (IWM)

9

10 ETFs tracking US value indices, another 10 tracking US growth indices, and 40 tracking various sectors of the US market like materials, energy, health care and financials

9

41 ETFs tracking counties and regions outside the US like UK (EWU), European Monetary Union (EZU), Japan (EWJ) and Pacific ex Japan (EPP)

9

14 ETFs tracking global sectors like global technology (IXN) and global energy (IXC)

9

nine ETFs tracking emerging markets regions like China 25 index (FXI), Emerging Markets (which covers BRIC, South America, South-East Asia, South Africa) (EEM) and Latin America (ILF). 220

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The i-Shares ETFs are listed on either the American Exchange (AMEX) or the New York Stock Exchange (NYSE). Most Australian online brokers can access both of these exchanges. If you don’t have a broker account, you can look up any US-listed stock or ETF on US market sites like .

Costs The annual fees range from extremely low — under 0.10 per cent per year for the large US ETFs — to about 0.75 per cent per year for some of the smaller, more specialised ETFs. These fees mean that the ETFs will underperform the index they are tracking by a fraction each year. ETF fees are a fraction of what active fund managers charge (most charge over 2 per cent and some also charge performance fees). The active funds can’t beat the indices consistently over the long term so I’m not sure why you would pay the high fees. Most Australian online brokers charge about $50 or $60 per trade on international exchanges. If you open a US-based brokerage account, you can get trades down to under $10 per trade, but opening an account as a ‘non-resident alien’ is much more difficult. Given that you need to buy or sell very rarely, the cost of using an Australian-based broker site to access international markets is fine. There is no cost to set up an online broker account, nor to set up the access to international exchanges.

What to do with all this choice? Don’t lose sight of the main game. Your aim is to have a portion of your long-term growth funds in low-cost index-style funds that give you access to global stock markets. A couple of different international index ETFs would probably suffice for most people. Following are some options: 9

Since the US stock market makes up half the global stock market value invest in one of the ETFs covering the broad US market, and perhaps one of the European funds. This would mean that you have most of the developed economies covered.

9

To tap into the potential rapid growth of the emerging markets invest in one or two of the emerging markets ETFs.

9

If you have a special interest in a particular country (for example, if you are planning to retire there or set up a business there and would like to build wealth in that market), there is a good chance there is an ETF tracking that country’s market index. See the full list on . 221

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Currency exposure With these US-listed international funds you are dealing with US dollars, so you have currency exposure as well as country exposure. All distributions (most are quarterly) are paid in US dollars as well. Personally, I am happy to have this US dollar exposure because of the long-term declining trend of the Australian dollar, especially in the current environment (late 2000s) with the relative high Aussie dollar due to the commodities boom.

Direct international shares Using your local online broker with international access, you can buy shares direct on the international markets. There is a huge amount of information and research on many thousands of listed stocks in the major markets and it is difficult to know where to start. You are back in the game of trying to pick stocks against all the other investors out there, except you have the added disadvantage of been thousands of miles away from the action. Not recommended despite the temptations and easy access!

Australian-listed shares with international operations and profits Even though the US-listed ETF approach is very low cost and relatively easy to do, there is an even easier way to tap into foreign markets. You are already doing it when you invest in companies listed on the ASX that are either foreign based or are locally based but have large operations in foreign markets. Fortunately, there are many such companies. Here are some of the biggest ones to have a look at: 9

Mining and resources — pretty much all of the Australian listed mining and resources companies are selling their minerals into foreign markets.

9

Gold — there are several very big global gold mines listed in Australia, including Placer Dome (PDG), Newcrest (NCM), Anglogold (AGG) and Newmont (NEM).

9

Steel — Bluescope (BSL), Onesteel (OST) and Smorgan Steel (SSX) all have large overseas operations and profits.

9

Building materials — Boral (BLD), CSR, James Hardie (JHX) and Rinker (RIN).

9

Agricultural — Nufarm (NUF), Orica (ORI), and Ridley (RIC). 222

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9

Health care — Ansell (ANN), Cochlear (COH), CSL, Resmed (RMD) and Sonic Healthcare (SHL).

9

Other goods and services companies with major operations overseas include Computershare (CPU), ABC Learning (ABS), Billabong (BBG), Fosters (FGL), Aristocrat (ALL), AXA (AXA) and Brambles (BIL).

In fact, the majority of the biggest 100 companies listed on the ASX have significant overseas operations. So, by buying these companies you are, in effect, tapping into foreign markets and the growth in foreign economies. In the early years of your investment funds you will be investing in shares through ETFs, index funds and/or listed investment companies — and the shares held by these entities would always include many with large exposure to foreign markets. In this way you are already getting significant foreign market exposure even when the fund is very small.

6.5 Summary of share strategies Shares form the basis of your plan to build long-term wealth over your life. In chapter 7 I will look at various types of property investments that can also play a key role, but shares will still make up a large proportion of your long-term growth portfolio. Lots of different ways to invest in shares have been covered, but it’s time to get back to what you are trying to achieve here. In your long-term investments plans (both inside and outside your super funds) you are trying to build your investments for the long term (the next 30 or 40 years or so) by investing primarily in growth assets — shares and property. In the case of shares, you should be happy to achieve the returns available from the overall stock market over the long term and your aim is to do it in the lowest cost, most tax-effective and convenient way possible.

Passive core For most people looking to achieve this with their long-term funds, the core or backbone of their portfolios should be made up of low-cost, tax-effective, convenient, ‘passive’ investments consisting of: 9

one of the index-based ETFs — you can start with as little as $500, but normally you would buy them in lots of $1000 to reduce the effect of brokerage costs

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9

a low-cost unlisted index fund — you can start with $5000, and make regular contributions straight into the fund (via salary deductions or direct debits from your bank account)

9

three or four of the larger, low-cost long-established ‘passive’ listed investment companies — even though they don’t strictly track the index they are effectively ‘passive’ investments. They are extremely low cost, tax effective, have low turnover of stocks within their funds and have very long track records. You can start with a minimum of $1000 and buy into two to start with ($500 minimum each).

You wouldn’t need to do all three strategies to generate the long-term returns needed to get to the $1 million target, you could pick one option. All are low-cost, tax-effective, easy-to-use, ‘set-andforget’ strategies. You could set up the necessary accounts structure in a couple of days for no cost, never have to worry about them and never sell them. They will get you to the $1 million target and they will generate the tax-effective returns to live off for the rest of your life.

Optional extras Your passive strategies can form the core of your long-term growth portfolio and will get to the $1 million target without going into any other types of share investments. Purely as optional extras, you could start to look at putting a small proportion of your funds into the following optional strategies: 9

Direct shares. When the fund grows to above, say, $50 000 you can now start to look at investing directly in individual listed companies, in addition to your passive core strategy. You wouldn’t sell the existing passive investments because you would just have to pay capital gains tax on any increases in value. You would keep the existing investments and make new investments using earnings from the existing investments, plus new contributions from your salary or bank account.

9

Active managed funds. Provide exposure to a particular sector of the market.

9

International. When the fund grows to above $50 000 or so, you may want to look into a couple of specific international share funds to increase exposure to foreign markets. You could do this with either:

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(

a locally run unlisted index fund (which covers the international market index in general)

(

US-listed index-based ETFs covering a global market index or specific regional indices.

These optional extras will allow you to diversify your portfolio and perhaps increase your returns even more, especially during the ‘down’ years in the Australian stock market.

Online brokers If you are using unlisted index funds (or unlisted active funds) you don’t need an online broker. You start by completing an application form for the initial units and at the same time you set up regular salary deductions or direct debits from your bank account that go straight to the fund to buy more units each month. However, if you are going to use EFTs, LICs and/or direct shares (or listed property trusts), you will need to set up an online broker account with a linked cash account to take your salary deductions or direct debits. There is no cost involved in setting up online broker and cash accounts. This is covered in detail in chapter 8.

Worrying about the stock market Although it’s extremely tempting to look at the prices of your shares all the time, don’t do this. The share price doesn’t matter — it’s irrelevant. If you bought one of the major exchange-traded share funds, index funds or a few of the passive listed investment companies, then the price is really irrelevant. Your investment will just track the overall sharemarket — year after year, decade after decade. That’s why you bought them — so you wouldn’t have to worry about the share prices. You can check the share price each time you get a half-yearly report and annual report from the company — just to make sure you’re on track. If you’re at the stage of buying individual company shares, then you also shouldn’t worry about the share price day to day or month to month. What you should really be worrying about is the business. You should only sell the shares if something major affected the company’s ability to keep growing earnings like it has in the past. You only bought into the company after spending time doing your homework, so you are not worried about minor ups and downs in the share price. You’re more interested in the half-yearly reports and annual reports, which contain the auditor’s report, the accounts, the director’s report 225

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and so on. If you’re happy with those things, the share price will take care of itself in the long term. So forget the share price and concentrate on the next investment!

‘Stop loss’ orders and ‘price targets’ This is another area that is a reminder to focus on the business rather than the share price. Many people will tell you to set a ‘stop loss’ price whenever you buy shares. For example, when we bought our BHP shares for $8.50 in 2000, many people would have said that we should set a stop loss price of, say, $8.00. This means that if the share price drops below $8.00, then we should sell at that point to ‘stop’ our losses from getting any worse if the share price fell further. These days it’s even possible to set up an automatic stop loss order on many broker accounts, so when the price drops below the stop loss order price, the computer will automatically sell the shares for you. Some broker services even offer price ‘alerts’ sent to the customer’s mobile phone when prices reach a set level. This all sounds very convenient, but in fact it can be very dangerous. The problem with stop loss orders is that they can sell you out at the worst possible time and prevent you from making any profits in the future. In our case with BHP shares, shortly after reaching $10.20 in mid 2001, the market fell over the next six months and BHP dropped to well below $8.00 by September 2001 (remember September 11?). Just because the price dropped below some arbitrary level, should we have sold out at, say, $8.00 in order to stop our losses from getting worse? Of course not — nothing had changed our view of the BHP business. It was a fine company producing a wide range of resources and selling them to customers all over the world, just like it was a few months earlier when the price was over $10. In fact, the share price dropped even further — to around $7.50 — but then it started its long rise to above $30 where it is today. If we had panicked and sold for $7.50 in September 2001 we would have made a loss of 12 per cent on our investment. But we kept the shares and now they have more than tripled in value. And the business looks stronger than ever.

Focus on the business Only sell shares when something in the business changes, not when the share price drops. Too many irrelevant factors affect share prices, so don’t look at the share price all the time to try to work out what’s going on. Nothing’s going on — the company is just quietly getting on with the job of growing its business.

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If your investments were ETFs or some of the larger, passive listed investment companies, then it would make even less sense to set up price targets and stop losses. You can expect the price to drift up and down from week to week or month to month or year to year. But you can be confident that they will keep more or less on track with the overall market. Leave your investments alone and worry about other things. They will be fine, and they will be the investments that get you to the $1 million target.

6.6 Borrowing to invest Most people who generate real wealth do so by using ‘other people’s money’, not just their own. That’s what you’re doing when you take out a home loan to buy your house. Many people have no problem with borrowing money to buy things like cars and boats, which depreciate heavily over time, and many others have no qualms about borrowing to start a new business, even though, historically, most new businesses fail within the first year or two. So it is strange that a lot of people are scared off by the prospect of borrowing to buy shares, even though a diversified share portfolio will generally grow at a healthy rate above the inflation rate over the long term, with very little risk of total failure. If you are building wealth over a period of more than 10 years, and are not going to need the money during that period, borrowing to buy shares can be a great way of turbo-charging your wealth-building plans. In addition, there are tax advantages to borrowing — you can deduct 100 per cent of the interest on the loan, and only pay capital gains tax on half of the capital gains if and when the shares are sold after 12 months. On the downside, using debt to buy shares can also magnify any losses in capital value of the shares, which is why it’s extremely important to consider it as a long-term strategy. If you are likely to need access to the capital within 10 years I would not recommend borrowing. There are three main ways of borrowing to buy shares — margin loans, loans secured by your house or other property, and protected equity loans. Each has advantages and disadvantages.

Margin lending A margin loan is a loan to buy shares or managed funds where the security for the loan is the shares or managed funds themselves. No extra security is taken by the lender, so you don’t need to take out a mortgage on your house or other property. Interest rates on margin loans are generally

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a couple of percentage points above the rates on loans secured by real estate. There are 160 000 margin-lending accounts in Australia and this is growing rapidly. The sector tends to grow during ‘bull’ markets and slow down during ‘bear’ markets. The past few years have been raging bull markets and the growth in margin lending has been huge.

Approved lists One advantage of margin loans is that margin lenders have restrictions on the shares they will lend against, and they set limits for the amount of money they will lend against each share. Each margin lender has a list of ‘approved’ shares and managed funds it will lend against. For each share and managed fund on its approved list, it also has an approved loan to value ratio (LVR) limit up to which they will lend. For example, you could be lent up to 75 per cent against the value of the major bank shares, but only 50 per cent against some mining stocks. These different LVR limits don’t mean that the margin lender believes the bank shares are a better investment than the mining shares. It just means that the bank shares are less volatile, and the chances of the share price falling below the LVR limit is lower than for the mining shares.

Fixed or variable Margin loans generally come in two varieties — fixed and variable. With a fixed margin loan, the amount of the loan and the interest rate are fixed for a period — some for up to five years. This means you can’t repay part of the loan and redraw it to buy more shares. The advantage of fixed rates is that the interest payments are a known quantity and remain constant for the loan period. With a variable margin loan, both the amount and the interest rate are variable. It is a bit like a line of credit, where you can repay part of the loan and redraw it again at any time to buy more shares.

Margin calls Aside from the high interest rate, the other disadvantage of margin loans is the dreaded ‘margin call’. If the value of your shares drops below its preset limit, you need to top up your security with cash to make up the shortfall. If you can’t find the cash within 24 hours, the lender will sell enough shares to bring the loan down to within its limit. This generally happens at the worst time and can cause further falls in share prices. The minimum margin loan from most lenders is about $10 000, so you will need to have about $5000 in cash to start. Use your $5000 plus the $10 000 margin loan to buy a portfolio

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worth $15 000. In practice, a good place to start for most people would be more like a $50 000 loan plus $50 000 of your own cash, making up a total portfolio of $100 000.

Where to find a margin loan There are three main places to look: 1

your bank — most major banks offer margin loans to clients

2

online broker services — most offer margin loans to clients

3

specialist margin lenders, including: (

Equity Margins Ltd (Merrill Lynch) —

(

Leveraged Equities Ltd (Adelaide Bank) —

(

Colonial Geared Investments —

(

Smith Barney Citigroup — .

Borrowing against property The other main way of borrowing to buy shares is to borrow using a loan secured by property like your house or an investment property. This is often considered more risky because you could lose your house if something goes wrong. In practice, it is no more risky than a margin loan secured against the shares you bought with the loan. When you sign any loan contract you become personally liable to the lender. If you don’t pay up, the lender will go after any and all of your assets, including the shares and your house, so your house is not safe with a margin loan either. There are three main choices when you borrow against property — a variable rate loan, a fixed-interest rate loan, or a line of credit (which usually has variable rates). Many investors like the certainty of fixed rates, but the longer the fixed-rate term the higher the rate. You can’t fix rates for the full term of your 10- or 20-year plan, so even with fixed rates you will need to change to a new rate every few years. Often it is cheaper in the long run to stick to variable rates.

Advantages and disadvantages The main advantage of using a loan secured by your house or an investment property is that the interest rates are generally about 2 per cent lower than the rates on margin loans. This makes a huge 229

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difference to the overall investment performance of the geared fund. The other advantage is that there are no margin calls and you don’t have to constantly worry about the values falling below some arbitrary level. The main disadvantage is that your home lender has to approve the additional loan. Plus, there may be additional costs of mortgage stamp duty and application fees. These costs will usually be outweighed by the lower interest rate on the home loan or line of credit secured by property.

Protected equity loans Protected equity loans are a bit like margin loans but with much higher interest rates and a limited capital guarantee. Interest rates on some are up to 15 per cent to 20 per cent and a large proportion of the interest is not tax deductible. Protected equity loans are highly structured investments, often with many layers of fees and lots of fine print. The capital guarantee is limited in the sense that there are only one or two specific points in time when the capital is guaranteed — for example, on a particular date in five years time. There is no allowance for inflation, interest costs and fees, so the capital guarantee is generally not worth much. The real killer is the interest rates and fees, which are much higher than straight margin lending and using lines of credit secured by property. As you would only borrow to buy shares if you were planning to hold the shares for at least 10 years, the chances of capital value being lower than at the start is very small.

Warrants Warrants are another structured product with very high interest rates built into them. They are covered in chapter 8. They shouldn’t be considered a long-term investment as the very high interest rates (often as high as 20 per cent or more for more volatile stocks) outweigh any benefits.

Which shares to buy for the geared fund Your total portfolio — made up of your own contribution plus the loan funds — can be invested in shares in a variety of ways. You could invest in one or more ETFs, an index fund, three or four passive LICs, or a broad basket of at least a dozen of the major listed stocks, which would be a bit like having your own index fund with no fees. You could also buy managed funds, but their performance will not necessarily match the market average over the long term and the high fees make them unviable.

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Impact of gearing on performance To show the impact of gearing on investment performance, let’s look at an example of a person who has $50 000 to buy shares. There are three alternatives: 9

plan A — use the $50 000 to buy either ETF units or a broad range of direct shares

9

plan B — borrow $50 000 making a total portfolio of $100 000

9

plan C — borrow $100 000 making a total portfolio of $150 000.

The taxpayer is in the 41.5 per cent tax bracket (income between $75 000 and $150 000), and inflation is assumed at 2.5 per cent per year. The loans are interest-only (meaning that the principal is not being paid off each year) at an interest rate of 8 per cent for the whole period. A typical portfolio of shares (either through ETFs, LICs, index fund or a broad range of direct shares) is assumed to produce the following returns averaged over the long term:

Unrealised capital growth

8 per cent per annum

Income yield

4 per cent per annum

Total investment return before tax

12 per cent per annum

The break-up of income distributions would vary each year but over the long term would average something like this:

Percentage of distributions Normal taxable income (including undiscounted capital gains, unfranked dividends, rent, interest)

10 per cent

Discounted realised capital gains

10 per cent

Tax-free or tax-deferred income

10 per cent

Fully franked dividends

70 per cent

Total

100 per cent

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This is does not assume that distributions consist purely of fully franked dividends. In practice, you could expect that about 70 per cent of the distributions would in the form of fully franked dividends, and the rest a mix of unfranked dividends, tax-free or tax-deferred income, some distributions from buybacks, capital returns and realised capital gains, some of which would be discounted (held for over 12 months). In each case the net fund income after tax is reinvested into the fund. The net effect of plan A (ungeared), plan B (50 per cent geared) and plan C (67 per cent geared) over the long term is shown in figure 6.4 and table 6.12.

Figure 6.4: net equity of gearing plans over time Net equity Net equity $1 000 000 $1,000,000

$863,668 $863 668

Plan AA. — ungeared Plan Ungeared

$900,000 $900 000

Plan BB. — geared 50%50% Plan Geared

$800,000 $800 000

Plan C C. — geared 67%67% Plan Geared

$700 000 $700,000

$644 227 $644,227

$600 000 $600,000 $500 000 $500,000 $400,000 $400 000

$424 787 $424,787

$300,000 $300 000 $200,000 $200 000

$100 000 $100,000 $0 $0 0

1

2

3

4

5

6

7

8

9

10 11 Years

12

13

14

15

16

17

18

19

20

This example demonstrates the power of gearing. Plan B with 50 per cent gearing ($50 000 cash plus a loan of $50 000) ends up with 38 per cent more net equity than plan A (no gearing) after 10 years, and 52 per cent more after 20 years. Plan C with 67 per cent gearing ($50 000 cash plus a loan of $100 000) ends up with 77 per cent more net equity than plan A after 10 years, and more than double the net equity after 20 years. 232

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Table 6.12: net equity of gearing plans over time Plan A (ungeared)

Plan B (50 per cent geared)

Plan C (67 per cent geared)

After 10 years

$145 737

$201 792

$257 847

In today’s dollars

$113 850

$157 640

$201 430

After 20 years

$424 787

$644 227

$863 668

In today’s dollars

$259 235

$393 153

$527 072

Before tax

+$2000

$0

–$2000

After tax

+$1646

+$951

+$257

Net equity*

Year one net cash flow

*Net equity is the value of the investments less the amount of the loan.

The performance of a geared share fund will vary depending on a number of factors, the main ones being: 9

The income tax bracket of the investor. Investors in the top marginal tax bracket of 46.5 per cent will arrive at net equity after 20 years of about 5 per cent less than the above figures. On the other hand, investors in the 31.5 per cent marginal tax bracket will arrive at net equity after 20 years of about 5 per cent more than the above figures. The impact of tax is not major because tax only applies to the income component of total returns. Most of the returns are in the form of capital gains, which are not taxable unless and until sold.

9

The interest rates on the loan. If the interest rate is 1 per cent higher for the whole period the net equity after 20 years will be about 4 per cent to 5 per cent lower. The higher the gearing, the bigger the loan, and the bigger difference interest rates will have on the overall plan. The difference in interest rates between a margin loan and a loan secured by property is about 2 per cent, and this will knock about 10 per cent off the end net equity in the fund. Since gearing should only be considered for very long terms, this puts the property secured loan option well ahead of margin lending.

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9

The asset mix in the fund. The previous example assumes a broad range of shares in the fund. Some investors skew the shares towards lower growth and higher dividend income to minimise negative cash flow, particularly in the early years. In most cases this is not necessary unless you are gearing up to very high levels like 100 per cent. In both the 50 per cent and 67 per cent gearing examples, the cash flows after tax are positive in every year. Contrast this with most investment properties, which are negatively geared for several years because net rental yields are relatively low in most cases, especially with residential property.

9

Stability of dividends and distributions cannot be assured from year to year. Although share prices go up and down from year to year, the overall level of dividends and distributions from a broad range of shares is remarkably stable and generally rises each year as the economy grows, even while share prices are all over the place. In serious economic recessions (which are expected to occur about every 10 years) earnings fall and dividends and distributions suffer for a year or two before recovering again.

It’s best to stick to a broad range of shares in a geared fund, rather than trying to pick individual stocks. Don’t change the shareholdings from year to year. This is not a trading portfolio — you’re in it for the long term.

Who is and isn’t suited to gearing? Gearing may not suit the following types of investors who: 9

constantly worry about where the market is heading

9

look up share prices in the paper or online every day, week or month

9

have no other source of income (either from working or from other investments) to supplement cash flow if dividends and distributions fall significantly

9

need the cash in less than 10 years.

Gearing is best suited to investors who: 9

have other forms of investments and income as well — gearing should be one of a number of strategies in the plan, not the only strategy

9

have discipline and patience — that is, to leave the fund alone and not tinker with it. 234

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6.7 Further reading Essential reading Graham, B, The Intelligent Investor, HarperCollins, 2003 (1950). This is the bible of ‘value’ investing. Graham, R & DL Dodd, Security Analysis, McGraw Hill, 2002 (1934). This is the original and best reference book for understanding the numbers.

Optional reading Browne, CH, The Little Book of Value Investing, John Wiley & Sons Ltd, 2006. Hagstrom, RG, The Warren Buffett Way, 2nd ed, John Wiley & Sons Ltd, 2005. Lynch, P, One Up on Wall Street, 2nd ed, Simon & Schuster, 2000. Malkeil, BG, A Random Walk Down Wall Street, revised and updated, W.W. Norton, 2004. Moe, M, Finding the Next Starbucks: how to identify and invest in the hot stocks of tomorrow, Portfolio, 2007. Roth, M, Top Stocks, Wrightbooks, 2007. Slater, J, The Zulu Principle: making extraordinary profits from ordinary shares, Trafalgar Square, 1995. For a step-by-step guide to all the mechanics of opening broker accounts and actually buying shares and dealing with the paperwork see my first book — How to Give Your Kids $1 Million Each! (Wrightbooks, 2006).

6.8 Key points 9

Shares are one of the two growth assets (the other being property) used to generate wealth over the long term.

9

Australian shares have generated total returns of over 12 per cent per year for more than a century.

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9

Total after-tax returns are very similar to the pre-tax returns, due to the tax-effective nature of share returns.

9

Returns are volatile and vary significantly, so only use shares if you are not going to need the money for at least 10 years.

9

Exchange-traded funds (ETFs) offer the most simple, low-cost, tax-effective, headache-free method of building your $1 million fund, either inside or outside super.

9

The additional investment types (index funds, listed investment companies (LICs), active managed funds and direct shares) are just icing on the cake, which can possibly offer more diversification.

9

Unlisted index funds are a low-cost, tax-effective way of investing in the overall Australian sharemarket.

9

Index funds are not as low cost as ETFs, but are better than active managed funds.

9

Passive LICs hold a wide spread of shares and have been generating good returns for many decades.

9

LICs are extremely low cost and tax effective.

9

You can use three or four LICs as the core of your share portfolio, or as an optional extra if the core of your fund is ETFs.

9

The average active managed fund can’t outperform the general market index over the long term because of its fees.

9

Active funds are not as tax effective as ETFs, index funds, passive LICs or direct long-term investing because they trade frequently and incur brokerage and capital gains tax.

9

It’s impossible to pick the funds that may outperform the index year after year.

9

If you want to use unlisted share funds in your long-term plans, index funds offer a lower cost, more tax-effective alternative.

9

In the longer term you are probably much better off buying into the fund management companies themselves and the big banks and insurance companies that own most of the large fund managers. 236

Step 4 — invest outside super (part I): shares

9

You can run your own index for very low costs by buying the largest 20 or so stocks in proportion to their relative size.

9

For amounts under $100 000, it’s cheaper to invest in ETFs, index funds or LICs.

9

There are many advantages of investing in shares directly rather than through managed funds, or even ETFs or LICs.

9

If you are going to pick stocks, only use a small portion of your share portfolio to do so. The core of your portfolio, say, 90 per cent, should be in passive share investments — that is, in ETFs, index funds or a selection of the low-cost LICs.

9

There are many different theories and methods of picking stocks. You need to develop your own approach in line with your needs, risk tolerance, skills and experience.

9

After a few years you will probably start to get a feel for some of the great potential growth companies in an industry that you know and understand. Take your time and start slowly — there is no hurry.

9

Investing in international shares will add a new dimension to your funds and provide another avenue for growth and diversification over the long term.

9

There are several low-cost listed (exchange-traded) international funds available that allow you to invest in international shares or you can invest directly via an online broker account. This is probably worth looking at if you have at least $50 000 or so in total investments (inside and outside your super fund).

9

Australia is in a great position to take advantage of the growth in Asia and we can benefit from this growth by buying into many of the big Australian companies listed on the ASX.

9

If you want to build wealth using shares over the long term, the best plan is to use low-cost passive investments as the core of your share portfolio — with an ETF, index fund, or two or three LICs. You can then use some optional extras for greater diversity and to specialise, such as direct shares, active managed funds and/or international ETFs.

9

Don’t fiddle with the investments in your long-term fund. Do some research and choose carefully — then leave them alone.

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9

The ability to gear your investments is one of the advantages of investing outside the super system, where gearing is generally prohibited.

9

Gearing can suit many people and has the same types of benefits and downsides as gearing to buy property and other assets.

9

The two main methods of gearing are margin loans and loans secured by your house or investment property. Each has advantages and disadvantages.

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Chapter 7

Invest outside super (part II): property

Money sense

7.1 Residential property Along with shares, property is the other major class of growth asset used to build long-term wealth. By far the most popular type of property for investment by individual Australians is residential — that is, houses and units. Other types of properties for investment are commercial (offices), retail (shops), industrial (warehouses) and tourist (hotels, motels). I will look at these later.

Houses or units? As is the case of most other areas of investing, there are no right or wrong answers — just personal preference. In chapter 3, I discussed the relative merits of houses versus units, supply and demand, and how land appreciates and buildings depreciate over time. When looking at property to invest in, there is another major factor in the equation — rent.

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Rent and rental yields For any given budget in any area of Australia you will almost always get a higher rent from a unit than from a similarly priced house. For example, the rent from a $500 000 unit might be $400 to $450 per week, while the rent from a typical $500 000 house in the same area would generally be lower, about $300 to $350 per week. Rental income is normally talked about in terms of ‘rental yield’. The rental yield of an investment property is the total annual rent divided by the property value. In the case of a $500 000 property renting for $300 per week, the rental yield is 3 per cent ($300 per week × 50 weeks = $15 000 ÷ $500 000). (I always assume 50 weeks rent per year because I build in a couple of weeks of vacancy per year.) A rental yield of about 3 per cent to 3.5 per cent would be a typical rental yield on a typical suburban house in any of the capital cities. Some houses attract higher yields (for example, in remote, declining country towns) and some have lower yields (for example, in high-growth inner-city and beach areas). On the other hand, in the case of units, a rental yield of about 4 per cent to 4.5 per cent would be a typical rental yield on a typical suburban unit in any of the capital cities. Again, you can get higher yields, sometimes up to 10 per cent in low-growth or declining areas, and lower yields in high-growth areas. The rental yield based on total rent, before rental expenses, like agents fees, council rates, insurance and so on, is referred to as ‘gross rent’ or ‘gross rental yield’, while the rent after all rental expenses is called ‘net rent’ or ‘net rental yield’.

Rents don’t rise steadily each year Rents tend to work in cycles. For example, from 2000 to 2003 rents in most areas remained flat as the property market boomed and many new houses and units were built. But from 2005 to 2007 rents started to rise as building activity stopped, and very few new houses and units were being built. Sudden rent rises of 10 per cent to 15 per cent came as a rude shock to tenants, who had become used to rents being stable for several years. The landlords were seen as the ‘bad guys’ for jacking up rents, but they were just trying to make up for all those years of little or no rent rises. The same thing happened in the mid 1970s, mid 1980s, early 1990s and again in the late 1990s, and it will keep happening with each property cycle into the future. That’s just the way it works with property cycles.

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Nightmare tenants I’m sure you have all seen the current affairs stories about ‘nightmare tenants from hell’. Tenants move in, refuse to pay rent, and are impossible to evict. In our case we have been lucky — we have never had a problem tenant in any of our rental properties. The best protection is to have a professional property manager who checks credit references, rental referees and agent’s tenant databases. A good property manager also makes sure all the paperwork is in order and takes firm action at the first sign of trouble. It is also another good reason for having landlord insurance cover, which only costs a couple of hundred dollars per year. The cost of an agent plus landlord insurance adds to the cost and reduces the net rent, but it is worth it most cases, unless you know and trust the tenants personally.

Total returns When comparing the investment returns from a house and a unit in any given area, a typical house can be expected to grow in value at a higher rate than a typical unit of the same value and in the same area, but the unit will generally produce a higher rental yield — that is, more rent per year — than the house. The expected returns from a $500 000 house or unit in most suburban areas in the capital cities are shown in table 7.1.

Table 7.1: expected returns from a $500 000 house or unit $500 000 house

$500 000 unit

Expected rent per week

$300

$500

Expected rent per year

$15 000

$25 000

3%

5%

Expected growth rate p.a.

5% p.a.

3% p.a.

Total return (yield + growth)

8% p.a.

8% p.a.

Gross rental yield

For the sake of this exercise I will use gross rents — that is, not taking rental expenses into account like interest, council rates, management costs and so on. I will look at these a little later. Looking at the above table, both the house and the unit would be expected to produce a total gross return of about 8 per cent over the long term. Which would you rather buy as an investment?

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The house will produce only $15 000 of gross rental income before expenses, but the unit will produce $25 000. On the other hand, the house is expected to grow in value at a quicker rate per year (because of the higher land content in the overall value). The rents of both the house and the unit will also rise over time, in line with the overall rise in the value of the house and unit over the long term. This means that the rent on the house will rise at a higher rate than the rent on the unit over the long term. This is because land (and therefore houses on land) is becoming more and more scarce compared with units, which are constantly springing up everywhere. Based on the above assumptions, after 10 years the house and unit will have produced the returns shown in table 7.2.

Table 7.2: returns from a $500 000 house or unit after 10 years House

Unit

Difference

Total rental income

$188 668

$286 597

+$97 929

Increase in value

$314 447

$171 958

–$142 489

Total gross return

$503 116

$458 555

–$44 561

Table 7.3 shows that over a period of 20 years the difference widens even further.

Table 7.3: returns from a $500 000 house or unit after 20 years House

Unit

Difference

Total rental income

$495 989

$671 759

+$175 770

Increase in value

$829 649

$403 056

–$423 593

$1 322 638

$1 074 815

–$247 823

Total gross return

It’s important to point out that rental yields and capital growth rates will vary significantly from area to area and from time to time. But within any given area, a house will almost always achieve lower rental yield and greater capital growth over the long term than a unit of the same value in the same area.

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Most people borrow to buy investment properties. Borrowing for investment magnifies losses and also magnifies gains. The higher the level of borrowing, the more magnified the impact of returns will be.

Tax As far as tax is concerned, the fact that income and capital gains are taxed in different ways will generally favour investments with higher capital gains and lower income, which in most cases is going to be houses rather than units. The first difference is the rate of tax. Most people will pay capital gains tax on only half the capital gains if an asset is held for more than one year. In contrast, rent is taxable as normal taxable income. The second difference is timing — that is, when tax is paid. Tax on capital gains is only paid if and when the property it eventually sold, but rental income is taxed each year it is received. All of this means that the tax system generally favours investment in assets in which the returns are mostly in the form of capital growth rather than income, which in most cases is houses rather than units.

What’s your goal Whether you buy the house or the unit in this example would depend largely on your objectives. Some people are looking primarily for income from their investment, rather than capital growth. If this is the case, not only will units generally provide a higher rental yield than a house of the same value in the same area, but well-chosen units can also generally be expected to provide rental growth to keep pace with inflation.

The whole block As I have shown, one of the great advantages of houses over units as long-term investments is the fact that with a house you have much greater flexibility and control over what you can do with it to add value. With a house you can potentially do lots of different things — subject to council approval. You might be able to renovate, rebuild, subdivide, build town houses or units and so on. But with a unit, you are stuck with a unit. On the other hand, buying a whole block of units is a very different proposition altogether. I put that in the same category as houses, because you own the whole block of land and you have all the flexibility and control over what you can do with it in the future. Unfortunately, if you own a whole block of units you will rarely be able to get the high rental yields you might get if you only

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owned one of the units, because whole blocks almost always sell for a premium. For example, a block of four units worth $200 000 each will generally sell for well above $800 000. You might have to pay up to $1 million because of the value of having that extra flexibility and control over the land. Always remember — it’s the land that’s providing the growth in value and building wealth.

Instant ‘experts’ Every boom market produces ‘instant experts’ who buy a couple of flats off the plan and then ‘flick’ them for a profit before the settlement date is due. Of course they make a profit during a boom. Almost everybody who buys into these over-hyped developments at the right time can make money during the boom. This doesn’t mean that they’re good long-term investments. Property should be considered a long-term investment. It has to be — the transaction costs are simply too high to make it profitable to continually buy and sell over the long term. These boom-time ‘instant experts’ soon disappear when the music stops at the end of each boom cycle.

Rental expenses Most first-time property investors get a rude shock when they find out that a good chunk of the rental income disappears in rental expenses. People always underestimate the costs before they take that first plunge and I was no exception. The percentage of rent that is eaten up by rental expenses varies from property to property and from year to year, but generally ends up being somewhere between 20 per cent and 30 per cent of the rent, and often more. The major rental expenses are: 9

council rates — 5 per cent to 15 per cent of rent

9

landlord’s insurance — 2 per cent to 5 per cent

9

repairs and maintenance — 5 per cent to 10 per cent (often much more)

9

managing agent’s fee — 5 per cent to 10 per cent

9

land tax — 0 per cent to 10 per cent.

If you are using a managing agent, total costs usually amount to about 20 per cent to 25 per cent of the rental income. Much more if you are up for land tax.

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Land tax Land tax is payable in most states if the aggregate land value of properties owned in that state exceeds certain thresholds. The thresholds and rules are different in each state. Northern Territory has no land tax but every other Australian state and territory does. Generally, an investor would need to own several properties in a particular state or territory before land tax thresholds are exceeded. In some states and territories the rules allow for husband and wife to have separate land tax thresholds, so each can buy properties in individual names and save tax by getting two thresholds. Other states group properties together and allow only one threshold. States and territories also have different land tax rules for properties owned by companies and trusts. You’ll need a local solicitor in each state and territory. Where land tax is payable it often amounts to 10 per cent or more of the gross rent received, which really has a significant negative impact on net yields. The only upside with land tax is that, like other rental expenses, it is tax deductible.

Managing agents Managing agents generally charge between about 6 per cent and 9 per cent of the rent, plus GST. Many property investors manage their own investment properties instead of paying an agent to do it for them. There are advantages as well as disadvantages to having an agent. On the plus side, it is useful to have a third party between the tenants and the landlord. Getting phone calls at all hours of the night about leaking taps and power failures is no fun for any landlord. Agents generally have access to reliable tradespeople to get things fixed. Agents also have access to rental databases, which help to ensure that prospective tenants are good credit risks. Having a managing agent is almost essential for rental properties in other cities and states. For properties in your own area there is no harm in trying to do it yourself. You can always give it to an agent if you want to later on. The laws and regulations regarding rental agreements, bonds, and duties and liabilities of landlords are getting more complex each year, so it is advisable to get some training first. Each state has a department of fair trading or department of consumer affairs (or similar), which usually has booklets and guidelines on the rights and responsibilities of landlords and tenants. These are generally geared towards the rights of the tenant, but it is a great place to start. In each state there is also a real estate institute, which provides information for landlords and runs courses for people training to be managing agents. I have done some of these courses and they are an excellent resource for landlords.

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Choosing a managing agent Many real estate agents’ offices have rental-property managers as well as selling agents. There are also a number of specialist agencies that do nothing but manage rental properties and have no selling agents. Property managers come in all shapes and sizes, from small, one-person operations to huge call centres with dozens or even hundreds of staff. I have found that the best agents are often in medium-sized operations close to the property location. One-person shops can be too reliant on that one person being there and available when needed. Many one-person operations manage properties only part time and don’t keep up to date with all the latest changes in laws and regulations in the industry. On the other hand, the huge operations with dozens of staff can be very impersonal — it seems you never talk to the same person twice. They also handle properties from all over the state or all over Australia, so their local knowledge can be limited. I have found that the mediumsized operations with a handful of staff generally provide the best service and have the best local knowledge of their area. They also handle sufficient volume so their systems and paperwork is automated. Like most other professional services, the best approach is to ask friends and family for recommendations. Word of mouth is always the best form of advertising for good operators.

Do it yourself and build a business Whether you do the managing yourself or use a managing agent is a question of personal choice. I know several property investors who started out with just one property, managing it themselves, and then gradually built it up to a sizeable business with numerous properties, all managed in-house. This approach tends to work especially well in regional and country areas where the level of local expertise in property management may be limited. In many cases these multipleproperty investors start managing properties for other investors and turn it into a very profitable business.

Depreciation In addition to expenses, like council rates and agent’s management fees, property investors are also able to claim for depreciation in value of various items making up the property. Just about everything except the land can be depreciated and written off against income to reduce tax. The value of buildings can generally be depreciated over 40 years if they were built after September 1987. For example, if a building was built in 1990 at a cost of $200 000 you can claim

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2.5 per cent of the value against rental income each year — that is, $5000 per year off your taxable income up until the year 2020. Due to some government changes to the rules, if you are lucky enough to find a property where the building was built between July 1985 and September 1987 you can claim 4 per cent of the cost over a total period of 25 years. Of course, this benefit runs out between 2010 and 2012 because that’s when the 25 years is up for these properties. On the other hand, no building depreciation is allowed on buildings built before July 1985. It amazes me how few real estate agents know about this. Of course, agents selling flats off the plan know it — they base their entire marketing presentation around depreciation allowances. But agents selling existing properties are amazingly ignorant. I get probably half a dozen calls from agents each week trying to sell me properties. One of my first questions is, ‘When was it built and what was the cost? Or, ‘Do you have a depreciation schedule?’ Not only do they never know, but they usually say that nobody has ever asked these questions before about the property they are trying to sell.

What is a ‘building’? ‘Buildings’ generally include all things that are fixed to the building permanently or with the intention of being permanent — for example, windows, doors, roof and so on. Items that aren’t part of the building itself, including things like carpets, blinds, appliances, furniture and fittings, are called ‘plant and equipment’ and can be depreciated over shorter periods of time. The value of items of plant and equipment can be depreciated over their effective useful life. For example, if you bought an oven costing $1000 for your investment property and it had an effective life of, say, 10 years, you can’t claim a tax deduction of $1000 in the year that you bought it. Instead, you would spread the $1000 tax deduction over 10 years. If you chose the ‘straight line’ method, you would claim a tax deduction of $100 per year over the next 10 years. If you buy a new property, ask the builder to give you a depreciation schedule of everything in the property. If you are buying an existing property, get a depreciation report from a qualified quantity surveyor who will estimate the current value of all depreciable items. The tax office has lists of hundreds of different items for various types of investments. For each item the tax office specifies a useful life and a depreciation rate. Visit and do a search for ‘depreciation schedule’ or ‘depreciation allowances’. Essentially, allowing tax deductions for depreciation is the tax office’s way of confirming that buildings depreciate in value, and that plant and equipment depreciate even faster.

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Depreciation should equal capital expenditure Real estate agents — especially the marketers of new flats off the plan — will often boast about high depreciation allowances as a positive. They focus purely on the tax advantages, but there are cash flow disadvantages that they won’t tell you about because they don’t understand them. Let me explain. Owning rental properties is a business and you should apply the same principles to looking at your property investments as you do for other types of business. If you get into the area of company shares as part of your overall wealth plan, you may get into the wonderful world of analysing company financial statements (I can tell you can’t wait!). One of the techniques used by share investors when assessing a business is to look at the amount of depreciation claimed in the profit and loss statement, and compare it with the amount of capital expenditure in the cash flow statement. This is money spent on buying new equipment or upgrading, replacing or rebuilding existing plant and equipment in the business. You can’t get a tax deduction for it up-front, but you get to claim depreciation each year over the useful life of each item. Comparing these two numbers will tell you a lot about how the business is run. For share analysts, the rule of thumb is that the amount of capital expenditure spent on replacing or rebuilding plant and equipment should more or less equal the amount of depreciation claimed each year. If the amount of capital expenditure is consistently lower than the depreciation claimed, the business is letting its assets decay and run down, which means that income is likely to suffer in the future — due to lower productivity or quality, downtime and so on. The owners are trying to artificially boost cash flows to inflate the true value of the business, perhaps because they are dressing it up for sale. The point is this — if a company is claiming that the value of plant and equipment is depreciating by $x per year, then it should also be spending a similar amount of money each year upgrading, replacing and rebuilding the assets in order to keep them up to scratch and in good working order. It is the same for property investors. Depreciable items in an investment property are simply bits of buildings, plant and equipment that help generate rental income, just like in the company. You simply can’t avoid it. For each rental property you own, every couple of months or so there is always some item of plant and equipment that breaks down and needs replacing. I’m not talking about minor repairs and maintenance, which is usually tax deductible in the year that you incur the cost, I’m talking about upgrading and replacing things that have broken down. Sooner or later items can no longer be repaired cost-effectively, they need to be upgraded and replaced such 248

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as ovens, hot-water heaters, dishwashers, carpets, blinds and so on. The more plant and equipment there is in the investment property, the more there is that breaks down and needs replacing. The old saying that ‘buildings depreciate’ really means ‘buildings depreciate so they need constant upgrading and rebuilding so they can continue to produce rental income’. Also, plant and equipment depreciate even faster than buildings, so you need to spend more on upgrading and replacing them. It is often said that units have tax advantages over houses because they have more depreciation (and therefore more tax advantages) than houses. An example of the impact of depreciation on a typical house and a typical unit — both worth $500 000 — is shown in table 7.4. The house would have more land value and the unit would have more value in the buildings, and plant and equipment. I have assumed an average rate of 15 per cent depreciation on plant and equipment, which would be the average for a fairly typical mix of plant and equipment in a unit.

Table 7.4: impact of depreciation on a house and unit Common assumptions A1

Depreciation rate on buildings

A2

Depreciation rate on plant and equipment

A3

Loan amount

A4

Interest rate

A5

Marginal tax rate

A6

Non-interest cash expenses as % of rent

2.50% 15% $300 000 7.0% 31.5% 25% House

Unit

Difference

Assumptions B1

Value of land

$300 000

$150 000

B2

Value of buildings

$175 000

$300 000

B3

Value of plant and equipment

$25 000

$50 000

B4

Total value of property

$500 000

$500 000

B5

Gross rental yield

3%

5%

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Table 7.4 (cont’d): impact of depreciation on house and unit House

Unit

Difference

Profit and loss C1

Rental income

$15 000

$25 000

+$10 000

C2

Less non-interest cash expenses

–$3 750

–$6 250

C3

Less interest expense

–$21 000

–$21 000

C4

Less depreciation of buildings

–$4 375

–$7 500

–$3 125

C5

Less depreciation of plant and equipment

–$3 750

–$7 500

–$3 750

C6

Net profit before tax

–$17 875

–$17 250

C7

Less tax payable/(or refund)

–$5 631

–$5 434

+$197

C8

Net profit after tax

–$12 244

–$11 816

+$428

Cash flow D1

Rental income

$15 000

$25 000

D2

Less non-interest cash expenses

–$3 750

–$6 250

D3

Less interest

–$21 000

–$21 000

D4

Less tax payable/(or + refund)

$5 631

$5 434

D5

Net cash flow after tax but before capex

–$4 119

$3 184

D6

Less capex (same as depreciation)

–$8 125

–$15 000

D7

Net cash flow after tax and capex

–$12 244

–$11 816

+$7 303

+$428

The gross rental income for the unit would be $10 000 higher than for the house (line C1) because of the higher gross rental yield for units. Depreciation deductions would also be almost $7000 higher for the unit (lines C4 and C5) due to the high components of buildings and plant and equipment in the unit. As a result, the unit will generate a bigger tax refund (line C7) for the taxpayer who I have assumed to be in the 31.5 per cent marginal tax bracket. 250

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Line D5 is where the cash flow statement usually stops in property marketers’ brochures. Net cash flow after tax shown in line D5 is a positive cash flow for the unit investor of more than $3000, compared with a negative cash flow of more than $4000 for the house investor. However, line D5 ignores the fact that, on top of normal repairs and maintenance (which are included in ‘non-interest cash expenses’ in line A6), the buildings and plant and equipment in both the house and the unit will need to be replaced and upgraded over time as they decay and break down. Line D7 shows the net cash flow after tax and capital expenditure assuming the buildings, plant and equipment had to be replaced evenly over their useful lives. The result is pretty lineball between the house and the unit. In practice this will not happen in an even fashion. A year might go past without anything major breaking down, but then there are the horror years when it seems everything goes wrong at once. To me, a high level of depreciation allowances is not a positive. It is a warning that there is a high level of things that will eventually decay and need replacing. I would rather have less of this stuff and more land, which appreciates instead. As the previous example shows, even though the gross rental yield on the unit is 5 per cent compared with only 3 per cent in the house, the net cash flow after tax, depreciation and capital expenditure ends up being very similar.

Holiday rentals So far, when talking about rents, I have been referring to properties leased to ‘permanent’ tenants, which usually means leases of six months’ or 12 months’ duration. In tourist areas, another viable option is holiday rental. A typical house or unit in a popular coastal area or snow area might rent for permanent tenants at, say, $300 per week, which would total about $15 000 per year, allowing for a couple of weeks vacant. On a holiday rental basis that same property might get $2000 per week during the peak season, $800 per week in other popular holiday periods, and perhaps $400 per week at other times. This certainly looks attractive at first sight, but you need to do the numbers carefully. Marketing expenses can eat up a quarter of your gross rent and often management expenses (including house cleaning, washing of linen and so on) can eat up another quarter of the rent. Repairs and maintenance costs are also generally much higher with holiday rentals. A typical comparison of permanent versus holiday rental for the same property is shown in table 7.5 (overleaf).

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Table 7.5: permanent versus holiday rental for the same property Permanent

Holiday

Permanent Rent per week

$300



50



Rent per week



$2 000

Number of weeks rented



6

Rent per week



$800

Number of weeks rented



16

Rent per week



$400

Number of weeks rented



20

$15 000

$32 800

Number of weeks rented ‘Peak’

‘Shoulder’

‘Off season’

Gross rental Marketing fees

0%

$0

20%

$6 560

Management

10%

$1 500

25%

$8 200

5%

$750

10%

$3 280

Other non-interest cash expenses

10%

$1 500

10%

$3 280

Total cash expenses

25%

$3 750

65%

$21 320

Repairs and maintenance

Net profit before depreciation and tax

$11 250

$11 480

In this example, even though the holiday property is rented out for 42 weeks of the year for rents of between $400 and $2000 per week, the total returns before depreciation and tax are very similar, due to the much higher marketing and management costs. In addition, you would 252

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normally need to provide furniture, crockery, cutlery and linen. These items don’t last long and need replacing every few years. On the positive side, the capital growth of these types of properties can also be high. The golden rule with holiday houses is never buy a holiday house or unit while you are on vacation. Always go back in the off season and buy for a lower price.

Renting out the family holiday house A popular strategy is to own a holiday house that is used by the family and is also rented out for short periods during the year. Many people try to claim the whole year’s worth of interest and other rental expenses and depreciation. This is a mistake and could cause major problems if you are audited. Interest, rental expenses and depreciation can only be claimed for periods when the property was actually rented out to other people for a commercial rent, or it was genuinely available for rent. For example, let’s say family and friends used the house for six weeks of the year, it was rented out to other people for a market rent for another 10 weeks and it was vacant for the remaining 36 weeks of the year. Generally, the owner would be able to claim only 10/52 of the year’s interest, other rental expenses and depreciation unless it was genuinely available for rent at a market rate for the rest of the year. A common tactic is to let the agent advertise it for the remaining off-peak periods but at a high, holiday rental rate. In these cases, the house is not genuinely available for rent and the deductions wouldn’t be allowed. Another common problem with holiday rental properties is that, generally, the family wants to use the property during the peak season when the rents would be highest.

Buying to renovate There are two main strategies for renovating residential investment properties. They are buy, renovate, rent, and buy, renovate, sell.

Buy, renovate, rent Let’s say you buy a rental property for, say, $300 000. If you were to rent it out ‘as is’ it may only rent for around $200 per week. The plan is to renovate it immediately by spending, say, $10 000 on it so it will rent for around $250 per week instead. This is a popular strategy because often you can substantially increase the rent returns by making minor cosmetic repairs and improvements.

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You can generally add a couple of per cent to the initial rental yield with a few weeks of painting, floor sanding, resurfacing bathrooms and kitchens, clearing up the yard and so on. The main mistake many investors make is assuming that money spent on painting, polishing floorboards and so on is tax deductible. Money spent getting a property ready to rent straight after the purchase is not deductible (but it can be depreciated, which is not as attractive as an immediate deduction). However, if you wait a year or so you can call it ‘repairs and maintenance’ and get an immediate tax deduction for much of the work done.

Buy, renovate, sell This strategy — buy, renovate, sell — is not really investing. I define ‘investing’ as buying things with the intention of holding on to them for the long term — perhaps 10 or 20 years or even holding forever. The transaction costs on property are so high (up to 10 per cent for a buy–sell turnaround) you really have to know what you are doing. Anybody can make a quick profit in a property boom. Thousands of novices do it each boom cycle and are caught in the inevitable bust at the end of the boom. It’s easy to make profits from quick renovations in the booms and it’s easy to fall into the trap of believing that it’s the renovations that generate the profit. It’s not — it’s the boom that’s working for you. When the boom stops and interest rates hit their peak many renovators are left with a big loan and a property that is hard to sell. You need to think of investing in property as a business and specialise in a particular type of property or geographic area that you get to know inside out. However, if you start to do it frequently as a business you get into tax problems as well. As a business you can’t get the capital gains tax discounts on sale because the gains are classed as ‘revenue’ not ‘capital’. So be careful, do lots of research and get to know your specialist area inside out.

Understand the cycle In every property boom thousands of people embark on a process of buying run-down investment properties to renovate quickly and then sell for a profit. Be aware of cycles. You need to pick your timing well and understand the boom and bust cycle in the property market. During property booms, renovating becomes the flavour of the month get-rich-quick scheme. Whole TV shows are dedicated to it, and new magazines and books are written to profit from the boom. Potential renovators, most of whom are first-timers, always underestimate the cost and time involved, and bid up the prices of unrenovated houses to way above what they are really worth. I have been to auctions where unrenovated houses actually sell for as much as, or sometimes even 254

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more, than recently renovated houses in the same street. The reason is that everybody thinks they can make money by adding their own flair and then selling for a quick profit. Many of the TV shows show people carrying out all sorts of major renovations, including removing walls, building new kitchens and bathrooms, and then selling the house in only a matter of weeks. In most areas of Australia, particularly in the capital cities, it is just physically impossible to get all the approvals, source all the materials and fittings, and find workers to actually turn up to do the work in less than several months, not weeks. In the boom years, council approval alone may take up to six months or a year to obtain.

Costs follow the cycle Another outcome of property booms and busts is that the cost of labour and materials go up and down with the property cycle. For example, in the property slowdown of 2000 to 2001 plumbers, electricians and carpenters charged up to around $30 per hour in Sydney. Only a couple of years later in the boom of 2002 to 2004, the same tradespeople were charging me up to $60 to $80 per hour for exactly the same type of work. Why? Simply because they could. It’s a case of supply and demand. There was a limited supply of labour trying to service an increasing demand from all the additional property renovation and development activity in the boom. They were making hay while the sun shone, and I can’t really blame them. Not only were they charging more, but they were impossible to find when you needed them. But everything works in cycles. Now we’re in a property downturn those same tradespeople call me for work and guess what? They have dropped their hourly rates back to where they were before the last property boom. In addition to everything costing more during a property boom, everything also takes longer to do, all the way through a project — getting council approvals, ordering materials and getting tradespeople to turn up. Even when they do turn up they always seem to be nipping off to work on other jobs when they should be finishing yours.

Time means money At the height of the boom markets, what should be a three-month project can drag out to six months or more. That means your holding costs (interest, council rates, land tax, scaffolding hire and so on) will be at least double what they should have been. The main lesson is to allow for plenty of contingencies in your costings — allow for things to go wrong and to cost more than you expect. The problem is that other potential renovators standing

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next to you at the auction competing for the same property haven’t built adequate contingencies into their price. They will inevitably outbid you at the auction and win the property. The end result is that it is very hard to find good properties at good prices in a boom. You are surrounded by first-timers who don’t cost the project correctly and don’t build in adequate contingencies.

Holding costs Holding costs are probably what first-timers get wrong most often. Holding costs are all the expenses involved in just holding onto a property. The largest holding cost is usually interest on the loan used to buy the property. Other holdings costs include council rates, land tax, electricity and water. Often the holding costs exceed the renovation costs. I have seen cases where people plan to do ‘cosmetic’ (that is, non-structural) renovations, like painting, carpeting and landscaping, totalling, say, $20 000. What they forget is that the holding costs over the six months will exceed the renovation costs. If they borrowed $500 000 over six months, the interest bill would be $18 000. Plus they would also have council rates of about $1000 and utilities costing another several hundred. And that assumes nothing goes wrong. They may not plan for it to take six months to sell, but that’s how long it usually takes for the simplest cosmetic renovation. The actual renovations might take only six or eight weeks, but then it takes another four to six weeks of marketing to get a buyer, and then another six or eight weeks to actually settle. That’s a total of 22 weeks, even if nothing goes wrong. For most of that time the property is sitting finished, but empty — waiting to be sold or waiting for settlement. You can’t even put tenants in to help pay the mortgage.

Transaction costs Transaction costs is the number one problem with property investing, and the number one reason in favour of holding for the long term instead of short term. If I wanted to buy $500 000 worth of shares, it would cost a total of about $500 to buy and another $500 to sell. So the total transaction costs to buy and sell would only be about 0.2 per cent of the value of the investment. If I was to buy and sell a property worth $500 000 it would cost about $35 000 in total (or about 7 per cent of the value of the property) just in transaction costs. On the purchase side the biggest cost is usually stamp duty on the purchase, which varies between states but is generally around 4 per cent or $20 000. Legal costs including disbursements and searches would come to around $2000. Add another couple of hundred each for a pest

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inspection and building report. On the selling side the biggest cost is usually the selling agent’s commission of around 2 per cent or $10 000. Advertising might be anywhere between $2000 and $5000, and legal costs of another $1000 or so. Plus add 10 per cent GST to everything except the stamp duty. The total costs to buy and sell the house for $500 000 would be around $30 000 to $35 000. This comes straight out of your profit. The combined impact of holding costs and transaction costs is this — if you are going to buy a property for $500 000 to renovate and sell in six months, you need to be able to sell if for at least $550 000 just to cover transaction costs and holdings costs, before even spending a cent on renovations, and before allowing for any profit margin. If you were thinking about spending, say, $20 000 on renovations, allow a 25 per cent contingency margin (that is, allow $25 000 total) for things to cost more than expected, so you would have to sell it for $575 000 just to break even.

Profit margin There’s no point wasting all that time and energy if you’re just aiming to break-even. You need to build in a profit margin in order to make it worth your while. Professional property developers generally aim for a 20 per cent profit margin on each project, so a $500 000 project would need to produce a profit margin of $100 000 to make it worth doing. Even if you would be happy with a profit margin of just $25 000, that means your target selling price needs to be $600 000. The total picture is this — if you buy a property for $500 000 and plan to spend $20 000 on a ‘quickie’ renovation, you need to be able to sell it for $600 000 to make a profit of just $25 000. My wife and I inspect about 200 to 300 properties a year and we have been doing this for over 20 years. Whenever we look at a property for quick renovation we work out the target selling price assuming a flat property market. We don’t allow ourselves to rely on growth in the overall market to produce a profit. Any increase in the overall market is a bonus. For example, if we are looking at an unrenovated property to buy for $500 000, we also look in the same area for newly renovated properties to see what they are selling for. What we often find is that, in a boom market there are very similar but renovated properties selling for, say, $520 000 to $550 000 in the same street or immediate neighbourhood as the unrenovated one. We say to ourselves, ‘If our target selling value is $525 000 in the current market, that makes our target buying price $100 000 less, so the most we will pay to buy the unrenovated property is $425 000’. In a boom market it is very hard to buy well, because we will almost always be outbid by first-timers who ignore the holding costs and transaction costs and bid the price up to $500 000. We started in the property game in 1986 and the period between 1987 and 1989 was fantastic. Properties in the major capital cities doubled in value during that time. There was a modest boom 257

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in the mid 1990s and another modest boom between about 1997 and 2000. The next big boom was from 2002 to 2004 when prices again almost doubled. Because of the high transaction and holding costs associated with property, doing ‘quickie’ renovations is something that generally only works in the crazy boom years in each property cycle.

Musical chairs It is relatively easy to get caught up a boom. Most renovators start out small in the early part of the cycle, then each project gets bigger and bigger as their confidence grows and the booming market rewards them with good profits. Then, when interest rate rises slow down the economy and kill off demand, the music stops and the boom ends. Many renovators are left holding a big property (or several properties) with a big mortgage and no buyers. That’s how the big property developers go broke at the end of each property boom, and it’s also how individual property investors get burned.

Renovate and develop properties as a business As I said earlier, this is not really property ‘investing’. It is a property renovating and developing ‘business’. To be successful you need to run it as a business. This means doing proper costings, keeping proper records and, most importantly, removing all emotion from the decision-making process. Over time you will develop a network of experts in a number of areas of the business — solicitors; lenders; architects; town-planners; builders; tradies; suppliers of materials, fixtures and fittings; and selling agents. It generally takes several years to build a team of people you trust, but they are out there. After a few years you will tend to specialise in an area you know inside out, and know better than the competition. You may want to specialise in a particular geographic location, or a particular type of project like student accommodation or office conversions. The key is understanding your target better than the hundreds or thousands of other people who are out there trying to do the same thing.

Borrowing to invest One of the great advantages property has over every other type of asset is that lenders love lending against property, in particular, residential property. This a disadvantage for owner-occupied

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housing because lenders encourage people to borrow too much and this just pushes up house prices to uneconomic levels. But in the case of investment properties, it means you can ‘gear up’ and accelerate your returns. Borrowing also accelerates and magnifies your losses if property prices fall, which they do from time to time. Property should only ever be seen as a long-term investment, because you need to ride out these bumps in the property cycle, and also because the costs of buying and selling are so big. There are hundreds of lenders with thousands of loan products. These days you can do your research and handle all aspects of the process online. The other common approach is to get to know a good mortgage broker. I looked at ways of finding and dealing with mortgage brokers in chapter 3. Many mortgage brokers specialise in lending for investment properties, which is different in many respects to lending for owner-occupiers.

Interest rates and fees There was a time when investment property loans carried higher interest rates than owner-occupier loans, but these days you can get the same low rates for both. Most investors go for the lowest cost basic loans without all the bells and whistles. You can normally get the lender to waive or reduce application fees, especially if you refinance your owner-occupier loan, if you still have one.

Fixed versus variable About 80 per cent of owner-occupier home loans are variable rate, but up to half of the investment property loans are fixed rate. The attraction of fixed rates for investors is that the repayments are fixed and certain, which matches the rent payments, which are also reasonably fixed. If you hold the properties over the long term (say over 10 years) you will need to refinance or rollover your fixed-rate loan every few year years, so you can’t avoid the variations in the interest rate markets. Over the years we have had both types of loans and both work well. You need to pick your timing well to get a good fixed-interest rate. Generally, you need to do it at the bottom of the interest rate cycle (after several cash-rate cuts when inflation is very low) and when everybody is talking doom and gloom. Otherwise you are probably better off with variable rates.

Interest-only versus principal and interest Choosing between interest-only loans, and principal and interest loans is another area of debate, with different investors having their own preferences. Interest-only loans have lower repayments, which allow you to use spare cash flow to borrow more and/or buy more properties. We have

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used both types over the years, but tend to prefer principal and interest loans because it is another forced-savings mechanism. In the early years most properties will be negatively geared (where loan repayments and other costs exceed rent), or at best cash flow neutral. The cash flow position slowly improves over the years as rents rise. Eventually, you will want to turn the whole plan into positive cash flow territory so you can live off the net rental income. There are two ways to do this: 1

Use interest-only loans. When you want to start living off the net income from the properties, sell some of them and use the proceeds to repay some or all of the loans.

2

Use principal and interest loans over, say, 10 or 15 years and the principal will gradually reduce each year. After 10 or 15 years the loans will be paid off and you can live off the net rent without selling any properties. Using principal and interest loans usually means you can buy fewer properties.

People following a ‘positive cash flow’ strategy are in a better position to make principal and interest payments because they have more cash flow coming in. In practice, most people following the positive cash flow strategy just use the lower interest-only payments to borrow more and buy more properties, which increases gearing and risk.

How much to borrow? If you want to buy a property and not put in your own cash, you will need to borrow about 105 per cent of the purchase price (100 per cent to cover the price and another 5 per cent to cover purchase costs). There are lenders who will do this, but it is expensive. It is always best to keep the loan-tovaluation ratio (LVR) under 80 per cent in order to minimise interest costs and avoid mortgage insurance costs. You will need to put up additional security (like equity in your own home or other investment properties) or cash in order get the LVR below 80 per cent. Let’s say you are looking at buying an investment property for $300 000 and you want to borrow the entire $315 000 (purchase price plus $15 000 in purchase costs). Keeping the LVR to 80 per cent would mean the investment provides only $240 000 in security for the loan (80 per cent of $300 000). You need to put up an extra $75 000 in security or in cash. However, instead of putting in $75 000 in cash you could use your existing house as security if you had at least $75 000 equity in it — for example, if your house was worth $500 000 and had a loan of $400 000 or less.

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Because the value of the properties generally rises, while the level of the loans reduces (or remains flat with interest-only loans), you build up equity in your properties over time. As you build up more equity you can borrow more to buy more properties without the need to put in cash each time. When looking to buy more property, coming up with the equity to borrow against is usually not the problem. Generally, the problem is cash flow. If you’re borrowing the entire purchase price, your interest (at, say, 7 per cent) will generally be more than the net rent after rental expenses (usually around 3 per cent to 5 per cent at the most), so the cash flow will be negative, even after allowing for depreciation. You will need to have access to other income (like your salary or other investment income) to fund this negative cash flow. This brings us to negative gearing and positive gearing.

Negative gearing The term ‘gearing’ means borrowing money, and the term ‘negative gearing’ means borrowing money so that the total expenses (including interest) exceed the income, resulting in a loss. This is a very common strategy in Australia because you are allowed to use the losses caused by the negative gearing of investments, like properties and shares, to offset investors’ other income (for example, from their salary) and thereby reduce their income tax. Because of the generally low residential rental yields in most areas of Australia, you have to negatively gear if you can’t put in cash of about 30 per cent to 50 per cent of the purchase price.

Positive cash flow properties The aim of the ‘positive cash flow’ or ‘positively geared’ property strategy is to find properties that have a high enough rental yield so that the net rent covers the interest on the loan from day one. Positively geared property strategies generally need to use interest-only loans in order to keep the loan repayments down. There are only two ways to buy a positive cash flow or positively geared property where net rent covers interest from day one: 1

You need to put cash into the purchase, because the net rental yields on most properties are well below the loan interest rate.

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2

If you are borrowing 100 per cent or 105 per cent of the property price (that is, purchase price plus purchase costs), you need to find properties with net rental yields in excess of the interest rate, which means gross rental yields of well above 10 per cent or 11 per cent, so that the net rent covers the interest repayments.

Finding properties with over 10 per cent gross rental yields is fine in theory, but these properties are invariably in areas that are not expected to achieve good capital growth over the long term. I have managed to find some over the years, but have never bought any because they are missing the critical capital growth factor. Only in serious recessions, such as in the early 1980s and early 1990s, can you find good-quality houses with good land content in good growth areas with gross yields above 10 per cent. Apart from during recessions, high-yield properties tend to be either old flats at the edges of metropolitan areas, or houses and flats in country towns with declining populations. Because the outlook for capital growth is poor, so is the likely rental growth and capital growth over the long term. For example, I have seen houses in small country towns where the tenants had been paying $100 per week for as long as they could remember. Rents don’t grow because the population of these towns is on a long-term downward trend and there are fewer and fewer potential renters but a fixed number of rental houses in the market. You can’t fight the law of supply and demand — too much supply and declining demand means limited real rental growth and limited real capital growth over the long term. These types of properties fail the fundamental test of long-term investing — that the primary aim is to generate superior capital growth well above the inflation rate over the long term.

Positive cash flow property marketers Positive cash flow property strategies are generally marketed to people who don’t have the cash to contribute to the purchase and who don’t have the cash flow to support negative gearing. These people are the least well informed and usually end up buying properties, through expensive property marketers, in remote locations with poor growth prospects, or with a high proportion of problem tenants. This strategy gained popularity during the most recent property boom (early 2000s), but as the saying goes, ‘every boat rises with the tide’. Even the poor properties rise with the overall property boom. Values rose in almost all areas of Australia (including remote country towns) from

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2001 to 2004, and rents rose in almost all areas in the rent boom of 2006 to 2007. But these were just short-term effects of the property cycle. In your long-term investment plan you should not be worried about short-term cycles. What you need to focus on are the long-term trends — the demographic changes in society, the decline of agriculture, the shift from the suburbs to coastal and beach areas around the cities and so on. These areas are going to achieve the best capital growth and rent growth over the long term. Properties are more expensive in these growing areas and yields are lower, but they will produce the superior returns in the long run.

Buying flats off the plan Buying flats off the plan is another area that is relatively easy to make money in during the property booms. It all comes unstuck during the bust; however, in a boom you can buy a flat off the plan by using a deposit bond, which costs only a few hundred dollars. A deposit bond is a bond provided by an insurance company that promises to come up with the deposit for the purchase. The insurance company does a quick credit check on you and sells you the bond for a few hundred dollars, and you can use this bond instead of putting up cash for the property deposit. Too easy. Let’s buy half-a-dozen flats off the plan and put them all on the credit card! The plan is to ‘flick’ (on-sell) most or all of the flats before the settlements are due. The idea is to make money because the value of the flats will often rise in the boom even though they aren’t even built yet. In the frenzy of the boom this does work a couple of times, so you become greedy and do it some more with more flats. Then the boom stops and the value of the flats falls. The problem is that you can’t sell them before settlement and you are forced to borrow money in order to settle the purchases. Even if you only bought one flat off the plan, suddenly you are forced to borrow, say, $500 000 to buy a flat worth maybe $400 000. If you don’t have enough equity in your own home, or it you don’t have the income to cover both loans you won’t be able to raise the $500 000, so you are sued by the property developer. Even if you do have equity in your home and sufficient income to support the extra loan you are stuck with an empty flat nobody wants, in a building full of empty flats that nobody wants. Eventually the economy comes good, you find a tenant and the value will rise after several years, but you’re still stuck with a flat with very little land value, so the capital growth over the long term will generally be poor. It’s not pretty, and it happens in every boom and bust cycle.

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Rental guarantees Flats off the plan are usually sold with rental ‘guarantees’. Guarantees are worth nothing unless they are from a licensed bank or a government. A rental guarantee provided by a ‘$2 company’ owned by a property developer is completely useless. The only reason it has to offer a rental guarantee is because the flat is not rentable. If it was rentable, you wouldn’t have to rely on a rental guarantee. Never touch anything with a rental guarantee.

Property marketers Be very careful about property marketing groups who advertise properties in far-away places to out-of-towners. Their properties are always overpriced — that’s how they make their money. Some of the tactics they use are: 9

rental guarantees — see above

9

seemingly low-interest loans — the interest discount is added to the price of the property, so you’re paying too much for it

9

high depreciation allowances — the numbers in the brochures are often much higher than the independent quantity surveyor’s report.

The golden rules are: 9

Never buy without independent legal and financial advice. Don’t trust anybody the property marketers have introduced — ‘valuers’, lawyers, accountants, lenders, building and pest inspectors — they’re on the payroll of the marketers and give you favourable reports and favourable terms to get a kickback from the property marketers. These conflicts of interest lead to biased opinions (or straight-out fraud), and all those kickbacks are loaded into the purchase price.

9

If you want to buy into an area, do your own research into the secondary market and the local rental market. You can almost always buy the same thing one-year old for much less than the new property sold through the property marketers.

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Where to buy One of my favourite sayings is, ‘The three most important things when buying property are location, position and where it is’. If you are investing to build wealth over the long term, the aim is achieve long-term capital growth at well above the inflation rate. You can do this by focusing on areas where demand is rising at a greater rate than supply. (This was covered in chapter 3.) The areas that are likely to lead to superior long-term capital growth include: 9

inner-city areas of growth cities

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beach and coastal areas within a few hours of growth cities

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rural villages within a few hours of growth cities

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areas with a broad range of industries — not relying on just one industry — for example, manufacturing, mining, tourism, medical, education, retail and retirement

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areas with planned transport links that will bring them closer

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popular areas that have limits to supply — for example, population ceilings, height restrictions, or are bordered by national parks.

Diversify or specialise? The benefit of diversifying is that you spread your risk across a number of different cities and states. This can also save on land tax because each state has its own separate threshold for land tax purposes. This means you can generally own a couple of properties in each state before paying any land tax. The advantage of specialising is that you can learn your chosen market inside out, which will mean you can assess values and find bargains where others often can’t. If you are planning to diversify and buy one property in each state, you simply can’t learn enough about each market to find bargains. Another advantage of specialising is that you can often use only one property manager and this can save money. The best solution is to specialise in an area that has good long-term growth prospects — supported by demographic shifts and a range of expanding industries.

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Become an investor before an owner-occupier One way that many people in their 20s and early 30s are approaching the housing market is to buy an investment property while still renting or living at home. Faced with the rising prices of houses, it makes sense to get a tenant to help with the mortgage payments. To buy a typical $400 000 house purchased with a loan of $360 000 at 7 per cent over 25 years, the monthly mortgage payments would be $2544 per month or $587 per week. In most metropolitan areas in Australia a $400 000 house would rent for about $300 to $350 per week. After allowing, say, 25 per cent for rental expenses this would leave $225 to $262 per week in net rent. The tenant would be paying 35 per cent to 45 per cent of your mortgage repayments for you so you only have to come up with $325 to $362 per week for the rest of the mortgage. Look at those numbers again for a second. The balance of the mortgage repayments that you have to cover (around $300 per week) turns out to be pretty much the same as the rent that your tenants would be paying, and it is the same as the rent you would have to pay if you were renting it, or a similar house, yourself. If you can live at home to save up the deposit, you could buy your first investment for the same net weekly outlay as you would otherwise pay in rent.

Invest with a friend A popular strategy is for two or more friends to pool their savings to buy an investment property. Many people are earning good incomes in their 20s but remaining single until much later in life. This is a great opportunity to start investing in properties with friends using surplus cash pooled together while also building super funds via employer contributions. You need to choose your business partners wisely. Probably the most important item to agree on is each person’s investment time frame. Always remember that property should be regarded as a long-term investment because of the high transaction costs involved in buying and selling. Property can be turned around for a quick profit in the boom times, but you should never bank on this happening. All partners need to agree on a plan of action and expected time frame before buying the property. I have seen this strategy work very well. In some cases the property is sold five or so years later and the partners go their separate ways with their share of the proceeds. In other cases, they put more cash in and buy further properties.

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Entities In the early days properties can be purchased by the individuals as ‘tenants in common’. Once the operation grows into a business the properties can be purchased through a unit trust or company structure, in which the trust units or shares are owned by the individuals. There are several ways to structure these types of arrangements — your accountant would be best placed to advise on this. This pooling strategy is a great way for young people to get into the property market and start building equity and experience along the way. This approach can work in a variety of strategies — including buying to rent, renovate then sell, rebuilding projects, or subdivisions. The most important factor in these kinds of relationships is that all parties agree up-front on the plan of action. The more details you can discuss and agree on before you start, the better the outcome will be for all concerned. Make sure you have a written agreement between all parties setting out matters like: 9

who is contributing what to the project — money, time, expertise and so on

9

who owns what percentage share of the property

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what the plan is for the property

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when it will be sold

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how much the renovation budget is

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how it will be funded

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how costs will be shared

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what will happen if one party wants to sell

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who will deal with agents, solicitors, builders, tradespeople

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who can approve bills for payment.

Try to think of everything that could happen with the property and agree on the roles each party will play. Never assume anything — cover as many issues as you can think of in the written agreement so there is minimal room for misunderstanding and conflict later on.

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Ensure that all parties are on the title to the property — usually as ‘tenants in common’ in the shares agreed up-front. Be warned that usually the names of all parties will also be on the mortgage as ‘joint and several’ borrowers. This means that, even though you may own only, say, 25 per cent of the property, the lender can chase you for 100 per cent of the loan repayments.

7.2 Non-residential property Non-residential property is often seen as an ideal way to finance retirement. It’s quite common to see recently retired people looking for a building to provide them with security and income for the rest of their lives. Non-residential property is often referred to as ‘commercial’ property, but commercial property is a more specific term referring to offices, which is only one type of non-residential property. Before setting out the main types of non-residential properties in Australia, let’s take a look at the advantages and disadvantages.

Advantages Following are the advantages of investing in non-residential property: 9

Generally, most types of non-residential property tend to at least hold their value after inflation. Hence, it is often described as a ‘hedge against inflation’. In fact, if you select well, you can often get capital growth well in excess of the inflation rate.

9

Income yields tend to be higher than from residential property and shares. Depending on the type of property, you can get yields of up to 10 per cent or more for some properties. But the general rule is the same as for residential property — higher yields are generally accompanied by lower capital growth.

9

There are some tax advantages in the form of depreciation and capital allowances, which can help reduce tax payable on rental income. Deductions you claim now against income will be deducted from the capital cost when you sell, so the tax break delays tax payable until you sell the property. In addition, capital gains on sale will attract only half the tax rate of income if you hold the asset for more than one year, so depreciation and capital allowances end up delaying tax as well as reducing it.

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9

Lenders love lending against the value of property — much more so than for shares, businesses, or other assets.

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Unlike residential tenants, non-residential tenants generally pay the landlord’s outgoings (council rates, land tax, electricity, water and so on), and also pay for ongoing repairs and maintenance. It is in the tenant’s interest to keep the premises in good condition, so wear and tear is often less than for residential tenants, who have no incentive to look after the place.

Disadvantages Following are the disadvantages of investing in non-residential property: 9

Traditionally, non-residential properties come in large chunks. This means that if you have, say, $1 000 000 to spend, you will only buy one or two relatively small properties and you will generally be paying a premium. Your risk will be concentrated and you won’t be diversified across a number of sectors. This means that you have to be extremely careful with your selection process. You can, of course, buy non-residential properties for much less, but you are likely to be compromising on quality or location or both.

9

Non-residential properties take a relatively long time to sell. If you need to raise money quickly, you can sell $1 000 000 worth of shares in a few seconds on the stock market and get the cash three days later, but it may take many months to sell a non-residential property.

9

Transaction costs (that is, the cost of buying and selling) are relatively high for property. If you buy or sell $1 000 000 worth of shares, it will cost you only about 0.1 per cent or $1000 in brokerage. To buy a property for $1 000 000 will cost around $50 000 in stamp duties, legal costs and due diligence costs (that is, the cost of paying experts, like architects, engineers, building inspectors and town-planners to check out the property before purchase).

9

Non-residential properties require management. You can outsource this to specialist property managers, but this costs money. If you have a real passion for it you can take the time to become an expert yourself. Non-residential properties generally require less management than residential properties because leases tend to be longer term and the tenants pay for the outgoings and most repairs and maintenance. But often more complex issues arise, which require legal expertise.

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9

Non-commercial properties can experience wide swings in capital values — much more so than residential property. For example, we know that residential property may fall in value by up to, say, 10 to 20 per cent in an economic downturn and may rise, say, 50 per cent in a boom. In contrast, non-residential properties can often halve in value in a downturn (for example, if vacant for long periods), and may also then recover quickly in an upturn and double in value. Because of this, it is possible to make very big gains if you get the timing right, or big losses if you get it wrong.

Boom and bust, and supply and demand A couple of partners and I built a three-storey office building on Pacific Highway in St Leonards in Sydney, and sold it at the very top of the 1988 property boom for $3.3 million, with vacant possession. The location was fantastic — on a corner site with great visibility up and down one of the busiest main roads in Australia. The tenants were superb — including a global brand phone company and a national electronics retailer. Sixteen years later, in 2004, it sold again for $4.25 million. This might sound like reasonable profit for the owner over the period, but the actual compound growth rate over the period was only 1.6 per cent per year. This was less than the inflation rate, so rents and capital values actually fell in value in real terms — a lousy investment for the owners during that period. Despite having everything going for it in terms of location, exposure and tenants, the capital value was crucified by the supply and demand characteristics of the surrounding area. Over the 16-year period there were two major factors (outside the control of the building’s owners) that killed its value as an investment. Firstly, on the demand side, there was a dramatic reduction in employment in the telecommunications, advertising and technology sectors following the dotcom bust in 2000, which made up a large proportion of the tenants in the North Sydney and St Leonards areas. Secondly, on the supply side, many new office buildings were built in the area, a number of which still stand vacant today. Hence, rents and capital values on the whole have fallen. The lesson is this — be very careful. Commercial buildings come in large chunks so you need to diversify in order to make sure that adverse changes don’t affect your overall position too much. Factors totally outside your control have a powerful impact on rents and values. This applies to residential property as well, but is even more critical in non-residential property markets.

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Investment returns from property Overall, non-residential property tends to produce higher income and lower capital growth than shares. Averaged over very long periods, the Australian sharemarket has tended to produce income (dividends) of around 3 per cent to 4 per cent per year, plus capital growth of around 7 per cent to 9 per cent per year, as we have already seen. On the other hand non-residential property funds have averaged income (called ‘distributions’) of around 6 per cent to 8 per cent per year, plus capital growth of around 5 per cent to 7 per cent per year. The total returns (capital growth plus income) from both types of investments turns out to be very similar over the long term, but the mix between income and capital gains is different. Investment returns from listed property as a whole and listed company shares as a whole have both averaged around 12 per cent to 14 per cent per year. Returns from property investments listed on the Australian Stock Exchange have been measured by the Listed Property Trust Accumulation Index, which was introduced at the end of 1979. Just like the All Ordinaries Accumulation Index, the Listed Property Trust Accumulation Index measures total returns, including both capital growth and income, and assumes that all income is reinvested, which is what you should be doing with your long-term investments. Over the 27-year period from the end of 1979 to the end of 2006, total returns from listed property trusts have averaged over 14 per cent per year. This is almost exactly the same average return achieved by the Australian sharemarket over the same period; though, the returns each year were very different, as table 7.6 shows.

Table 7.6: annual pre-tax returns from shares and listed property Year end

Return from shares*

Return from listed property†

50–50 mix of shares and property

1980

+48.9%

+6.4%

+27.6%

1981

–12.9%

+31.3%

+9.2%

1982

–13.9%

+5.7%

–4.1%

1983

+66.8%

+50.5%

+58.6%

1984

–2.3%

+10.1%

+3.9%

1985

+44.1%

+5.2%

+24.7%

1986

+52.2%

+35.4%

+43.8%

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Table 7.6 (cont’d): annual pre-tax returns from shares and listed property Year end

Return from shares*

Return from listed property†

50–50 mix of shares and property

1987

–7.9%

+5.2%

–1.3%

1988

+17.9%

+16.7%

+17.3%

1989

+17.4%

+2.4%

+9.9%

1990

–17.5%

+8.7%

–4.4%

1991

+34.2%

+20.1%

+27.2%

1992

–2.3%

+7.0%

+2.3%

1993

+44.1%

+29.1%

+36.6%

1994

–7.9%

–4.8%

–6.3%

1995

+20.2%

+12.7%

+16.5%

1996

+14.6%

+14.5%

+14.5%

1997

+12.2%

+20.3%

+16.3%

1998

+11.6%

+18.0%

+14.8%

1999

+16.1%

–5.0%

+5.6%

2000

+4.4%

+19.7%

+12.1%

2001

+9.2%

+13.5%

+11.4%

2002

–8.1%

+11.0%

+1.5%

2003

+15.7%

+8.9%

+12.3%

2004

+27.8%

+32.0%

+29.9%

2005

+21.1%

+12.4%

+16.7%

2006

+25.0%

+34.0%

+29.5%

Average

+14.0%

+14.9%

+14.5%

*According to the All Ordinaries Accumulation Index. †Returns from property uses the Listed Property Accumulation Index. Note: figures are for calendar year end.

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Figure 7.1 shows the returns from both listed shares and listed property between 1979 and 2006. If you had invested just $1000 in each of the two sectors at the end of 1979 and reinvested all earnings, your shares would be worth over $34 000 today and your listed property would be worth over $42 000.

Figure 7.1: shares versus listed property trusts — 1979 to 2006 45,000 45 000

AllAllOrds Accumulation Index Ordinaries Accumulation Index

40,000 40 000

Property Trust Trust Accumulation IndexIndex Property Accumulation

35,000 35 000

30 000 30,000 25 000 25,000 20,000 20 000

Both started at 1000 end Bothindices Indices started at at 1,000 of December at end of1979. December 1979

15,000 15 000

10 000 10,000 5 000 5,000

2006 2006

2005 2005

2004 2004

2003 2003

2002 2002

2001 2001

2000 2000

1999 1999

1998 1998

1997 1997

1996 1996

1995 1995

1994 1994

1993 1993

1992 1992

1991 1991

1990 1990

1989 1989

1988 1988

1987 1987

1986 1986

1985 1985

1984 1984

1983 1983

1982 1982

1981 1981

1980 1980

1979 1979

00

Both results have been outstanding and you should be more than happy to get those kinds of returns in your long-term investment funds.

Shares and property together If shares and listed property both return around 14 per cent per year over the long term, why not just invest in one or the other? Table 7.6 also shows what happens if you have a mix of shares and property in your fund. The right-hand column shows the average returns from shares and property each year assuming you had equal amounts of each in your portfolio. This shows us that over the past 27 years, shares had eight negative years and listed property had only two negative years. 273

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If you had both these classes of assets together in your fund, then the returns would be averaged out each year. The losses in one asset class would be partially or fully offset by gains in the other asset class. The worst year for shares was 1990 (loss of 17.5 per cent), but in that year property did quite well (gain of 8.7 per cent). The worst year for property was 1999 (losses of 5 per cent), but in that year shares did very well (gain of 16.1 per cent). So owning both shares and property smooths out the bumps and creates more consistency in returns. Figure 7.2 shows the returns from both shares and listed property between 1980 and 2006.

Figure 7.2: returns from shares and property together — 1980 to 2006 +80%

+80%

+70%

Return Shares Return from shares

+70%

+60%

Return from listed Return Listedproperty Property

+60%

50:50 + Property 50–50Mix mixofofShares shares and property

+50%

+50%

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

-10% –10%

1989

+0% 0%

1988

+0% 0%

1987

+10% 1986

+10% 1985

+20%

1984

+20%

1983

+30%

1982

+30%

1981

+40%

1980

+40%

-10% –10%

–20% -20%

-20% –20%

Shares Accumulation Index. Property = ListedAccumulation Property Accumulation Index. Shares==All All Ordinaries Ords Acumulation Index. Property = Listed Property Index. Source: ASX, S&P –30% -30%

-30% –30%

By having both shares and property trusts in your fund you end up with the best of both worlds. The highs might not be as high, but the lows are not as low as if you had just shares or just property in the fund. By adding both classes of assets to your portfolio, the returns are less variable from year to year. Overall returns still averaged around 14 per cent per year over the period, but the returns were more consistent and stable. You can choose the mix of shares and property trusts in your own portfolio. Whatever mix you choose, total returns over the life of your long-term fund is likely to achieve or even exceed the returns of 12 per cent needed to reach the $1 million target on time. 274

Invest outside super (part II): property

Tax benefits of non-residential property In chapters 2 and 6 we saw that the effect of tax breaks on income from shares meant that the after-tax returns were only a fraction lower than the before-tax returns. This is very similar to non-residential property. We have seen how the before-tax returns from listed property investments have averaged around 14 per cent or more per year over the long term. Because of the tax breaks attached to a significant portion of the distributions from most property trusts (both listed and unlisted), after-tax returns are generally around 1 per cent to 2 per cent lower than the before-tax returns, even for investors in high tax brackets. So the 12 per cent per year target for total returns after tax is still achievable by investing in listed property. The break-up of income distributions varies for different property trusts, and also varies from year to year, but for the whole sector over the long term, the break-up of distributions average the following:

Percentage of distributions Normal taxable income (including undiscounted capital gains, unfranked dividends, rent, interest)

60 per cent

Discounted realised capital gains

10 per cent

Tax-free or tax-deferred income

20 per cent

Fully franked dividends

10 per cent

Total

100 per cent

You will notice there is a small component of franked dividends in the distributions from property trusts. This is because several property trusts are ‘stapled’ to property companies that pay dividends, and are included in the property index. For the following calculations I will assume that property trusts achieve average pre-tax total returns of 12 per cent per year over the long term (even though they have actually achieved 14 per cent in the past). This 12 per cent total return is projected to consist of 6 per cent capital growth and 6 per cent distribution yield. Using these assumptions, table 7.7 (overleaf) shows the after-tax total returns where the investments are held in super funds and by individuals in various tax brackets.

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Table 7.7: total returns after tax for different types of investors — property trusts Total returns after tax

Effective tax rate on total return

Super fund before retirement, paying 15% tax

11.52% p.a.

3.9%

Super fund after retirement, paying 0% tax

12.26% p.a.

–2.1%

Direct investor in 31.5% marginal tax bracket

10.76% p.a.

10.3%

Direct investor in 41.5% marginal tax bracket

10.28% p.a.

14.3%

Direct investor in 46.5% marginal tax bracket

10.05% p.a.

16.3%

Table 7.7 shows that even for individual taxpayers in the top marginal tax bracket of 46.5 per cent (earning more than $150 000), the after-tax returns are only a couple of per cent lower than the after-tax returns of a super fund in pension mode paying no tax and holding exactly the same assets. Remember, the table assumes ongoing pre-tax returns of only 12 per cent, whereas property trusts have historically returned more than 14 per cent per year on average. The net result is this — property trusts are very tax effective, even when held by individual investors in high marginal tax brackets.

Types of non-residential property The main types of non-residential property are: 9

retail (shops)

9

commercial (offices)

9

industrial (warehouses and sheds)

9

bulky goods (large retail on main roads)

9

tourist (hotels, motels, resorts)

9

specialist (car parks, medical, childcare centres, self-storage, student accommodation and so on).

A snapshot of the key features of each type is shown in table 7.8. 276

Invest outside super (part II): property

Table 7.8: key features of each type of non-residential property Type

Yields

Capital growth

Retail (shops)

Low — can be as low as 4% to 5% for popular areas

High, if in high-demand Low to moderate due to high land content in areas — many have redevelopment potential high-demand areas

Very low in highdemand areas — often high turnover of tenants

Commercial (offices)

Medium — from 6% to 9% for cities, lower for suburban centres

Moderate — many have Moderate due to low strata potential land content and high development costs

Can be high vacancy rates in recessions, or over-supplied areas

Industrial (warehouses)

High — from 8% to over Limited due to generous Moderate to high due to 10% in many areas supply of industrial land low land content in many areas

Bulky goods (large Medium to high retail on main depending on the area roads) Tourist (hotels, resorts)

Vacancies

Long-term tenants, but long vacancy periods at end of lease

Moderate to high due to low land content

Tend to be long-term tenants in high-demand areas

Varies, depending on Often huge swings in Often high, due to large the property — can be capital values depending development cost and very high (over 10%) for on economic cycle low land value some

Often require frequent redevelopment, leading to long periods with no income

Specialty areas Can be high, depending (car parks, student on type accommodation, medical)

High — if located well on major roads

Tax advantages

Varies

Varies

Varies

The story of the phantom tenants A couple of years ago a business partner and I were looking at buying a bulky goods property in Aerodrome Road, which is the main commercial road in Maroochydore on Queensland’s Sunshine Coast. The tenants were a furniture store and an electronics retailer. The leases looked good, the body corporate records looked good and all the other investigations checked out. However, just before settlement we discovered that there were secret side agreements between the owner and both tenants for rent ‘holidays’ — meaning that the tenants were actually paying a lot less rent than was specified in the leases than shown on the records. The actual yields were much lower 277

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than advertised and showed in the leases. Fortunately, we discovered this in time to pull out of the contract, but not before spending several thousand dollars on due diligence and legal costs. The lesson is this — you need to spend a lot of time and money investigating each potential purchase. This is the case with all types of non-residential properties. There are often secret deals relating to rent holidays and fit-out deals that may take time and effort to uncover. You may have to do this with a few properties for each one you end up buying. But if you take your time and be careful, the rewards will be worth the effort and cost.

How to find out more about non-residential property A great way to find out more about non-residential property is to befriend one or more commercial agents in the areas you are looking to specialise in. You will be pleasantly surprised at the quality of salespeople, compared with most residential real estate agents. Commercial agents tend to be much more professional and knowledgeable than their residential counterparts. They are generally used to dealing with investors and are happy to spend time developing a relationship with you. Tell them up-front what you are looking for and how much you want to spend. Go to auctions held in the city offices of the major real estate firms to get a first-hand look at the market in action. The major commercial agents are part of national or global groups and they all have extensive research reports available on their websites that you can download. These reports cover yields, capital values per square metre, trends in supply and demand and so on in all the major sectors and cities. Some of their reports are available for sale, but if you ask your agents for a copy, they are generally happy to give them to you for free if you have developed a good relationship with them. Start going through the non-residential properties for sale in your local paper. You will find it much more straightforward and easier than the residential section. This is because it’s written for a much smaller specialist audience — you, the serious investor!

How to invest in non-residential property There are five main ways to invest in non-residential property: 9

direct investing

9

unlisted property funds and trusts

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Invest outside super (part II): property

9

property syndicates

9

listed property funds and trusts

9

property exchange-traded funds.

Direct investing The main problem with direct investing in non-residential property is the amount of money required. You’re dealing with amounts from $1 million to hundreds of millions. You can buy for less then $1 million, but for small properties the yields tend to be lower because you are competing against thousands of other investors with the same idea. Banks and other commercial lenders are happy to lend up to 70 per cent or 80 per cent of the value of the property (compared with 90 per cent or 100 per cent of residential property). Interest rates also tend to be about 1 per cent higher than home loan rates. Super funds cannot borrow money, so they must purchase for cash. The main disadvantage with direct property is the lack of diversification and liquidity. Most high net worth people can afford only one or perhaps two good-sized buildings. This makes their portfolio very ‘lumpy’ — that is, very illiquid, and the risk is concentrated in one area and one industry.

Unlisted property funds and trusts Unlisted property funds and trusts (ULPTs) are essentially unlisted managed funds that own properties. Most of the main ones own dozens of buildings totalling billions or hundreds of millions of dollars, so the risks are spread across a number of markets and industries. Many unlisted property trusts have rules limiting investors’ ability to withdraw all their money quickly. Their problem is that, if everybody wanted their money quickly, the property fund manager would have to sell buildings quickly. Large buildings often take a long time to sell — six months or a year even in the best of times. In the last big recession in Australia (during the early 1990s) hundreds of thousands of unlisted property trust investors had their investments ‘frozen’ so they couldn’t get their money out, for several years in some cases, because some of the buildings simply couldn’t be sold. To compensate for this lack of liquidity, unlisted property trusts generally need to offer investors higher returns, so the income is often higher than for listed property trusts.

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Unlisted property trusts also tend to charge high up-front fees (which they use to pay sales commissions to financial planners), annual management fees and sometimes exit fees (just like active fund managers for shares). ULPTs are not intended to be short-term investments. Only use them if you don’t need the funds for at least 10 years. The minimum investment amount for most unlisted property funds is around $2000 to $5000. You should probably wait until your investment fund has at least $10 000 in it before getting into unlisted property, so you can spread the risk over two or three different property funds and property fund managers. Most property fund managers have moved towards listed property trusts, and away from unlisted funds, but there are still some large unlisted fund managers offering a variety of unlisted funds and ‘syndicates’, including: 9

Australian Unity —

9

AXA —

9

Challenger Financial Services Group —

9

Centro Properties Group —

9

MacarthurCook —

9

Orchard Funds Management —

9

Tishman Speyer Office Fund — .

In addition, most of the active fund managers also offer unlisted funds that use the money to invest in a range of listed property trusts. Why anyone would do this is completely beyond me. Anybody could just buy into the same listed trusts themselves for a fraction of the cost and save on the up-front and annual fees charged by the active fund managers.

Property index fund One option is to use the Vanguard Index Property Securities Fund, which is an unlisted property fund that tracks the S&P/ASX 300 Property Trusts Index. Minimum investment is $5000 and the entry fee is a 0.20 per cent buy spread (cost). Annual management fee is 0.90 per cent for the first $50 000, then 0.60 per cent for the next $50 000, then 0.35 per cent for the balance over $100 000.

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Invest outside super (part II): property

See . The advantage of this fund is that it covers all trusts in the LPT index. But this is still more expensive than property ETFs.

Property syndicates Property syndicates are small, unlisted property funds usually formed to purchase a single building. The idea is to pool the funds from, say, a dozen or so individual investors who all want to invest for the same term. The benefit is that individual investors with, say, $50 000 can buy into a building that they couldn’t by themselves. The main disadvantage is that you don’t have access to your money before the specified term is up. This is different to an unlisted property trust managed where you can at least get part of your money back each year.

Listed property funds and trusts Listed property trusts (LPTs) are ‘listed’ because their units are listed on the stock exchange, and you can buy and sell units through your online broker account. The main advantage of listed property trusts compared with unlisted property trusts, is their lower fees and lower transaction (buying and selling) costs — you just pay brokerage of $20 or so when you buy or sell them via your online broker account, rather than pay the up-front and exit fees you would with many unlisted property trusts. You can also buy into LPTs with as little as a $500, which you can’t do with unlisted property trusts.

The main listed property trusts There are over 100 listed property trusts and funds on the ASX, of which a couple of dozen are large (more than $1 billion in assets). Some are diversified and hold hundreds of properties across the different sectors of the market, and others specialise in their particular sector — that is, in retail, office, industrial and so on. The best place to start would be the larger, more-established diversified funds, shown in table 7.9 (overleaf). The main retail funds are shown in table 7.10 (overleaf), commercial funds in table 7.11 (on page 283), industrial funds in table 7.12 (on page 283) and tourist funds in table 7.13 (on page 283).

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Table 7.9: major diversified property funds Name

ASX code

Size

Listed

General Property Trust Group

GPT

$10 billion

1971

Stockland Group

SGP

$12 billion

1987

Mirvac Group

MGR

$6 billion

1999

DB RREEF Trust

DRT

$5 billion

2004

Valad Property Group

VPG

$2 billion

2002

Table 7.10: major retail property funds Name

ASX code

Size

Listed

Westfield Group

WDC

$39 billion

1961 (as WSF)

Centro Properties Group

CNP

$8 billion

1997

CFS Retail Property Trust

CFX

$5 billion

1994

Macquarie CountryWide Trust

MCW

$3 billion

1995

Centro Retail Trust

CER

$2 billion

2005

Centro Shopping America Trust

CSF

$1 billion

2003

Macquarie DDR Trust

MDT

$1 billion

2003

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Invest outside super (part II): property

Table 7.11: major commercial property funds Name

ASX code

Size

Listed

Investa

IPG

$4 billion

2000

Macquarie Office Trust

MOF

$3 billion

1993

Commonwealth Property Office Fund

CPA

$2 billion

1999

ING Office Fund Real Estate

IOF

$2 billion

2000

ASX code

Size

Listed

GMG

$12 billion

2005

IIF

$3 billion

1991

MPR

$1 billion

2002

ASX code

Size

Listed

Thakeral

THG

$0.6 billion

1994

Macquarie Leisure Trust

MLE

$0.7 billion

1998

Table 7.12: major industrial property funds Name Goodman Group

ING Industrial Fund

Macquarie ProLogis Trust

Table 7.13: major tourist property funds Name

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The funds in the previous five tables are all very big funds with many thousands of investors. Use the ASX codes to look a few of them up on your online broker account or via the ASX website and learn more about them. Their websites contain information about the funds, including annual reports, prospectuses and product disclosure statements, which can be downloaded or ordered online. Many of these LPTs have been around for a number of years and have survived recessions and property downturns. Always check their current details before investing. My wife and I have invested in several of these over the years, and we still do. They are the kinds of investments we can buy, hold and never sell, particularly the larger diversified ones.

Property exchange-traded funds Perhaps the easiest, lowest cost way to invest in the listed property market is by buying into the exchange-traded fund that buys into a range of LPTs. There is one in Australia (run by State Street Global Advisors), which also runs the main exchange-traded share funds looked at in chapter 6 and is shown in table 7.14.

Table 7.14: the major property exchange-traded fund Name SPDR S&P/ASX Listed Property Fund

ASX code

Size

Annual fee

SLF

$100 million

0.40%

This exchange-traded fund invests in property trusts and funds instead of shares. It invests across the main LPTs and its performance is designed to match the Listed Property Trust Index. We have already seen how this index has produced great returns over several decades. There are no entry or exit fees and the annual fee is very low, a fraction of the fees in unlisted property trust funds. You can buy and sell units in this fund in small parcels using your online broker account, just like you can for LPTs and shares. You can also borrow to invest in this property ETF in the same way that you would borrow to invest in shares or direct property investments.

Non-residential property in your plan You can put together your $1 million fund purely with shares if you like, but it’s usually better to include property as well — to add diversity, smooth out volatility and boost returns. Aim to make 284

Invest outside super (part II): property

property about 20 per cent to 40 per cent of your total long-term fund. On the other hand, many successful investors use property as the main component of their long-term funds. The choice is yours. Buying direct non-residential property is out of the question for most people, due to the size of each investment. It is possible to buy some smaller properties (like strata offices, small warehouses or shops) but the yields are low and you will be paying a premium. Here is a simple, low-cost, tax-effective, ‘set-and-forget’ way to use non-residential property to build wealth, even if you are starting out with a very small fund. You can do this outside super or inside super if you run your own self managed fund. 9

Core — use either: (

a property EFT

(

two or three of the larger diversified LPTs.

You can buy these with cash or you can also borrow to increase your investment the same way you can with shares — either using a margin loan or borrowing against your home or investment property (you can’t borrow in your super fund). 9

Optional extras: (

select one or more of the specialised sector LPTs (such as retail, office and industrial)

(

select one or more ULPTs or property syndicates.

If you do invest in these optional extras, you wouldn’t sell your core investments because you would just have to pay capital gains tax. Keep the core investments and never sell them. They will provide the backbone of your fund and will get you to the $1 million target by reinvesting earnings during your working years. Then, when you need the income to live off, these same investments will generate tax-effective income for the rest of your life, both inside and outside your super fund.

7.3 Further reading There are hundreds of books on residential property investing. Many of them are written by people who only appeared in the latest property boom. They make outlandish claims and the plans are 285

$1 Million for Life

not realistic or sustainable over the long term. Stick to books written by people who have seen through interest rates higher than 15 per cent and a recession or two, including Margaret Lomas, Jan Somers, Peter Cerexhe and Neil Jenman.

7.4 Key points 9

Houses generally generate higher capital growth and lower rental yields than units, because of their higher land content, and supply and demand.

9

The tax system favours investment in assets in which the returns are mostly in the form of capital growth rather than income, which in most cases is houses rather than units.

9

Residential rental expenses eat up around 20 per cent to 30 per cent of gross rents.

9

Always get a depreciation schedule listing the items of plant and equipment, and showing the date and construction cost of the building. Be careful of properties with high depreciation — it just means there are more things that are going to need constant repairs, maintenance and replacement.

9

Never buy a holiday property while on holiday. Don’t underestimate the much higher costs of holiday renting. Holiday houses can provide great long-term capital growth if you select your locations carefully.

9

It is easy to make money renovating properties in a boom, and it is easy to get caught with high debts when the boom stops.

9

The biggest costs are usually transaction and holding costs, which are often underestimated.

9

Never let emotion play a role in decision making.

9

To buy into growth properties you generally need to be able to put in a significant amount of cash into the purchase, or have other cash flow to support the negative gearing.

9

Properties with positive cash flow bought with no cash contribution to the purchase price will need to show initial gross rental yields over more than 10 per cent. These are generally not going be in areas that will generate long-term capital growth.

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9

To build long-term wealth, concentrate on properties that can generate growth at well above the inflation rate over the long term.

9

Get to know an area or a market inside out and become an expert. That way you will buy better and avoid paying too much.

9

Just because people aren’t getting married until their 30s or 40s doesn’t mean they can’t start in the property game much earlier. There are several different strategies to get into the game by pooling resources with family or friends.

9

Non-residential property can provide good rental yields, good capital growth and can be a good hedge against inflation.

9

The main disadvantage of non-residential property is that it comes in big chunks — several million dollars each for good quality properties. Most individuals can only buy into nonresidential via property trusts.

9

Income from property trusts often carries significant tax benefits for investors.

9

After-tax returns are still going to be on track for the investment returns required for the $1 million target.

9

There are several very large and well-established property trusts with diverse ranges of properties.

9

In the early years, stick to the larger, more diversified property groups. In later years, as your portfolio grows, you can buy into some funds in individual property ‘sectors’.

9

If you are investing in non-residential property directly, do plenty of research and understand your market inside out.

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Chapter 8

Invest outside super (part III): other asset classes

Money sense

8.1 Income products ‘Growth’ investments (shares and property) are used to build wealth over the long term, which is 10 years or more. On the other hand, ‘income’ products (cash and fi xed interest) are used to provide for cash needs over the short and medium terms. ‘Cash’ products allow immediate access to funds and ‘fi xed interest’ (bonds) provides for short to medium term requirements. I don’t refer to income products as ‘investments’ because they are not used to build wealth over the long term.

Income products don’t build wealth It’s only natural for people to want to generate income so they can leave their jobs or top up their existing salary or pension. The thought processes of most people are shown in figure 8.1.

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Figure 8.1: how most people try to generate extra income Need to generate income

Chase high yield (mortgage funds, unsecured notes, debentures, convertible notes, etc.)

Interest income starts now

High risk of loss; no capital growth; no inflation hedge; income is taxable

Trading income starts now (usually losses)

Very high risk of loss; no capital growth; no inflation hedge; income is taxable

or Need to generate income

Trading (shares, CFDs, options, warrants, futures, etc.)

The plan in this book does not follow either of these processes, as shown in figure 8.2.

Figure 8.2: how smart investors generate income

Need to generate income

Investment income starts small but grows

Use spare cash to invest in growth assets

Low risk of loss; capital growth; good inflation hedge; no tax on growth; tax breaks on income

Most people don’t go for the investing option because it’s too easy to get lured into high yields from ‘capital guaranteed’ income products, or ‘quick profits’ and ‘easy money’ from trading schemes. I will look at trading a little later.

Don’t chase yield We have all heard of collapses, like Westpoint, Fincorp, Australian Capital Reserve, Estate Mortgage, Pyramid, Kovelan Bangaru and Carl Suleman, where a lot of people lost a lot of money. We have also heard or read about trading systems involving derivatives like options, ‘covered

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calls’, warrants and CFDs. People get into trouble with these schemes because they are chasing income and, in the process, getting into risky territory without knowing it. This plan to build wealth for life does not involve a chase for income yield. Even though you are ultimately aiming to provide an income for life (both inside and outside super), the plan focuses on growth investments, not income. The income from these growth investments is reinvested during your working years, but provides income to live off for the rest of your life. Your long-term investment funds (both inside and outside super) consist primarily of: 9

shares (in the form of exchange-traded funds, listed investment companies and direct shares)

9

property (in the form of listed property trusts, property ETFs, unlisted property trusts and direct properties).

Together they generate income yields of no more than about 4 per cent to 6 per cent per year. An additional advantage of these growth investments is that the income has significant tax advantages, as we have seen, and the income grows over time as the capital value grows. On the other hand, income products, like term deposits, mortgage funds and debentures have few or none of these the tax advantages and don’t grow in value to keep pace with inflation. After tax and inflation, you just end up going backwards with income products.

Twenty times multiple Throughout this book, when I talk about income generated from capital, I generally use a multiple of 20, which is the same as an income yield of 5 per cent. For example, if you are aiming to build a fund that can provide you with an ongoing income of say, $50 000 per year, you need to build a capital base of 20 times $50 000, which equals $1 million. By using a multiple of 20 (which assumes an income yield of 5 per cent), this allows you to live purely off the income, without the need to eat into capital. That way the capital base keeps growing and keeps the income rising each year to stay ahead of inflation.

Retirees This same multiple of 20 also applies to people already in retirement. We have all heard elderly people saying things like, ‘I can’t afford that, I’m on a fixed income’. Fixed-income investments may have been fine years ago, when life expectancy was only a few years after retirement age, but

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now people may live to 90 or 100, so they still need have a good chunk of their capital invested in growth assets. This capital can then keep growing ahead of the inflation rate and still provide good levels of income, complete with tax advantages.

Build capital, don’t chase yield In this plan you don’t chase yield or expect anything more than a 5 per cent income benchmark from your investments. Instead you need to concentrate on building your capital base by using growth investments. These investments will not only grow over time, but they will also provide you with the tax-effective income yield of about 5 per cent to live off and keep rising ahead of inflation. There are plenty of income products on the market promising 8 per cent, 9 per cent or even higher yields. But you’re not building wealth with income products, you’re just increasing risk.

The plan Income products, like cash accounts and term deposits, do have a key role to play in the plan — they provide essential emergency funds and savings for specific items you may need cash for in, say, one to two years, but they don’t build long-term wealth.

Bonds/fixed interest You should have specific funds designed to finance specific needs in the short to medium term — like buying a new car, paying for a holiday, or putting a deposit on a house. You should not take risks with this money. The money has to be there when you need it. Again, this money doesn’t have the tax advantages or capital growth of your long-term investments, but you’re not after that with this money.

Fixed-interest products for savings funds Here we want products that have no fees, are easy to buy and are backed by a bank. It’s not a question of a risk-reward trade-off. The money has to be there when you want it. Use the following: 9

Bank term deposits. These are offered by all banks. The terms are from 30 days up to a year. Interest rates depend on the term, but are usually a little above the cash rate. 291

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9

Bank-owned finance company debentures. These products have terms from one year to five years. Only use finance companies owned by a licensed bank — the main ones are Esanda (ANZ), CBFC (Commonwealth Bank), NAB and Bank of Queensland. Never use investments offered by property developers (as were Westpoint, Fincorp, Australian Capital Reserve and Estate Mortgage), or even by large industrial companies. This is not the time to take risks.

Never use any of the following products for your savings funds (or for your long-term funds, for that matter): 9

mortgage funds

9

mezzanine debt — higher risk property development finance

9

hybrids — these are various combinations of debt and equity

9

subordinated debt

9

corporate bonds

9

collateralised debt obligations (CDOs)

9

preference shares — these often pay franked dividends (which means tax advantages) but don’t have capital growth, and they go up and down in value with the market. You may look at using these as a small part of your long-term portfolio, but not for your savings because their capital value varies.

Mortgage funds and property finance In every property slowdown and recession small investors are burned by lending directly or indirectly to property developers. In many or most cases the investors didn’t even know that they were financing property developers with their money, because the developers hide behind property finance companies with safe-sounding names. The property developers usually get their initial finance from the banks, and the banks take the property as security. The developers then raise further finance from the retail market (‘mums and dads’) by using all sorts of safe-sounding products like mortgage funds, mezzanine funds, debentures and first ranking notes. When the music stops and the property developers get into trouble, the banks almost always get their money back because they have taken the best 292

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security — the land and the partially built buildings. The small investors are the ones who suffer, because they are usually left with the shortfall and no real security. Every cycle the same thing happens. In the 1960s there were Stanhill and Reid Murray. In the mid 1970s there were Cambridge Credit and Mainline. In the early 1990s there were Estate Mortgage, Pyramid and the state banks of every Australian State (except Queensland, which didn’t have a state bank). In the mid 2000s there were Westpoint, Fincorp, Australian Capital Reserve and probably a couple more by the time you read this.

What about capital guarantees? The investments may be ‘guaranteed’, but guaranteed by whom or what? It’s only ‘guaranteed’ by a bankrupt property development company. You don’t even get the personal guarantees of the directors. The only capital guarantees worth anything are guarantees from either a government (state or federal) or a licensed bank. Other guarantees are generally not worth the paper they’re written on.

Bonds (fixed-interest) products for your long-term fund You will recall that bonds are one of the four major asset classes (the other three being shares, property and cash). Bonds generate little or no growth over the long term and have few, if any tax advantages (similar to cash). They do, however, provide a level of certainty and reliability of income. Many long-term funds contain a small percentage of bonds in their portfolio. How much depends on the risk tolerance of the investor and the time period involved.

Why bonds? For the bond component in your long-term investment fund, all you are looking for is certainty and reliability of income, and stability of capital value if everything else goes wrong in the world like nuclear war, global depression or a massive natural disaster. I’m talking about once-in-acentury events here, where governments may be the only thing left. Don’t forget that over the 20th century the Australian sharemarket and property market has survived world wars, global depressions and recessions. But you never know. What I can say for certain is that if such a major disaster does occur, you don’t want to be anywhere near those dodgy finance companies and property developers offering high rates and so-called capital guarantees. Stick to funds consisting of boring government bonds and government inflation-linked bonds. Very simple, very reliable and very low cost.

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Different age groups For people in their 30s and 40s who are in the process of building wealth for the rest of their lives (say, the next 30 to 50 years), and who will not need the capital for the next 10 to 20 years, all or almost all of the long-term investment fund would be in shares and property, with little in bonds and cash. On the other hand, people in their 60s or 70s who are already relying on the fund for income and are looking for the fund to provide capital growth and income for a period of 10 to 20 years at the most, they would probably have a significant portion of their fund in bonds.

Even government bonds can lose value There is a common misunderstanding that fixed-interest securities, even government bonds, can never fall in value. If you buy a 10-year 6 per cent government bond for, say, $100 000, the value doesn’t stay fixed at $100 000. In fact, the market value of the bond will almost certainly go up or down almost every business day over the next 10 years. What you can be certain of is that the government will give you back your $100 000 if you hold the bond until maturity at the end of the 10 years. The other certainly is that you will receive the regular interest payments (the ‘coupons’) during the period. But if you sell your bond before the maturity date, you may get a lot more than $100 000 for it, but you may also get a lot less. If long-term interest rates have risen since you bought the bond, the market value of your bond will have fallen and you will have lost money. If long-term interest rates have fallen since you bought the bond, the market value will have risen and you will make a profit. But you only make a profit or loss if you sell the bond before the maturity date. If you hold on until maturity you get the full $100 000 back, plus the regular interest coupons during the whole period. Even if you buy ‘inflation-linked’ bonds, the capital value will still vary as interest rates change, but at least the coupons rise along with the inflation rate. In your long-term investment fund you need to hold bonds for the long term, through all the ups and downs in the interest rate cycles, so the bonds will generally hold their value. Don’t trade bonds, or try to pick whether interest rates will go up or down — leave that to the professional bond traders.

Bond investments in Australia There are more than 100 unlisted bond funds in Australia that are designed for small investors. All the major fund managers offer them. Several dozen of the major ones are listed in The Australian 294

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Financial Review (the weekend edition has the most comprehensive listing). There are retail funds (for investments outside super funds) under the heading ‘Investment trusts’ and superannuation bond funds are listed under the heading ‘Superannuation funds’. There are various categories: ‘Australian bonds — diversified’, ‘Specialty Australian bonds — cash’, ‘Specialty Australian bonds — cash enhanced’, ‘Specialty Australian bonds — high yield’, ‘Global bonds — diversified’ and ‘World/Australian bonds’. The main problem with this sector is that each fund contains a different combination of different types of bonds and their risk varies greatly. Most contain various levels of higher risk assets like hybrids, mezzanine debt, subordinated debt, collateralised debt obligations, credit derivatives and higher risk corporate debt. This leads to variations in their performance. Don’t be swayed by high returns because the ‘high returns’ are generally brought about by these higher risk elements the fund managers have snuck into the bond funds. In most cases the fund managers themselves don’t understand the added risks involved.

Action plan 1

Find out how much of your existing super fund is in bonds.

2

If you can, find out the types of bonds in the bond component of your fund. You will need to look up the PDS on the fund manager’s website. You may be surprised at what your ‘safe’ bond fund actually contains.

Cash In chapter 9 I will talk about the need to have an emergency cash fund to pay for unexpected bills and to get by if you lose your ability to earn income temporarily. This is a cash account at a licensed bank. There is no need to take risks and chase a higher yield for this fund. Yes, the income is taxable and no, it doesn’t provide any capital growth, but this cash is there for peace of mind in emergencies and to make sure you can handle the occasional crisis without getting into debt again. It has to be certain, reliable and guaranteed to be there if and when you need it. The cash emergency fund would make up only a few per cent of your whole investment asset position as you build wealth for the long term using super and your investments outside super. Some cash products for emergency and savings funds are: 9

High-rate internet accounts. Most banks now offer these. High-rate internet accounts pay high rates, up to about the official cash rate and have no minimum balance requirements. Most 295

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of them also require a separate linked transaction account, which is where they make their money. There are several specific accounts listed later in the chapter. 9

Cash management accounts (CMAs). Offered by most banks, CMAs have minimum balance requirements and many have interest rate ‘tiers’, meaning you don’t get the top interest rate on the whole balance. Most have cheque book access and many have access via ATMs or the internet.

9

Cash management trusts (CMTs). In contrast to CMAs, CMTs are not strictly guaranteed by the bank, but they are still managed by them. They generally consist of cash and bank bills that are very low risk, and pay slightly higher interest rates. Most have cheque book access but usually no access via ATMs or the internet.

The best place to start looking is your existing bank, building society or credit union. It is bound to offer a range of suitable products. I cover cash accounts in more detail in chapter 11 because you will need one to link to your online broker account so you can buy listed investments. Also look at the following websites for a full run-down on what’s available in the market: 9

Infochoice —

9

CANNEX — .

8.2 Cash accounts and online brokers for your investments When you set up your long-term investment funds (both outside super and inside your self managed super fund, if you have one) you will have a broker account to buy the listed investments like ETFs, LICs, LPTs and direct shares. This broker account will be linked to a cash account that is used to collect salary deductions, direct debits, dividends and other investment distributions. While you are waiting to make your next investment you will always have a small amount of cash sitting in this account. It is useful to have a bit of cash in an account like this so you can take advantage of any new opportunities when they come up. This is not money to be taken out and spent, or even used in an emergency. This is money to be used to build long-term wealth. If you are investing outside super and also running a self managed super fund, you need to make sure that the two sets of cash accounts, and broker accounts and investments are kept completely separate at all times. The broker accounts and cash accounts cost nothing to open and you can start the process today. Many can be started with as little as $1. 296

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How it works The cash account and the broker account go hand in hand. You set up salary deductions or direct debit from your bank account to put cash regularly into the cash account. Once you have enough money in the cash account you can start buying investments through the online broker account. When you log on to the broker account and buy shares in a company, or units in a trust or fund, the broker account will automatically take the amount of the purchase price plus brokerage out of the linked cash account three business days later and use it to buy the shares. At the end of the month the cash account statement will show that the balance has been reduced by the amount of the purchase, and the broker account will show the investment in the company or trust. It’s as simple as that — you don’t need to write cheques, fill in application forms, make phone calls or anything. Once the cash account and broker account are set up and linked together, you will be ready to start investing.

Salary deduction

Cash account

Online broker

Cash accounts There are several key features to look for when selecting cash accounts, whether you are using them for day-to-day banking, storing savings or emergency funds, or using them with an online broker account. Key features needed for the cash account are: 9

Pays high interest — preferably around the ‘official cash rate’. Most internet cash accounts pay more or less the same rates because the market is very competitive. The ‘official cash rate’ is the Reserve Bank’s ‘cash rate target’, see .

9

Pays the high rate of interest on the whole balance, calculated on the daily balance. Most modern internet cash accounts do this, but some of the old accounts offered by the big banks don’t, especially where they have interest rate for ‘tiers’ — for example, a low rate on the first, say, $5000, then a higher rate above this tier. 297

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9

No regular account keeping fees — that is, no annual fees, no monthly fees, no fees for making deposits and no fees for making withdrawals. Some of the cash accounts will have fees for making cheque or ATM withdrawals but this is okay because you aren’t going to order an ATM card or cheque book anyway. (Never spend the money!)

9

Free direct credit facility with no minimum direct credit amount. You need to be able to pay money automatically into the account — for example, automatic payments from your salary, dividends from company shares, distributions from property trusts and so on. Almost all cash accounts offered by Australian banks allow free direct credits inward.

9

No minimum deposit amount (after the account has been opened).

9

The ability to link the cash account with an online broker service. Most ‘at call’ accounts offered by banks can do this. There are several types of accounts that can’t link to broker accounts. These include passbook accounts, term deposits and cash managed funds. Also, many ‘internet saver’ accounts can’t be opened by themselves without also opening a linked transaction account.

9

Monthly statements ideally in paper form, but emailed statements are fine.

9

Low minimum opening balance — this is the minimum you will need to open the account in the first place. If you are starting from scratch, you need an account with a $1 opening balance. In practice, you would probably start with, say, $100 or $1000 just to kick it off. The more you can start with, the bigger the fund will grow. Most internet saver cash accounts have can be opened with just $1.

9

Low or no minimum ongoing balance — some accounts set a different ongoing balance from the opening balance. You will be making regular deposits to the account, but you are also going to be buying other investments with the money, so the minimum ongoing balance should be as low as possible — preferably no minimum. Even when the total investment fund reaches, say, $10 000, $20 000 or $100 000, it’s unlikely that much of that will be sitting in the cash account — most will be in other investments.

It’s very hard to find accounts that have all of these things.

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Cash accounts that can’t link directly to broker accounts The following are examples of internet saver accounts that may be ideal for your day-to-day cash needs, savings and emergency funds. However, they can’t link directly to online broker accounts: 9

AMP Bank’s Personal Easysaver —

9

BankWest’s TeleNet saver —

9

Citibank’s Citibank Plus —

9

Commonwealth Bank’s NetBank Saver —

9

HSBC Bank’s Serious Saver —

9

ING Bank’s Savings Maximiser —

9

National Australia Bank’s National iSaver —

9

St George’s DragonDirect Direct Saver —

9

Westpac’s Max-i-direct — .

These accounts all pay high interest rates on the whole balance at around the current cash rate and are great, but they aren’t ‘stand-alone’ accounts — this means that they can be opened only if they are linked to another bank account somewhere. Normally you would put your salary directly into these accounts and then do your day-to-day transacting out of the other transaction account that is linked to it.

Cash accounts that can link directly to broker accounts At the time of writing, only four high-rate cash accounts are stand-alone accounts, which means you can have them without having to have a separate transaction account as well. Check their current interest rates against the current cash rate on the RBA website. The following accounts can link directly to an online broker account and work with your investment plan: 9

Elders Rural Bank’s ERBonline Savings Account — no minimum balance requirements and pays a high rate on the whole balance, see .

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9

Citibank’s Online Cash Manager account — pays good interest rate on balances below $5000 and higher rates above this; has no minimum balance requirements, see .

9

St George Bank’s Power Saver or BankSA’s Power Saver. For customers in Australian Capital Territory, New South Wales, Northern Territory and South Australia it pays a good rate for balances under $5000 and high rates for more. For customers in Queensland, Tasmania and Western Australia it pays a high rate on all balances, see .

9

AMP Bank’s Cash Management Account — pays a good rate on balances below $20 000, then high rates above this. It has a minimum opening balance of $1000, but can drop below this after the account is opened, see .

9

HSBC Bank’s Online Savings Account — pays a good rate on the entire balance, but has a minimum opening balance of $2000. The balance can drop below this after the account is opened, see .

By ‘high rate’ I mean the rate is about 0.5 per cent below the cash rate. A ‘good rate’ means within about 1.5 per cent of the cash rate. Rates are always changing, so check the bank’s website and the RBAs website when selecting accounts. Also check the following websites for more cash accounts and latest rates: 9

CANNEX —

9

Infochoice — .

Accounts with a higher minimum opening balance If you have more cash to start the plan, some alternatives are available. Accounts with higher balance requirements also tend pay better rates of interest. All have cheque book access. 9

Adelaide Bank’s Cash Management Plus — has a minimum $5000 opening balance, but the balance can drop below $5000 once opened. Their Cash Management Trust pays a slightly higher rate, see .

9

Bank of Queensland’s Cash Management Account — has a minimum $5000 opening and ongoing balance, see .

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Invest outside super (part III): other asset classes

9

Macquarie Bank’s Cash Management Trust — has a minimum $5000 opening and ongoing balance, see .

Action plan 1

Decide what cash accounts you will need for different parts of your wealth plan.

2

Decide how much to put regularly into each account.

3

Look at your own bank’s website and see what high rate cash accounts it offers.

4

Make a short list of other accounts that may be suitable.

5

Set target dates for opening accounts and setting up salary deductions into the accounts.

Online brokers Online brokers are a very cheap and easy-to-use way of buying and selling shares on the ASX. These are ‘no advice’ services, which means they can’t advise you on what to buy or sell. If you want advice you need to go to a ‘full-service’ broker service, which costs extra money. (See chapter 11.)

What to look for in an online broker account Most of the major online stockbroker services offer plenty of features for long-term investors. Many services also have lots of fancy extras that are purely for short-term traders. Most also have lower brokerage rates for frequent traders, but what I have included in the following list are the brokerage rates for infrequent traders. The ‘tests’ to find a suitable online broker account are: 9

Low brokerage rates. The major online brokers charge between $20 and $30 for small transactions (generally under about $10 000 to $30 000 per parcel bought or sold).

9

No fees. Several of the brokers offer two or three different levels of service. For people who want more features (mainly designed for short-term traders) there is usually a monthly fee or annual fee. You need the basic services with no regular fees (apart from the brokerage fee per trade).

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9

Basic information for transactions. You need to know things like the current price (some services offer only delayed prices with the basic service), market depth, order status, online contract notes and share price charts.

9

Research database. Most online brokers have access to a great deal of information about listed companies — for example, 10 years of balance sheet data, profit and loss statements, per share information, dividend histories and announcements. These are essential if and when you start looking at individual listed companies.

9

CHESS sponsorship. In the old days shareholders used to get a share certificate when they bought shares. Now you just get a CHESS (Clearing House Electronic Subregister System) Holding Statement saying that you own shares in the company. There will be a CHESS application form as part of the paperwork to open the broker account.

9

Phone orders. All online broker services have call centres and staff who can answer questions and take phone orders in addition to the internet orders. The brokerage for phone orders is higher than for internet orders — usually about $60 per phone order. New investors can make their first orders over the phone because one of the staff can them help out. But most people find very quickly that using the internet is much more convenient — you can see other buyers and sellers in the market right there on your screen, you can see your order being processed and executed in the market, and you can get a contract note almost instantly.

9

Access to international stock exchanges. This will be useful later on if you want to buy US-listed exchange-traded funds of international stock indices (see chapter 6).

9

Margin lending. This is useful if you want to go down this path later on (see chapter 6). You can’t use this in your self managed super fund.

Online brokers that work with the plan Some online brokers only link to their own in-house cash account. In some cases this is a good account that pays good interest, but in others it’s not. Some brokers can link to other cash accounts outside their group, including the following: 9

St George Bank’s Direct Shares — or phone 1300 133 500. Brokerage is $27.95 per trade up to $25 000, which is lower than most

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brokers. Can only link to cash accounts offered by St George Bank or BankSA. There are two good cash accounts: (

St George’s Power Saver pays a high rate in Queensland, Tasmania and Western Australia, and a low rate in Australian Capital Territory, Northern Territory, New South Wales and Victoria.

(

BankSA’s Power Saver pays a good rate in all states. The rate is a little on the low side but still workable. Does not link to St George’s DragonDirect Direct Saver Account, which is otherwise a good cash account.

9

Andrew West Online — or phone 1300 360 071. Brokerage is $29.95 for trades under $30 000, then 0.11 per cent of the value of larger trades. The in-house cash account (which is a Money Market account run by BankWest) pays a moderate interest rate for balances under $10 000, which is okay, and good rate on balances over $10 000. The beauty of this option is that the combination is opened all at once. The broker organises the cash account and the link is done automatically on the same day. This is the simplest solution with the least paperwork. Based in Sydney and has offices in Melbourne and Gold Coast.

9

CommSec (Commonwealth Bank) — or phone 13 15 19. This is the largest and most popular online broker service in Australia. Brokerage is $19.95 per trade for trades up to $10 000 if it is linked to its CommBank Direct Investment Accounts (CDIA), which pays no interest on cash balances under $5000. For the cash account link-up there are three things you could do: (

use the CDIA cash account and get $19.95 brokerage but no interest on the first $5000 cash balance in the CDIA

(

use the CDIA cash account and get $19.95 brokerage but no interest on the fi rst $5000 cash balance in the CDIA, plus set up an additional high-rate internet cash account from another bank (for example, ING, Citibank, ERB, AMP bank or HSBC bank), then manually transfer money between the two cash accounts when you need to buy shares

(

don’t use the CDIA, instead open a high-rate internet cash account and link it directly with the CommSec broker account. Because you are not using the CDIA account, the

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rate is higher ($29.95 per trade up to $10 000), but you get better interest on all your cash funds. 9

9

Morrison Securities — or phone (02) 9033 8383. There are two options: (

brokerage is $22 for all trades if you use the in-house cash account (which is run by Westpac), but this pays no interest and has minimum opening balance of $1000

(

brokerage is $30 for all trades if you link to either a Macquarie Bank CMT or Adelaide Bank CMT. These pay good interest rates but have minimum opening balances of $5000.

Westpac Broking — or phone 13 13 31. Brokerage is $24.95 per trade for trades up to $25 000 if the linked cash account is either a: (

Westpac CMA Investor Option Account (which also pays nil interest on balances under $5000). This account has a minimum opening balance of $5000. It also has a monthly fee of $4 if the balance drops below $10 000 for even one day each month, plus a page of other fees and charges. This is a poor account for your needs.

(

Westpac Max-i-Direct. This is a great account, but you can’t use it by itself. You need to open an additional transaction account.

It’s possible to link another cash account from another bank, but the brokerage rate is higher — $29.95 per trade up to $25 000. 9

Suncorp Broking — or phone 1300 135 190. There are two options: (

Brokerage is $23.95 for trades up to $15 000 if linked to a Suncorp cash account. The Everyday Saver has a $5 monthly fee, or you can link to the Everyday Options Subaccount, which pays a good rate, but you have to also open an Everyday Saver account, which has the $5 per month fee.

(

Can also link to a non-Suncorp cash account, but the brokerage rate is higher — $28.95 per trade up to $15 000.

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Broker accounts that aren’t ideal for the plan There are several other online broker services available in Australia. However, they are either too expensive for the plan or have poor cash accounts and can’t link to better ones: 9

E*Trade (ANZ) — or phone 1300 658 355. Brokerage is too expensive ($32.95 for trades under $30 000 if making less than 10 trades per month) and can only link to an in-house ANZ cash account, which pays only 2 per cent on balances less than $5000. There also needs to be a second cash account (can be from any bank) and transfer money across the night before — messy.

9

National Online Trading (NAB) — or phone 13 13 80. NAB’s broker services mainly target frequent traders, not long-term investors. If there are fewer than two transactions per month there is a fee of $9.95, and there is no access to important features like charts and market depth. Brokerage is $29.95 per trade for trades up to around $27 000. There are frequent trader discounts, which are of no use to long-term investors. Can only link to NAB accounts, but there are no ideal accounts. The ‘National iSaver’ account is good, but can only operate if combined with a separate transaction account.

9

Macquarie DirecTrade — or phone 1300 657 619. Brokerage is too expensive ($39.95 for trades under $25 000) for non-traders. Can only link to Macquarie CMT, which pays good interest on the whole cash balance.

9

Sanford Securities — or phone 1300 360 892. Sanford Securities is one of the oldest and most experienced operators in the market. It offers three different levels of service. The ‘casual’ level has no monthly fees and is fairly limited, but offers most things needed for long-term investors. Brokerage is $29.95 per trade for trades up to $10 000 if there is less than $5000 in the cash account, and $19.95 if there is more than $5000 in the cash account. Only links to its in-house BankWest cash account — but it pays just 2.5 per cent for balances under $5000, then higher rates above that.

9

E-Shares (Grandbridge) — or phone 1300 135 189. This service is run by the same firm that runs Sanford’s broking service. Services are exactly the same, but the brokerage is slightly lower.

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9

HSBC Stockbroking — or phone 1300 308 938. Brokerage is $29.95 per trade for trades up to $10 000. The cash account must link to its internal online savings account, which pays only 0.5 per cent for cash balances under $2000 — too low.

9

Goldman Sachs JBWere — or phone 1300 366 566. Really a cross between a discount broker and a full-service broker. Minimum brokerage is $75.

Opening the online broker account If you are going for a broker using their in-house cash account, you can usually open them together and the broker will organise the link-up between the two accounts automatically. Otherwise you can open the cash account first and then set up a broker account. On the broker account forms you nominate the cash account used for settling trades. Download the application form from the broker’s website or phone its call centre for a new accounts pack. The application form will include a section for CHESS sponsorship. Make sure you ring the call centre and ask any questions before opening the accounts.

Action plan 1

Take a look at the online broker services offered by your bank.

2

Research others that may be suitable.

3

Ask friends and family which online brokers they use and whether they would recommend them.

8.3 Other investments This strategy to build wealth for life is based on building long-term investments (both inside and outside your super fund) with growth assets — primarily shares and property. I have looked at the various ways of doing this. In addition, there are a number of other types of investment that you will come across. They are often called ‘alternative asset classes’. Every couple of years fund managers announce that that they have ‘discovered’ a new asset class that has suddenly become an ‘essential’ part of every portfolio. They haven’t — it’s just another way for them to get their hands on your money. There have only ever been four asset classes — shares, property, bonds and cash. It’s never going to change. All the other so-called alternative assets are 306

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made up of different combinations and permutations of these. Stick to the basics and you will build wealth.

Hedge funds The term ‘hedge’ means the same as ‘protect’ as in ‘to hedge your bets’ or ‘to hedge your losses’. The idea took off in the 1950s and 1960s in the US, as a way of protecting investors against losses in the stock markets.

Long and short Most traditional share funds — including those run by fund managers and even by you — buy shares and hold them. When you buy something it’s called ‘going long’. We all run ‘long’ funds because we own shares and we make money when share prices go up. In the 1950s a few fund managers started funds that not only bought shares (went ‘long’), but they also sold shares that they didn’t own in the first place (called going ‘short’). They did this by borrowing shares from someone who did own the shares and then selling those borrowed shares to a third party. If the share price went up, the fund manager would make a loss on those ‘short’ positions because they would have to buy back the shares on the market to repay the loan at a higher price than they sold them for in the first place. But if the share price fell, the fund manager could buy shares back at a lower price and make a profit. Funds that do this are called ‘long–short’ funds or ‘absolute return’ funds because they aim to make money in rising and falling markets. They tend to be popular in bad years for the stock markets because they aim to still make a modest return. They tend to go out of fashion in good markets (like we are in at the time of writing) because investors are too busy making money from their ‘long’ share positions. In practice, the performance of these ‘long–short’ funds has been mixed. In rising markets the returns are not as high as traditional ‘long’ share funds, but in falling markets the losses are also not as bad.

Flavour of the month That was how the whole hedge fund movement started. These days it’s much more complex. Basically, any fund that is not a traditional ‘long’ fund is labelled a hedge fund. It’s anybody’s guess as to what they’re really doing with your money — commodities, currencies, complex credit derivatives, takeovers, arbitrage positions, private equity buyouts, anything and everything. Many have extremely complex structures and borrow billions of dollars to leverage their positions. They 307

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use ‘rocket scientists’ with PhDs in maths and finance to build complex computer programs to run their investments. These days, running a hedge fund is an open ticket to operate in any market at any time, using any method and any amount of debt. It’s ironic that the term ‘hedge’ fund is now the complete opposite of the idea of ‘safety’. There are around 10 000 hedge funds in the world and they look after around $2 trillion. Many of them don’t last long. Each year around 2000 new hedge funds are launched globally, but over 800 of these go out of business in their first year. In Australia there are about 130 hedge funds managing around $60 billion. About two-thirds of this is from individual investors (mums and dads), with the rest coming from institutional managed funds and super funds. While the good times roll nobody cares that they can’t understand hedge funds because everybody is making money. But when things go wrong they can be disastrous. Even Nobel prize winners and PhD holders can lose billions if they don’t fully understand the risks. For example, one of the most famous hedge funds was Long Term Capital Management (no, it wasn’t a joke, that was its real name!). It lasted only four years — that’s what hedge fund managers call ‘long term’! It was founded and run by two Nobel prize winners in finance and employed dozens of people with PhDs, but it still lost $4 billion when it collapsed in 1998. At the time of writing, there is a string of hedge funds in the process of losing billions in the fallout from the ‘subprime’ credit derivatives crisis. The problem started with two US hedge funds called, ironically, High Grade Structured Credit Strategies Fund and High Grade Structured Credit Strategies Enhanced Leveraged Fund. ‘High Grade’ indeed! The rot spread around the world and several Australian funds were caught up, including some with safe-sounding names like Basis Capital, Absolute Capital, Federation and Fortress. It seems the safer the name sounds, the higher the risk of failure. Many of these funds had very high credit ratings from global rating agencies like Standard & Poor’s and Moody’s (some had ‘AAA’ ratings, which is the same credit rating as Australian Government bonds!). You can’t trust credit ratings — rely only on common sense. Hedge funds are very high risk and you should generally stay well away from them.

Performance The problems are similar to the problems in reading any fund manager returns — except that hedge funds tend to have a much higher failure rate. Published performance figures are purely voluntary, so you’re never quite sure whether the fund manager is telling the truth. On the whole, hedge funds generally underperform the stock market indices around the world over the longer term. Hedge funds also tend to have relatively high fees and commissions. Most have a complex fee structure including a straight annual fee of around 2 per cent of the size of the fund plus a performance fee of about 20 per cent of the profits over and above a particular level. 308

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Another issue is taxation. Many hedge funds don’t have the tax advantages of a traditional ‘long’ share fund like franking credits, and perhaps tax-deferred and tax-exempt distributions. In many cases, their cash distributions are in the form of normal taxable income with no tax breaks. In some funds you are liable for capital gains tax even on unrealised gains.

You already have some Most Australians would already have some exposure to hedge funds via their super funds, as most of the large super funds put an average of around 3 per cent or 4 per cent of their overall funds into hedge funds. That’s probably enough for most people. A good exercise would be to try to find out how much hedge fund exposure you already have in your existing super fund. Once you have discovered that, then you can decide whether you want more.

Private equity funds Hedge funds have gone out of fashion over the past couple of years and now private equity funds are the ‘new black’. Private equity funds are managed funds that generally aim to buy businesses — often listed companies — work on them for a couple of years, strip costs out, maybe split them up or add other businesses to them, then sell or refloat them again for a profit. They are basically a 21st-century version of the ‘greed is good’ leveraged buyout (LBO) firms of the 1980s. Everything’s fine while the stock market is going up and interest rates are low, but when the music stops the whole thing collapses under the weight of debt. While the market’s running hot there are more and more new private equity firms hitting the streets, each with a bag full of money to spend. This increased competition is pushing up prices of companies (and the overall stock market) way beyond sensible levels. At the time of writing this market is still expanding and prices are still going up, but by the time you read this the market may have already collapsed and everybody has started talking about the new, new black — whatever that may be.

Pot luck Trying to understand private equity firms is very difficult because they are private and don’t have the public disclosure requirements of listed companies and funds. What we do know is that they rely on debt for their own funding and for the funding of their takeovers. Picking private equity funds is a bit like picking active managed funds — you never know who is managing your money from one year to the next so you can’t go by return figures.

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The bottom line on private equity funds for your wealth plan is this — if you don’t have a self managed super fund, your existing super fund probably has a couple of per cent of your funds invested in private equity already, and that’s enough. On the other hand, if you don’t have any exposure then you may want to put a couple of per cent of your investments into one or more private equity funds. Think of it as a pure ‘punt’.

8.4 Derivatives and trading Originally, I was not even going to mention derivatives or trading in this book because they have nothing to do with investing. Big institutional investors (fund managers and super funds) do use derivatives sometimes for arbitrage and hedging of long-term positions, but for individual investors the emphasis is always on short-term trading, which is very different. I have included this topic because it is so easy for small investors to get lured into derivatives and trading by slick marketing, unrealistic promises and straight-out fraud. Open any magazine about finance and money, and it will be full of advertisements for trading systems and online brokers promoting things called options, covered calls, warrants, CFDs and futures. Even respected publications include regular stories and case studies like ‘A week in the life of …’ a trader. These may be real case studies but they are carefully hand-picked. They only pick the good weeks, and the traders’ stories are supplied by the trading firms or brokers who sponsor the magazines. It’s purely a sell job. There are some very successful traders in Australia, but for every successful trader there are probably about 100 novices who fail. Having said that, it is possible to generate regular income from trading but, like any other new business venture, it has an extremely high risk of failure and requires years of training, trial and error, and refining. Before getting into how this can be done, trading needs to be put into perspective. Trading is not investing: 9

Trading involves buying things for short periods of time — a few minutes up to perhaps a few weeks at the most. On the other hand, investing involves buying things with the aim of never selling them, or perhaps selling in 10 or 20 years.

9

Trading profits are taxable as normal income and franking credits can’t be claimed on any dividends received (unless you hold the shares for 45 days). Investing provides tax breaks on income, tax-free unrealised gains and tax discounts if you hold for more than one year.

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9

Trading takes a lot of time — time to learn and refine your method. Long-term investment plans using shares and property (inside your super fund and outside it) take almost no time at all. You set up the salary sacrifice agreement into super and salary deductions into your fund outside super, and then two or three times a year you invest in simple, low-cost, tax-effective investments and that’s it.

9

Trading is generally expensive, because of transaction costs and interest on margin accounts. Most of the examples of ‘real results’ in the ads are before transaction costs, interest and taxes. Investing is very cheap — about 0.1 per cent brokerage up-front then nothing until you sell, which may be never.

9

Trading can provide income, but it doesn’t necessarily build wealth because when you stop trading the income stops. When you take a week, a month or a year off to travel, the trading income ceases. Trading can only add to wealth if you regularly take some money off the table from trading profits and put it into long-term investments. This is a lot easier than it sounds. You need to have the discipline to take money off the table out of your winnings, and not succumb to the temptation to plough winnings back into more trading.

Trading is never a substitute for long-term investing. At best it might be a bit of supplementary income on top of the income from your investments. When you ‘invest’ you are buying shares or properties because you believe that over the long term value will go up. It may not go up steadily each year and it may go backwards a couple of years along the way, but it doesn’t really matter because you are in it for the long term. With trading you have to pick three things correctly to have a ‘win’: 1

direction (whether the price is going to go up, down or stay flat)

2

quantum (how much it is going to go up or down, or the range within which it is going to stay flat)

3

timing (when it is going to do this).

The probability of getting all three things right is very small, but that’s what you are trying to do with trading. The art and science of getting these three things right consistently and without going broke in the meantime, is what trading is all about.

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What you can trade You can trade all sorts of things. They fall into two classes: 1

physical things — like shares, currencies, commodities (for example, oil, gold, even ‘pork bellies’, which you hear about in the movies)

2

derivatives — these are synthetic instruments based on the price of underlying physical things. Derivatives include options, contracts for difference (CFDs), warrants and futures. Derivatives are generally favoured by traders because they can put a small deposit down and control a large stake. For example, with an option, CFD or futures contract you can control 1000 shares in BHP (worth $30 000 assuming a $30 share price) by putting down just a few hundred dollars. Because of this gearing, wins and losses are much more magnified than if you put up whole $30 000 to trade 1000 actual BHP shares. You can lose thousands of dollars — much more than the few hundred you put up.

Trading method The actual item you are trading is not the most important thing. Of course, it’s important to understand the forces driving the market for the particular item you are trading, but what’s of critical importance is your trading method. Every successful trader I have ever met, read about or heard about developed their own method. It inevitably took years of trial and error to refine and perfect their method. I use the word trading ‘method’ instead of ‘system’ because ‘system’ focuses too much on technology. Most trading methods use technology to crunch the numbers but the most important factors are not the technology. The most important factors are the rules and disciplines in the method, and these have nothing to do with technology.

Roulette versus blackjack Most people think trading is like roulette — with a small amount of money you can have big wins. You can buy a CFD or option contract over BHP shares one day and, if the BHP share price moves just 1 per cent in a day, the value of your CFD or option contract might double or triple. You can win big money in a short time. These are the examples you read about in the trading ads in newspapers, magazines and brochures, and hear about at seminars. Good trading methods are the exact opposite of this. They are more like blackjack than roulette. In blackjack it is impossible to win big or lose big in a short period of time because you make tiny 312

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bets each time, and because the upside and downside are very small each time. It takes a several hours to turn a $100 stake into $200, or several hours to lose it altogether. You learn the rules and make dozens or hundreds of small bets and just follow the rules. It’s routine, repetitive and even boring. The odds are stacked slightly against you, but sometimes you end up winning. Trading is much the same. It’s a zero-sum game, which means that for everybody who wins $1 there is somebody else in the game who loses $1. On top of that, both parties have transaction costs like fees, brokerage and interest. Probably only 10 per cent of traders make money, the other 90 per cent lose, give up and go away, only to be replaced by the next batch of newcomers a few months later. There is no such thing as ‘easy money’ from doing things like ‘covered calls’ or ‘buy-write’ strategies. They are often marketed as ways to make ‘easy’ extra money from your existing shares, by writing out-of-the-money call options against your existing shares. The danger is that people write calls over the shares in their long-term funds, and over the long-term end up losing the shares that show the most growth. These are the very shares you need to hold onto to build your long-term wealth.

Developing your method To be a trader you need to develop two things: 1

a method for deciding what positions to take and when to take them

2

a method for putting these decisions into action.

Most people only focus on the first aspect. This is the one that says, ‘How do I know that BHP is going to go up by more than 50 cents by next Tuesday?’, or that gold is going to stay in a $10 trading range for the next three days and so on. Developing this method involves crunching lots of numbers, looking at patterns and reading charts. Many traders spend decades searching for the ‘Holy Grail’. Nobody has ever found it. Success comes from doing the small things well and sticking religiously to your rules. Coming up with this first aspect is hard enough, but it’s not the most important part. The critical parts are the rules and disciplines you put into place to ensure that you don’t get wiped out by a few losses in a row, and that you stay in the game long enough to make money. These rules govern things like: 9

how much to trade each time (for example, 1 per cent or 2 per cent of your available trading funds at the most) 313

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9

when, how and how much to sell to take profits

9

when, how and how much to sell to cut losses

9

when, how and how much to add to existing positions

9

how to modify your trading after making a loss (for example, most people try to ‘double up’ to get back on track, but you should do the reverse — take a break or bet half the amount).

There are dozens of rules like this that you need to develop and refine. They’re all about money management and psychology, and they are even more important than developing your method for selecting your actual trading positions. If you are going to trade, here are some further rules to follow: 9

only do it after your long-term wealth plans are already set up and working

9

‘paper trade’ (practice without using real money) for at least six months before starting — and don’t fudge the results!

9

only use a small amount to trade — for example, restrict your trading fund to, say, 5 per cent of the value of your long-term investment fund. Within this you should then restrict each trading position to, say, 1 per cent or 2 per cent of the trading fund

9

remove all emotion from your decisions — be completely dispassionate, never trade for excitement or thrills, never trade angry or to get back and so on

9

never put up any of your long-term investment assets as security for your trading margin account and never write calls or puts against your long-term shares

9

never buy a ‘trading system’ — this includes those sold at seminars, via direct mail or from anybody else

9

never let somebody else make your decisions for you, even if they are licensed securities dealers. If they were any good they would be doing it for themselves, not working at a stockbroking firm.

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8.5 Further reading Edwards, RD & Magee, J, Technical Analysis of Stock Trends, 9th edition, Auerbach, 2007. This is the original and best reference book used by professional traders everywhere. McMillan, LG, Options as a Strategic Investment, 4th edition, Prentice Hall Press, 2001. Good coverage of the technical rules. Pring, MJ, Martin Pring on Price Patterns, McGraw-Hill, 2004. Good coverage of the technical rules. Schwager, J, Market Wizards: Interviews with Top Traders, Marketplace Books, 2006. Any of the ‘Market Wizards’ series provide a good introduction to the various methods, rules and psychological factors. Any of the books by Daryl Guppy are also useful — providing practical examples in the Australian market.

8.6 Key points 9

Cash and bonds (fixed interest) are income products and don’t generate capital growth.

9

Cash and bonds can be used to finance short and medium cash needs.

9

Don’t chase high income yields by taking risks — the money has to be there when you need it.

9

Cash accounts will be used to play several roles in your wealth plan. There are a number of good cash accounts that you can use for your day-to-day banking, savings and emergency funds.

9

Stick to cash accounts run by licensed banks — this is no time to take risks and chase high yields.

9

Most cash accounts can be opened online for as little as $1 and for no cost. You can also set up the salary deductions easily and for no cost.

9

If you are going to invest in ASX-listed shares for you long-term growth investments, you can do so by using low-cost online broker services. 315

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9

You can do this for your investments outside super, and also for your self managed super fund it you run one. The two accounts must be kept separate at all times.

9

There are several low-cost online broker accounts that are ideal for long-term investors. Many can be opened with a deposit as little as $1 and cost nothing to set up, so you can get started straightaway.

9

For most people, ‘alternative investments’, like commodities, currencies, hedge funds, private equity funds, are just overkill.

9

Stick to the basics and don’t get diverted into the flavour-of-the-month investment fashions.

9

If you are in a super fund you don’t run yourself, you probably already have some exposure to alternative investments via your existing super fund, which is more than enough.

9

Trading is not investing and is never a substitute for investing.

9

Only get involved in trading after you are well on the way to building wealth by using longterm investments.

9

Never buy a trading ‘system’ or let anybody else make decisions for you. The only way to succeed is to develop your own method that you know and trust intimately.

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Protection House

Chapter 9

Step 5 — protection in case things go wrong

Money sense

9.1 Don’t rely on luck The plan to grow $1 million to live off for the rest of your life does not rely on luck, so don’t let bad luck ruin your plan. All it takes is one incident to partially or completely ruin your plan, and adversely affect your income and lifestyle. Your finances could be put back years and it could take a long time to get back on track. Therefore, it’s important to put a range of mechanisms in place to protect your investment plans and your lifestyle. When I was about 15 or 16 I learned to drive in Hobart, which is one of the hilliest and wettest cities on the planet. I got plenty of practice doing hill starts on steep slippery streets using a manual gearbox Mini Minor. Since then, wherever I am driving in the world, when I park a car at a curb, in addition to leaving the car in gear and putting on the handbrake (which would be normal for most people), I automatically turn the wheels into the curb if the car faces downhill and away from the curb when facing uphill. Even if the street is perfectly level. I don’t even realise I’m doing it — it’s a reflex action. There is probably only a one-in-a-million chance that the car would roll away with these three levels of protection in place — the handbrake, the gearbox and 317

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the curb. So why do it? No logical reason based on statistical probabilities, just habit drummed in from those early days 30 years ago in Hobart.

One-in-a-million chance Most of the protection measures in this chapter are simply good habits to get into. The chances of everything going wrong at once may be a million to one, but for some things it’s just not worth the risk. If we were talking about protecting a lottery win, then perhaps it would not be worth protecting. Easy come, easy go. But we are not talking about a lottery win here. We are talking about your family’s future lifestyle. You have worked hard for it over several years and it may be jeopardised by a whole range of things. It may be a one-in-a-million chance, but if you happen to be that one in a million, you will be kicking yourself that you didn’t do something simple to protect yourselves. You may not think that protection is necessary or desirable. You may want to live life on the edge — what happens, happens. If you live by yourself and have no dependents, then that is your decision to make. On the other hand, if you have a family and other people who rely on you, you need to think of their futures too.

9.2 Emergency cash fund So far I have talked about: 9

investing — putting money away to build wealth for the long term, primarily investing in growth assets like shares and property

9

saving — putting money away for specific needs like upgrading your car in two years, going on a holiday in six months, or a house deposit in three years. For these things you would use cash and fixed-interest products matched to the term of the specific savings goal

9

spending — using money in your cash account from your salary, business or investment income.

In addition to these needs you should also have an ‘emergency’ cash fund to be able to pay for unexpected expenses. I’m not talking about regular bills and expenses. These should be paid out of your normal cash reserves. 318

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What I’m talking about are things that aren’t planned — for example, car repairs, appliances that need repairing or replacing, unusually high medical bills not covered by insurance and temporary loss of income. I will cover insurance to protect against loss of income later in the chapter, but there is usually a waiting period before the payments kick in.

How much? One exercise you can do is estimate how long it would take to find new employment if you lost your job or your regular income. Then double it because everything takes longer than you expect. After that take your weekly or monthly budget and work out your total living expenses during that period. Don’t forget to include the mortgage or rent, and all the annual bills, including house insurance, car insurance and registration, and so on. Also allow for one-off items, like essential repairs and maintenance, and for things like new appliances, which inevitably occur every few months. If you have total living expenses of $35 000 per year and you estimate that if you lost your income you might be out of work for three to four months, you should aim for an emergency cash fund of around $10 000.

When to do it? The top priority is always to use whatever spare cash you have to get rid of all personal debts, but after that is taken care of, you can start building up your emergency cash fund so you can handle the occasional emergency without having to get back in debt.

Where to ‘invest’ it I only use the term ‘invest’ when I am talking about long-term growth investments, so I don’t regard the emergency fund as an ‘investment’. It’s there as protection in case you need it for your normal living expenses. You need to be able to access it at short notice and you are not trying to chase high-interest yields here.

Internet cash accounts There are a dozen or more internet cash accounts that pay high interest, require no minimum balance and have no fees. They don’t have a cheque book attached, but they can be accessed online 319

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(for transfers to other accounts or BPAY) and via ATM and debit card terminals. They link to your transaction account so you can transfer money to and from the internet cash account when you need it. One common technique is to pay your salary directly into the high-rate internet account and then transfer enough money to your transaction account when you need it. Increasingly, bills and other expenses can be paid by BPAY, internet transfers or card, so there is not much use of cheques these days, which means you don’t really need a transaction account with a cheque book. But here’s the catch. Nearly all of these high-rate internet accounts must be linked to another bank account somewhere. They cannot operate by themselves. It’s in the transaction account where the bank catches you with fees.

Separate accounts? If you are using a high-rate internet account for your day-to-day expenses, the best plan is to have a separate cash account specifically for your emergency funds. These accounts cost nothing to set up and the process is very simple. And you can elect not to get an ATM card to access it. That way you are not tempted to use the cash if you don’t really need it.

Bank term deposits Another option is to use short-term bank term deposits — for example, 30 days. You would get very similar interest rates to the cash accounts, but at least it’s tied up and out of the way. You can’t access term deposits online or via an ATM, so you won’t be able to get at it even if you had a lapse in discipline and went on a wild spending spree. This is also a good solution if you are one half of a couple and the other half doesn’t have the same discipline as you. See chapter 8 for specific accounts to use for your emergency cash fund.

Action plan 1

Estimate how much you need in your emergency cash fund.

9.3 Insurances Nothing in life ever goes according to plan. You can use insurance to make sure your wealth plans are not destroyed or set back when things go wrong. 320

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Life assurance and total and permanent disablement insurance Life assurance and total and permanent disablement (TPD) insurance go hand in hand as they are usually sold as a package, so I will look at them together. When we moved from Melbourne to Sydney in the mid 1990s we sold our house to a family — mum, dad and a couple of kids. The husband and wife signed their side of the contract as purchasers, and my wife and I signed our side as the vendors. Once the contracts were exchanged, they became binding and my wife and I then exchanged contracts on a house we wanted to buy in Sydney, and we paid a deposit. A couple of weeks later we heard through our solicitor that the purchasers of the Melbourne house wanted to pull out because the husband had died. Under the terms of the contract, the vendor (the seller — that is, us) had a right to cancel the contract if one of the vendors died, but the purchasers did not have the right to cancel if one of the purchasers died. We were not in a position to help out the wife by cancelling the contract on the Melbourne house and then trying to sell the house again to somebody else because we needed the cash from the sale in Melbourne. We were on a deadline and had to settle on our Sydney purchase in a few weeks. If we missed that deadline we would lose our deposit on the house in Sydney and we could be sued by the vendors. The problem for the wife in Melbourne was that her husband had no life cover. Without her husband’s income, their bank wouldn’t go ahead with the mortgage to buy the house and she would lose the 10 per cent deposit they had already paid. Even if the bank did lend her the money, she would not have had her husband’s income needed to make the mortgage repayments. We did what we could to delay settlement, but the only way out was for the wife to borrow from her family to settle on the purchase, then immediately sell the house again and find a much smaller place for her and the kids. This was the best outcome for her but was still very expensive because she had to pay the costs of selling the house and buying the much smaller place, plus the hassle of moving twice in a couple of months. If the husband had a good term-life policy, the payout would have provided the cash to pay the balance of the purchase price on the house. This would have allowed her and the kids to live mortgage free in the house they wanted. A good life policy would also have provided enough additional cash to allow her and the kids to live comfortably. TPD offers cover in the event of the total and permanent disablement of the insured due to injury. The definitions differ from policy to policy, so it is worth checking the fine print.

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Who should get cover? Every household that has a mortgage or other debts, or doesn’t have enough investments to cover current and future living expenses should look at term life and TPD cover, at least for the primary breadwinner. Small business operators are particularly vulnerable because many have no super either, and many have no ‘hard’ assets (like business property) in the business.

How much cover? To be properly covered the amount should pay out the mortgage and other personal debts, plus enough to generate investment income to pay living expenses. For example, if a family has a mortgage of $200 000 and living expenses (excluding mortgage payments) of $2000 per month, the amount of cover might be:

$200 000 + ($2000 per month × 12 months) ÷ 5 per cent = $200 000 + $24 000 ÷ 5 per cent = $200 000 + $480 000 = $680 000 Any amount in their super funds or other investments could be regarded as an added bonus, or alternatively they could be deducted from the amount of cover obtained, which will lower the cost of premiums. The amount of cover would allow the family to live in the same house and continue with the same level of living expenses as if the breadwinner was still alive. When the payout is invested in a mix of property, shares, bonds and cash, the capital would generate investment income to live off and also grow to at least keep pace with inflation, allowing the investment income to rise each year as well.

Life inside super funds Before buying term life or TPD cover, check what cover you already have in your super fund. Most corporate, industry and even retail super funds offer various types of insurance cover. Contributions to super funds to pay for term life premiums are tax-deductible for the selfemployed and employers, but premiums for term life outside super are not deductible. Having life cover through super also makes sense if you have dependents, as they can receive lump sums tax free upon death of the member.

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Life outside super funds If you run your own self managed super fund, or if the cover offered through your super fund is inadequate or not flexible enough for your needs, you can look outside and buy direct from insurance companies, which is more expensive than through super funds. Annual premium for term life cover outside super funds is around $500 for $500 000 cover for a 40-year-old non-smoker. Premiums are not tax deductible. Most of the major life offices offer a range of policies including term life, TPD, trauma and income protection. Some of the major ones are AIG, AMP, Asteron, Aviva, AXA, Comminsure, ING, Lumley, MetLife, MLC, Suncorp, Tower Life and Zurich. You can get quotes from a range of insurers at the following free websites: 9

Lifebroker —

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xLife —

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Artog —

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Life Insurance Australia —

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eChoice — .

Trauma cover A trauma policy provides a tax-free lump sum payout if the insured is diagnosed with one of a defined list of medical conditions specified in the policy. The list is different in each policy, but they generally cover things like heart attack, cancers, stroke, lung diseases, quadriplegia and organ transplant. With improvements in medical treatments in recent years, a greater percentage of people now survive and recover from cancers and heart attacks. Trauma insurance can be very useful to cover the high cost of treatment and care during this period after diagnosis, whereas life cover only pays out if and when the person dies. Despite this increasing need for trauma cover, its popularity is declining in Australia, with probably only a couple of per cent of the population covered.

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Income protection This is also known as ‘income replacement’ insurance. It provides a monthly income stream of 75 per cent of your normal working income in the event of loss of income. There is usually a waiting period from the time of injury to the time the payments start. The benefits are paid for a period of either two years, five years or up age 65, depending on each policy. The benefits stop being paid when you are able to return to work. The annual premiums are tax deductible but the benefits paid under the policy are then also taxable as income. The cost of cover can vary greatly depending on factors like the length of the waiting period, length of the benefit period, whether you are a smoker or non-smoker, your age and health.

Health insurance There are two health systems in Australia — public and private. Some people are philosophically opposed to private health. Personally, when the chips are down and I need an operation or urgent medical attention, I will want the best help there is, and quickly. The doctors, nurses and other staff in the public system do a great job, but they are always operating under tremendous pressures because of limited government funding. Before Medicare was introduced in Australia in 1984 over 60 per cent of people were covered by private health insurance. The level of private cover is now down to around 40 per cent, and the public system is creaking under the strain. Private health also covers a number of areas not covered by the public system, including optical, dental, chiropractic and physiotherapy. The people with the biggest medical claims are the elderly, and the system is designed so the young and healthy subsidise the elderly because there is simply no way the elderly could afford their own medical expenses. Bear in mind that 80 per cent of all people over 65 earn less than $20 000 per year. The public medical costs (which are mostly spent on the elderly) are funded by the income tax system. All taxpayers earning over about $30 000 pay a 1.5 per cent Medicare tax on top of their normal income tax. Retirees on the government age pension fall below this threshold and private pensions from super funds after age 60 are also exempt from tax and the Medicare levy. The private medical costs of the elderly are funded mainly by premiums paid by private health insurance members of working age.

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Is private health insurance worth it? Many people see private health insurance as not being good value because they are really subsidising the elderly. This is probably not the right way to look at it. It is better to view it as insurance for our old age, because when we are old we will be relying on most of our medical costs being funded by premiums paid by the younger members of our fund. There are a couple of incentives that the government has introduced to induce us to take out private cover: 9

Taxpayers earning over $50 000 also pay an additional Medicare levy surcharge of 1 per cent tax on their income if they don’t have private health cover.

9

There is a ‘lifetime health cover’ penalty that adds a 2 per cent penalty to the premium for every year you are over 31 when you first take out private cover. So, if you put off joining until you are 40, you will pay a penalty of 16 per cent on top of your premiums. This 16 per cent premium penalty will stay with you for all subsequent years. It pays to start taking out private health insurance when you are young. Private health premiums often rise at well above the inflation rate each year. So, once you add the additional 2 per cent penalty each year, the actual cost will often rise by up to 10 per cent each year you put it off.

9

There is also a 30 per cent tax offset (rebate) for private health insurance premiums each year. In practice, when you get a quote for a private insurance premium, the 30 per cent tax offset is usually already taken out.

The impact of the Medicare levy surcharge and the 30 per cent tax offset means that for many people it is actually cheaper to have private cover than not, especially if they start early. For young people on high incomes, taking out private cover can even put money in their pocket after the tax offset and saving in the Medicare levy surcharge. For most workers, even if it does cost a few hundred dollars a year that is a cheap price to pay for peace of mind for you and your family. Private health insurance is one of those things that you will look back on and say, ‘Why didn’t I do it sooner?’

Where to look Here are the websites of some of the major private health funds: 9

Medibank Private —

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9

MBF —

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NIB —

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HCF —

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HBF —

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Manchester Unity —

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SMHP Super Members Health Plan — . Available to members of industry super funds.

You will find that each offers a different range of cover. Many even cover things like gym fees, running shoes, massage and physiotherapy to entice healthy active people into private cover. In addition, there are several services you can use to help select cover, including: 9

iSelect —

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Privatehealth.com.au —

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Australian Health Cover Advisors — .

Home and contents insurance Up to half of the households in Australia have no home and contents insurance. The ‘home’ component covers damage to the building from things like fire, flood, hail, storms and public liability (for example, if a visitor is injured on your property). The ‘contents’ component covers your possessions. It pays to shop around because premium rates vary considerably between insurance companies for no logical reason. Another way to save money is to get a large excess. The excess is the amount you pay out of each claim. The higher the excess the lower the premium. Most policies are priced on the basis of a low excess like $100 or $500. In terms of this plan you should not be interested in making tiny claims for minor damage or breakages. You should only really be interested in making a claim if you are cleaned out by burglars or the house burns down and so on. So ask for a big excess like $10 000 — this can halve the premium costs in many cases.

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Business insurances Small business operators are probably at most risk of financial stress in the event of something going wrong because they often have little or no super, or other investments. Often all their eggs are in one basket, making it all the more important to have various levels of protection in place. In addition to life, TPD, trauma and income protection, there is also a range of business insurances that every business should at least consider. In a high proportion of cases, business operators simply don’t know they are available. Business insurances include: 9

business expenses insurance — a cheaper alternative to income protection cover. Things to cover include regular expenses, like rent and general overheads, plus an allowance for temporary staff if needed, and an amount to cover regular super contributions

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key person insurance — recommended for key individuals in the business, for example, if they are responsible for key products or customers

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fire and damage cover

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public liability and workers compensation insurance to cover injury to the public and to staff.

Action plan 1

Find out whether you have insurance cover through your super fund — what type of cover, how much, special conditions and restrictions.

2

If you or your partner died or was disabled, how would you cope financially? How would you pay the mortgage, finance living expenses, clear the debts and so on.

9.4 Wills There are several good reasons for everybody to have an up-to-date will — to ensure that your assets are dealt with according to your wishes, to save tax and to save costs by avoiding or minimising possible legal challenges. Not only should you have a will, but you should review it each time there is a major change in circumstances in your life like getting married or divorced, moving in with a de facto, the birth of a child, receiving an inheritance, or buying or selling a business. 327

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Dying without a will If you die without a will it is called dying ‘intestate’ (not interstate!). There are different rules in each state and territory that determine how the assets are distributed, and they involve various formulas that include spouses, children, parents, siblings, half-brothers and half-sisters, grandparents, uncles and aunts. If there are no relatives or if they can’t be located, your assets go to the government.

Death of two people at once There can be some unexpected consequences of two people dying at the same time — for example, a husband and wife both dying in a crash. If both die at the same time, or if it is impossible to establish who died first, the law assumes that the older person died first. Take the example of a husband is who is older than the wife and their will leaves their assets to each other if they are still alive, then to others if they are not. If both die in the same accident, the husband is presumed to have died first, so his assets pass to the wife and all the assets are then distributed according to her will, which may not be what both intended. If the wife had no will and if there were no children, her family could get the lot and his family nothing.

Challenges The Family Provision Act allows a variety of people to challenge a will, including the spouse, former spouses, domestic relationship partners, children, grandchildren and anybody who at any time was financially dependent on the deceased. This gets very complex with combined families where former spouses and the kids of the first marriage are often overlooked in favour of kids of subsequent marriages.

Do debts get passed on? Debts that are secured by assets — for example, a loan secured by a mortgage over property — are paid out using assets of the estate. However, debts that are not secured do not pass on to the person who receives assets from the deceased. So, a spouse who inherits business assets would not inherit the debts unless the debts were secured against assets, or unless the spouse was party to the debt or signed a guarantee. On the other hand, personal tax debts of the deceased are paid out of the estate before distribution — the tax office always wins! 328

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Nominate executors You need to name one or more executors in your will. Executors are responsible for the proper administration of the estate — obtaining probate, collecting assets, paying outstanding debts and taxes, lodging tax returns and distributing assets in accordance with the will. It is usually best to have a professional executor or co-executor due to the onerous responsibilities and potential liabilities. Consider nominating your solicitor or a professional trustee company as one of the executors.

Testamentary trusts Testamentary trusts are trusts that are set up to hold assets, including proceeds of life policies and super fund death benefits, of a deceased person. Income from the trust can then be spread between the beneficiaries to take advantage of each recipient’s income tax free threshold. This can save a considerable amount of tax each year, compared with what the surviving spouse would pay if he or she received all the income and then used it to pay expenses for the whole family. Minor children (under 18 years old) also have the benefit of the full $6000 tax-free threshold under a testamentary trust, as against the lower $416 threshold (plus the penalty tax rates) if they received the inheritance directly and invested it in their own name. (See chapter 2 on tax issues.)

How to prepare a will There are three main ways to prepare a will: 1

DIY. There are a variety of will kits on the market that offer a cheap, quick solution. You can find them at many newsagents and bookstores. They come complete with instructions and examples. They are fine if your affairs are very simple, but as soon as you have dependents or de factos, family trusts, business assets or any other complications you may need to move to the next step.

2

Trustee company. A trustee company helps you draft the will and it is usually free. It appoints itself as one of the trustees of your estate, in addition to other trustees you nominate. When you die, the trustee company manages the estate for a small percentage of the value of the estate, normally 1 to 2 per cent. It is very useful to have this expertise when managing and distributing the estate.

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3

Lawyers. If your affairs are complex, with family trusts, companies, super funds, previous marriages, or if you want to establish a testamentary trust, then it may be best to have your lawyer draft the will, with the help of your accountant (for tax issues) and your financial planner (for superannuation issues). This can cost a couple of thousand dollars or so, depending on how complex you want it to be.

Assets not covered by a will There are an increasing number of assets that fall outside a will and are not dealt with by the terms of a will. Examples include any assets held by the deceased as joint tenants (like the family home), joint bank accounts, superannuation, assets in discretionary trusts, assets held by companies, proceeds from life policies if the beneficiary is not the estate. In these cases it is important to ensure that your wishes are covered clearly in the trust deeds and constitutions of the companies.

Capital gains tax Assets acquired by the deceased before 19 September 1985 are inherited by beneficiary at the market value as at time of death, and then becomes a post–19 September 1985 asset (CGT will be payable on eventual sale of the asset). Assets acquired by the deceased after 19 September 1985 are inherited by the beneficiary at the asset’s the original cost base. In the case of the family home of the deceased, if the beneficiary of the home also uses it as the family home, it continues to maintain its capital gains tax-free status. However, if the beneficiary doesn’t use it as the family home, the beneficary can sell it within two years free of capital gains tax. If the beneficiary retains the home and sells it after two years, refer to the above rules to determine how the cost base is calculated.

Death, taxes and super funds Here’s a section on the three things people hate talking about the most — death, taxes and super! Take a deep breath and try to read on if you can. The first thing to come to grips with is the fact that trustees of your super fund are the legal owners of the assets in your super fund, not the members (you) or your beneficiaries. That means you are not the legal owner of ‘your’ money in ‘your’ super fund. So, regardless of what you say in your will, the trustee can distribute the fund assets to spouses and dependent children even if you

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don’t want them to. In order to have a say in how the assets are distributed when you die you must ensure that you have filled in a form called a ‘binding death benefit nomination’ with your super fund. This is the case whether the fund is a corporate, industry, retail or self managed fund. In the case of self managed super funds, where husband and wife are usually the trustees of the fund, there should also be an agreement in place and held by your accountant or lawyer specifying who should take over as trustee of the super fund if one or both partners die. Super death benefits can be paid to a spouse and/or dependent children as a either a lump sum or a pension. Other beneficiaries receive only lump sums.

Death tax In chapter 4 I mentioned that assets held in a super fund that pass to everybody except the spouse and dependent children after the death of the member pay an immediate tax of 16.5 per cent of the value of the assets, excluding a proportion that represents after-tax contributions and pre-1983 contributions to your fund. This immediate ‘death tax’ on non-dependents doesn’t apply to assets held outside super funds. If you die while your super fund is still in accumulation phase and your beneficiaries are dependants (spouse and/or minor children), they can apply for refunds of the contributions tax paid by the fund.

Action plan 1

If you have a will, find it and read it. Does it reflect your current situation and wishes?

2

Make time to update your will and see an appropriate professional to help you.

3

Check all super funds owned by your family and make sure binding death benefit nominations are in place.

4

If you run a self managed super fund, make sure you have a plan in place for new trustees to take over if one or both trustees of the fund die.

9.5 Entities As you embark on your investment journey you will need to think about how investments and other assets are held. 331

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Individual names When you first start out it may just be you or it may be you and your partner. You can hold investments in either name individually (for example, holding investments in the name of the person in the lower tax bracket will save tax), or in joint names.

Joint tenants versus tenants in common When two or more people hold an asset together, they can usually choose whether to hold as ‘joint tenants’ or ‘tenants in common’. Where an asset is owned by two or more people as ‘joint tenants’ they jointly own the whole asset, rather than each owning a fixed share of it. One of the parties cannot sell their share because they don’t own just a share — they jointly own the whole. When one party dies the whole asset automatically passes to the other rather than going into the estate of the deceased. Husband and wife usually hold matrimonial asset, like the family home as joint tenants, so the home goes straight to the spouse regardless of what the will says. Where two or more people hold an asset as ‘tenants in common’, each person has a fi xed, predetermined share of the asset. Each person can sell or otherwise deal with their share of the asset. When a person dies, their share goes into their estate and is distributed according to their will or under the relevant intestacy rules if there is no will. Tenancy in common is usually the method chosen by business partners — for example, two or more friends or colleagues pitching in to buy an investment property together. The percentage share is agreed up-front and there is usually a formal agreement between the parties setting out the percentage shares of the purchase price, how and when the asset is to be managed and/or sold, and how the income and proceeds from the sale are to be distributed.

The family home There is a widely held (but mistaken) belief that you can keep the family home out of reach of your creditors by putting it in the name of your spouse. This is the reason many professionals (including many lawyers surprisingly) and business owners put the house in the name of the non-working spouse. However, this doesn’t protect the house from creditors of the working spouse. The High Court has confirmed that equity in the matrimonial home is deemed to be owned 50–50 by husband and wife, regardless of whether the title is held in both names or only one, and regardless of the percentages actually contributed by each to the purchase price.

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This is not the case for de facto couples, who are presumed to own the home in trust for themselves as tenants in common in the proportions that they contributed to the purchase price, even if they actually hold the property as joint tenants.

Trusts There are various kinds of trusts you may want to use in your investment plan because of the benefits they offer.

Discretionary trusts There can be several benefits from setting up a trust to hold your investment. There are several different types of trusts; the most common for managing family finances is the family discretionary trust. Your accountant or lawyer draws up a trust deed and establishes a trust. The trustees are usually the family company or husband and wife. The assets of the trust are held ‘in trust for’ or for the benefit of ‘beneficiaries’ of the trust, which are usually the family members and other family entities. The advantages include: 9

Asset protection — liabilities arising from assets held are kept away from the family members individually. For example, having a trust to hold investment properties is popular with many investors. Any type of liability in relation to the property — for example, public liability or tenant liability — is ‘quarantined’ in the trust and can’t touch assets of the beneficiaries. The trust can also protect the assets of the trust from any creditors of the beneficiaries. For example, if a family member has business or personal liabilities the creditors can’t access assets held by the trust.

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The ability to spread income around to low-tax family members — at the end of each year the trustees decide how to distribute the trust’s income and capital gains. The trustees can distribute trust income to family members in low tax brackets in order to reduce the overall tax bill. The trust can be used to ensure that every family member’s tax-free threshold is fully utilised.

There are also some disadvantages of discretionary trusts, including: 9

You need to prepare accounts and returns each year (around $500 per annum for a simple trust), plus also the cost of initial establishment (about $1000 for a simple trust).

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9

In many states, properties held by trusts don’t get several benefits, like tax-free thresholds for land tax, stamp duty discounts or first-home buyer grants. This can make property investment significantly more expensive in many cases.

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When borrowing for investments held in trusts, banks often charge higher fees for preparing documentation.

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Some financial institutions don’t set up certain accounts for trusts. For example, most high interest rate online banking accounts.

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Trusts can distribute income and capital gains to beneficiaries, but they can’t distribute losses. This makes trusts unviable for negative gearing strategies if you want to make use of tax losses to offset other income of beneficiaries to reduce tax.

The cost issue is a bit like deciding whether to set up a self managed super fund — it depends on your family’s circumstances and if the amount of the investments is large enough to justify the expense. There are also several different types of trusts, so it pays to get advice from your accountant for the best solution for your family.

Unit trusts Another popular type of trust is a unit trust with fixed units. This is very much like a managed fund, which is just a unit trust on a large scale. In a unit trust, there are a number of units in the trust and each unit holder is entitled to a fixed number of units. Each year the trust’s income is usually distributed to the unit holders in proportion to their ownership of units. The ownership of units is agreed up-front and there is usually a formal agreement between the parties setting out the terms of the relationship. Unit trusts are often used when a number of people are entering into a joint venture — for example, a number of friends get together to buy a block of units, or subdivide a block of land, or buy a commercial building.

Companies Companies are another popular entity often used when planning family finances. A company is a separate legal entity from its shareholders. It’s like a unit trust in that it has a fi xed number of shares on issue and each investor’s shareholding determines their right to receive dividends.

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Unlike trusts, companies pay income tax at the rate of a flat 30 per cent and can retain earnings in the company forever, without the need to distribute them to shareholders. Companies can serve many purposes in the family finances.

Business income Many sole traders operate through companies. The attraction is that companies pay tax at 30 per cent as against personal rates of tax that look a lot higher. The tax advantage is not as high as it looks because the individuals have a tax-free threshold and only pay the marginal tax rate on the excess above certain levels. The net result is that only individuals earning more than $106 000 pay more than 30 per cent tax. Another issue is that the money from consulting, earned by the individual through the company, can’t be used by the individual for living expenses unless the company income is paid out to shareholders as dividends. When a dividend is paid by a company to a shareholder, the shareholder ends up paying tax on it, less franking credits for the income tax already paid by the company. The net result is that the individual ends up paying the same tax he or she would have paid without the company.

Investments Companies can be used to hold and accumulate investments by retaining investment income, whereas trusts can’t. However, because of the 30 per cent flat company tax, investments are often more tax effective if held by individual family members in the nil or 16.5 per cent tax brackets. Unlike discretionary trusts, companies cannot change the distributions each year to different shareholders in low tax brackets to save tax. Dividends are shared with all shareholders according to the shares they own. Perhaps the biggest disadvantage of using companies for investments is that they don’t receive capital gains tax discounts.

Protection Companies can provide useful protection against creditors and other liabilities. Creditors and liabilities of businesses owned and operated by a company only have access to assets of the company itself; they can’t touch other assets held by the individual shareholders or other family members. For these reasons it is common to use a company to own family businesses, to act as trustee of self managed super funds, family trusts, and as unitholders in unit trusts. Companies are also a good

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way of holding businesses and for providing a structure for transition of ownership to other family members on retirement of the business founder.

Costs Companies cost more or less the same as trusts to set up and to administer. About $1000 for initial establishment and then about $1000 to $1500 per year for accounts, returns, tax, BAS returns, minutes of meetings and so on — depending on the number and complexity of transactions each year. In the case of my family we use a combination of discretionary family trusts, unit trusts, companies, a self managed super fund and a charity foundation. The overall structure and entities need to be carefully designed to suit what you are trying to achieve. The other thing to note is that many of the people advising on setting up trust structures are in the business of making money through fees from setting up trusts. The best thing to do is talk to your regular accountant — he or she will understand your full circumstances and will be in the best position to advise you on the structures that are best for you.

Action plan 1

Which assets and investments are held in what names in your family?

2

Can you put investments in the name of a person in a low-income tax bracket?

9.6 Powers of attorney Powers of attorney are documents authorising somebody else to act for you in matters like signing contracts and handling your affairs. For example, you may be travelling interstate and want to buy an investment property in joint names or your spouse’s name (perhaps for income-tax or land-tax reasons), but they are out of town. You can execute contracts on his or her behalf if you have a power of attorney authorising you to do so. A power of attorney could be general in the sense of granting unlimited authority in all matters, or it might be a limited authority, specifying only certain types of transactions that can be executed, or it could be limited to a specified time period. Often husband and wife have unlimited general powers of attorney appointing each other.

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Enduring powers of attorney Normally, powers of attorney only remain valid while the grantor of the power is sane and remains of full capacity. For example, say a husband and wife have general powers of attorney appointing each other. If the husband is injured in an accident and is in a coma, he is no longer of full capacity and therefore the power of attorney ceases to operate. In this case, the wife can no longer sign documents on behalf of the husband while he is incapacitated. An ‘enduring power of attorney’ goes one step further and allows the power of attorney to operate despite the insanity or other incapacity of the grantor. This is often very useful in the case of husband and wife, and also in the case of elderly parents and grandparents appointing one or more adult child or grandchild as their power of attorney.

Action plan 1

Talk to your spouse or de facto about whether you want to have joint enduring powers of attorney.

2

If you have ageing parents, have they granted powers of attorney to anybody?

9.7 Key points 9

You need an emergency cash fund that is there for use in absolute emergencies without having to get into debt. The amount should be enough to cover living expenses for a few months. Store the emergency fund in a special account with limited access to minimise temptation.

9

Having life, total and permanent disablement and/or income protection covers are usually seen as essential where you have a mortgage or other personal debts — at least for the major breadwinner. The earlier you take out private medical insurance the less it will cost. If one party in a couple earns over $50 000, it can usually save them money to join.

9

Having a valid, up-to-date will is essential to ensure your assets are dealt with according to your wishes, to save tax, and to save costs by avoiding or minimising possible legal challenges. The more complex your financial affairs become, the more you need to have a solicitor draft the wills. If you have kids or other dependents, testamentary trusts are essential in the wills. 337

Chapter 10

Step 6 — do what you love doing

10.1 $1 million for life! Building your $1 million investment fund won’t just generate income for the rest of your life, it will also enable you to live the kind of life you really want to live. When I’m walking or driving around the city, or even sitting in a café or restaurant, everywhere around me there are people frowning, scowling and/or barking into their mobile phones. It’s pretty obvious that most of them would rather be somewhere else. I believe that everyone has a passion that they would rather be doing instead of serving out their time in their current job. Wouldn’t it be great if you could pursue your passion without having to worry about money? If you could turn your passion into an income as well, then that would be even better. Your $1 million fund can buy you time to research and get your new venture under way until it generates income. If you can’t turn your passion into an income, then that’s okay too, because your $1 million fund will generate investment income to live off for life, so you don’t have the pressure of needing to earn money to pay the bills. 338

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10.2 Do you really love your job? We’ve never had more choice of careers, but we’ve never been more stressed and dissatisfied with our careers. Due to the extreme specialisation of work, many people work in very routine, repetitive jobs. Even the ‘professions’ appear attractive at the outset but, for most professionals, they end up being repetitive and routine much of the time. Many medical students start out with starry-eyed visions of finding a cure for cancer, but most end up as suburban general practitioners spending their lives being coughed on by kids, battling endless paperwork and worrying about being sued left, right and centre. They’re still making a great contribution to society, but it’s a long way from the vision they had when they started out. Many law students dream about contributing to human rights and world peace, but end up specialising in ever narrower subcategories of tax law or corporate law, because specialisation is the name of the game. Or they end up in the suburbs doing endless routine conveyancing and wills — and dreaming of suing their local GP! Many dentistry students start out with grand visions of helping kids in Africa — but end up spending the next 30 years peering into middle-class mouths full of decaying teeth and bad breath. Another problem with the professions is that people start earning money only in their late 20s or even early 30s and miss out on their early years of investing. On top of this, many build up student loans and debts while at university. When they do start work, many succumb to the perceived need to live in expensive houses, drive expensive cars, send their kids to expensive schools, join expensive golf clubs and take expensive holidays. High-income professions often lead to high-(or even higher) expense lifestyles. Banks and lenders love professionals because they have high incomes and therefore high capacity for paying high interest on expensive loans and credit cards. In the early years, many businesspeople worked 12-hour days, running on adrenalin in the excitement of creating something new from scratch. These years were hard because everything ran on a shoestring, but they enjoyed it because they could see it grow and they could control every aspect of the business. But over the years as the business grew, more and more time was spent away from the actual business and too much time was spent dealing with staffing issues, fixing quality problems, battling technology, chasing debtors, finding investors, pacifying bankers, waiting in airport lounges, and having meetings with accountants and lawyers. It’s no longer a passion, it’s a chore, and it seems they’re still working around the clock. The ultimate test is this — would you do your current job if you weren’t paid? Would you do it for the sheer thrill or excitement it provides, the sense of achievement and satisfaction, the sense 339

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of making a contribution to society or the world? Or are you doing your job today because that’s what you did yesterday, you get paid quite well and you need the money to pay the bills?

10.3 Have a real plan for the rest of your life Most people drift along in their careers. They have a few long-term plans. More money comes in each year, but more money goes out again. Their super fund balance drifts up with the investment markets from year to year, and eventually they may have enough money to retire and top up their age pension. They’re pretty much on autopilot. There’s got to be more to life than that! If they had the financial backing today, many people would probably be doing something completely different with their lives. But they don’t, so they haven’t really put much thought into what it is they could be doing instead, beyond some vague notion of playing golf or travelling.

You can’t play golf for 30 to 40 years When I left full-time work in my early 40s I joined a golf club and had great ambitions of playing at least once a week. This lasted about a month. Other people I know have done similar things and also became bored and restless very quickly. Have you ever dreamed of a going on a particular holiday, then when you got there you were bored after the first week? Now imagine being there for 30 years. Most people can only relax for so long. Being so far from the ‘action’ will probably drive you crazy after a while. Even if they don’t need the money, most people will go crazy without the social interaction and stimulation. Not only will you get bored and restless, you’ll deteriorate quickly — mentally and physically. There’s plenty of research showing that the best way to live longer and happier lives is to stay productive, challenged, involved, engaged and intellectually stimulated.

‘Retirement’ is a recent concept The idea of spending decades in idle leisure is a very recent concept and goes against 100 000 years of human history. In the hunting-gathering age, kids started contributing to the economic life of the family and tribe when they were very young. They started having children in their early teens and only lived until around age 30 before dying from disease, accidents, predators, wars or in

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childbirth. They were productive members of the family and community until they died, except in the case of disease where there may have been a short period of sickness with no pain relief prior to death. The ‘elderly’ were valued members of society — they were the custodians and teachers of knowledge, skills, customs, heritage, history and spirituality. In the agrarian age that followed (from about 10 000 BC), the pattern was very similar. Kids made economic contributions from a young age, started having children in their teens and continued to contribute economically until they died, generally at 30 to 40 years of age. The economy was mainly agricultural, together with the growth of cottage manufacturing industries and trades. In the industrial age — from the 18th to mid-20th centuries — people started to work in repetitive, boring jobs in dangerous, dirty factories and mines, often beginning in their early to mid teens and worked until they dropped. Retirement, if any, was very short. Old age pensions were introduced in the late-19th and early-20th centuries to assist the very few people who lived past age 65. Today, the picture is vastly different. People spend the first 25 or 30 years, or about one-third of their lives learning (living off their parents and other taxpayers), another third of their lives working and paying tax, and the final third of their lives in retirement (living off their savings but mainly off other taxpayers). So we only spend around one-third of our lives contributing to society, to the economy and to the tax base, with the other two-thirds living off it. This is not sustainable. Something’s got to give. It doesn’t make any sense at all. When you are considered past your ‘use-by date’ in your current career at some arbitrary age, like 55 or 60, you’re still going to have another 30 or so years of productive, healthy life left to live and contributions yet to make. You may as well put them to good use — for the sake of your health and your sanity, and for the sake of society and the economy. Why wait for your employer to tell you to go? Why ‘serve time’ in a job or career you would rather not be doing anyway? You can start planning your real future now.

‘Retirement is wasted on the old’ There is a saying, ‘youth is wasted on the young’, but there should be another saying, ‘retirement is wasted on the old’. Retirement used to be seen as the last couple of years of old age after many decades of work. But who wants have to wait until the age pension cuts in at 65? Or until you can get your hands on your super tax free at 60?

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Two key tasks for the next few years This plan is designed for you to use the next few years to do two things: 1

Take the money you are making in your current job or business and use it in smarter ways to accelerate your wealth, and build your investments to the point where you can start doing what you really want to do with your life.

2

Develop a picture of what your ideal life would look like — identifying and refining your passion, and doing the research and planning to turn this into a satisfying, stimulating and rewarding new life after ‘work’.

If you are one of the minority who are already living your ideal life now, and are happy and able to do this indefinitely, then that is fantastic. Even so, you could probably still benefit from using your money in better ways to build more wealth to provide greater financial security.

10.4 Focus on your passion, not on the money Building wealth and getting rich should not be a goal in itself. Wealth is just a by-product of success. It is success in your chosen field that is what brings about wealth, happiness, and a sense of achievement, accomplishment and satisfaction. I can almost hear some readers say, ‘Yes, that’s all very well, but I’ll be a success when I’m rich! Now, let’s just get on with making money!’ Some people spend their whole lives trying to get rich. They are obsessed with it and go from one get-rich-quick scheme to the next. Others work 80 or 100 hours each week to make money, working at jobs they don’t even like. Then they wake up one day and find that their life is not working out — their partner has left them, they are unfit and heading down the path to a heart attack or obesity. Life has passed them by while they were trying to get rich. The plan set out in this book is a way for you to build wealth for the long term, while you get on with living your life. The techniques and products used in the plan don’t take a lot of time to implement. The plan doesn’t involve working harder or smarter. Making money is not your life’s work. Making money is the thing that enables you to live the life you want to live. It will enable you to get out from what you are doing now and start doing what you really want to do. Money by itself doesn’t buy happiness, but doing something you love doing, and having the financial freedom to be able to do it, does. I have met dozens of people who tell me that they would be much happier and more secure if they just had another $10 000, or another $100 000, 342

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or another $1 million. When I talk to them a couple of years later, invariably they have that extra money, either from a pay rise, promotion or business, but they usually tell me that they are more stressed than ever before.

10.5 Case studies The following case studies are about real people. They demonstrate how different people from all walks of life can turn their passions into satisfying and rewarding businesses or hobbies that they can do for as long as they like, well beyond some arbitrary age that their current employer might consider their use-by date. They show how they used what they learned and earned during their working life to create their new life after ‘work’.

Case study one — Geoff and Judy The idea first came to me in the early 1990s when I was running a division in one of the big banking groups. I was in my early 30s and I was too busy with my job to worry about my own plans for the future beyond my current career. It was in the middle of Paul Keating’s recession ‘we had to have’ and just about every company in Australia, including the banks, was downsizing, especially in the middle management ranks. Geoff was one of those middle managers in the firing line. He had joined the bank after leaving school and had reached his early 50s, having worked his way up the ranks to be in charge of a district of 30 branches. With the senior ranks thinning out, there were only limited opportunities in the banking system for him. We sat down and did the traditional career-planning process but this was very narrow. The process only involved the person in their capacity as an employee, and only considered their skills and experiences inside the career structure of the organisation. It didn’t deal with the whole person. Geoff was a fanatic amateur bicycle racer. He’s one of those people who finds cycling from Melbourne to Warrnambool and back (a 500-kilometre round trip) a relaxing way to spend a weekend. He had been doing amateur cycle races for 30 years, and his wife Judy and their two sons had become involved in it as well. During his working career Geoff never considered cycling as anything more than a good way to keep fit and unwind after a busy week at work. We looked at Geoff’s strengths and weaknesses and different ways he might be able to turn his passion into a new life beyond traditional work. To cut a long story short, after a couple of years of research

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and planning after being retrenched, Geoff opened a bike shop in Melbourne (Salter Cycles in Altona). It caters to all forms of cycling, from the standard $300 bikes right up to the top-end racing bikes — $15 000 Giants and Colnago’s — serious stuff! On the investing front, his retrenchment payout went straight into his super fund and he hasn’t touched it since. He had some money invested outside super and this provided him with a buffer during the planning stages, then he used it to fund the start-up of the business, and it even helped him to buy the premises as well. Geoff doesn’t see the cycle shop as a ‘job’ or even as a ‘business’. It’s a passion and he could do it for as long as he wants. Not only does it allow him to tinker with racing bikes all day and chat to other bike racers, it also generates an income for as long as he wants it to, and it keeps the whole family super fit. One of their sons has taken over the day-to-day running of the business, which has given them time off to do bike tours through Western Australia, Tuscany and southern China. Geoff’s only regret is that he didn’t start planning the transition while he was still working. One of the things that spurred him into action was the embarrassment of having to say to people that he was ‘retired’. He was only in his early 50s and he probably had another 30 years to go. Many of his friends and colleagues at the bank tell him now that he was ‘lucky’ that he had a hobby he could easily turn into a business, but he never actually thought of it that way while he was working. It wasn’t luck — he spent a couple of years research and planning, which he wished he had started before he left work. Geoff is now thinking about expanding to new premises, and he and Judy are planning their next big cycling adventure — a trip around Slovenia.

Case study two — Will I have known Will for eight years. He started out teaching at primary and high schools in Sydney and London during the 1970s and 1980s, specialising in geography. The thing he really loved about teaching was helping kids learn and develop. As he became more and more senior in the school system he was taken further and further away from actually helping kids learn directly. So he starting doing some private coaching on the side to make a bit of extra money and get back to being more involved with kids on a one-on-one basis. After a while Will found that his private coaching students wanted to learn other subjects outside his area of direct expertise, so he hired other teachers to cover these other subjects. This grew into a ‘business’ organising a network of teachers coaching a wide range of students. He ‘retired’ from teaching in schools in his early 40s and started a number of ventures. Some took off

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and did well, while others suffered in the recession. During these years it was his private coaching ‘business’ that kept him in touch with kids and provided reliable cash flow. On the financial front he didn’t have much super because teachers in the private school system didn’t get super until much later than public school teachers. Will put some of the profits from his ventures into his super fund, and his private coaching has always provided cash when he needed it. He runs his own self managed super fund and, to date, he hasn’t started withdrawing money from it to live on. Will is now in his 60s and is still doing what he loves doing. And he has the financial freedom to pick and choose his projects. Currently he runs classes with a major university helping kids prepare for uni. He refuses to take a promotion because it will take him away from direct interaction with students. He doesn’t do it for the money — he does it because it is his passion, and it provides him with a challenging and satisfying way of passing on his knowledge.

Case study three — FRANO My wife and I have known Fran for about seven years — he has a daughter in the same class as our daughter at school. Fran is a Kiwi who spent 20 years in advertising agencies in Australia and New Zealand as a creative director. What he loved doing was ‘creating’, but the advertising world is full of compromises and trade-offs. What starts out as a brilliant creative idea often ends up as a watered down, lukewarm compromise, after the finance person has cut the budget in half, after the strategy person changes the strategy, after the account director and production department have had their say, and after it has been tinkered with by the various approval committees. As the agencies grew, so did the politics and the committees. The advertising game paid well — lots of money came in but lots of money went out again, living the life of an agency creative director in the 1980s and 1990s. Through all these years what Fran really loved doing was painting. He started painting as a way to release tension from work. The more he painted the better he got. Painting allowed him to create what he wanted to create, without the compromises and without the committees. His favourite subjects for his paintings are the harbour beaches around Sydney, where he loved to spend his spare time. After a few years of refining his painting he found that people wanted to pay him for them. Several years ago Fran stopped working full time for agencies and started to do freelance creative work on an occasional basis, while he spent more and more time painting. What allowed him to make this transition were his investments. While he was doing a campaign for MLC in the 1990s he discovered that he didn’t have any super at all (these were

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before the days of compulsory super) and nor did he have any other investments. This came as a rude shock because he knew how fickle and fragile the advertising industry was. One minute you have a great job, the next minute your agency could be sold from under you (which actually happened to him). You never know what could happen, or how long it could last. Over the next 10 years, Fran concentrated on two things — building up his investments and spending more time painting. As his investments grew it gave him the flexibility to be able to stop working full time. His investments provided him with the financial backing he needed to support his passion. Income from his investments allowed him to pick and choose his advertising projects, and to devote a good proportion of his time to painting. Fran now spends his time in three ways — working on the occasional advertising project for a couple of his favourite clients, painting, specialising in his favourite subjects, and being with his family. He doesn’t consider himself as either ‘working’ or ‘retired’. He’s just doing what he wants to do, when he wants to do it. You can see his works around Sydney — he signs his paintings ‘FRANO’.

Case study four — Christine Christine is the sister of a friend of mine in Perth. When she was growing up she was always good at art, especially pottery and jewellery design. After leaving school she qualified as a teacher and spent the next couple of decades being posted to several different schools in mining towns all over Western Australia with her husband, also a teacher. Her teaching had nothing to do with art, but she continued painting, purely as a hobby for stress relief. Being posted around the countryside has many disadvantages, but one advantage is that it is relatively easy to save money, especially with two salaries. Christine and her husband put money away regularly into simple low-cost investments. Teaching in country towns had its ups and downs, but what she really dreamed about was getting back to the coast and spending more time with her art. After many years in the bush they used their investment fund to retire in Margaret River, a booming, trendy, arty town in the middle of the prime wine district on the coast south of Perth. They built a commercial building and rented it out for income. Christine set up her home studio and got back into her designing jewellery and painting. Things went really well and she started building up a regular income from it. She began having exhibitions around the region and is making a nice income. Life’s great — Christine and her husband are living in one of the best places on earth, there’s regular income from their investments, Christine is doing what she loves doing, building

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up a reputation and even making some money from it, and they haven’t even touched their super yet.

Case study five — Marilyn and Steve Marilyn and Steve live up the road from us in Sydney — well sort of. Their main hobbies and pastimes have always been searching through antique shops and hiking. They would do this whenever and wherever they went away on holidays. One of their early trips took them to France about 15 years ago and they liked it so much they kept going back whenever they could get away from their busy jobs. Marilyn worked for a shoe importer and Steve was developing an information technology training business. In 1994 they managed to spend three months having a closer look around the south-western wine districts of France. They made the decision to find out how they could buy a small place in one of the ancient villages around Carcassonne. After their return home they spent the next thee years researching the ins and outs of how foreigners could buy into the area. After three years of research and planning Marilyn and Steve bought an old house in the ninth-century village of Trausse. It is a sleepy little town well away from the tourist districts so the house was not expensive. They arranged for the renovations to be done by tradespeople in the local area. There was a lot of trial and error in those early days — with the distance, cultural and the language differences. They visited the house themselves when they could, and let their friends from Sydney stay there as well. The word soon spread and pretty soon people were lining up to pay to stay there. Over the next 10 years they rented out the house and used the money to buy three more houses in the same area. Whenever they went back to Trausse they would supervise the renovations and search around the local antique shops for furnishings. As looking after the houses started to take more and more time, Marilyn scaled back her work and did some contract work for Diners Club — ‘Interesting work, but long hours and not a great return’, she says. She gradually scaled back ‘work’ altogether and now she and Steve spend most of their time travelling, managing bookings for the houses and looking around the French countryside for new ones, but they still spend a few months each year in Sydney. This has turned into the perfect life for them. Word has spread and now they have people coming from all over the world to sample a little piece of paradise in the wine districts of France. They’re not working, they’re not retired — they’re just doing what they enjoy and it generates enough income so they can continue doing it for as long as they want. Check out their houses on . We haven’t had a chance to go there yet but it sure does sound good! 347

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Common elements There are several common elements in these case studies: 9

None of these people had a lot of money to start with and they only earned regular incomes while working, but they still managed to build wealth to last them for life

9

They don’t regard what they do as a ‘job’ or as a ‘business’ — they do it because they love doing it.

9

They have turned their passion into financially rewarding enterprises, and this helps maintain the lifestyles they want.

9

They have used their investments to help finance the development of their passion.

9

They would probably do it even if they weren’t paid. It’s not about the money — it’s about doing what they really want to do. The idea of making money from it just adds to the challenge and excitement. If it pays off that’s great, but if it doesn’t they wouldn’t stop doing it.

9

They can decide their own level of involvement. They don’t have the pressure of needing to produce regular income because they have a financial backup plan with their investments — often both inside and outside super.

9

They can decide how long they want to do it for and when to stop.

9

They look back at their decades of work — their ‘official’ careers — and think of them as just the prelude to their real life.

9

Their biggest regret is not following their passions sooner.

Lessons There are a number of lessons that can be learned from these case studies: 9

Use the skills you develop in your work and apply them to your passion — budgeting, planning, people skills, marketing, industry knowledge and contacts.

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9

Things don’t just happen — you’ve got to make them happen. They require planning, research, testing, marketing, trial and error, and time.

9

You need to apply the same disciplines to your passion as you do to your working life — time management, goal setting and measurement.

9

You need the confidence to back yourself. You need to know that what you learned in your working life can work for you in pursuing your passion. It often takes years of planning and preparation before you can actually start turning your hobby into a money-making venture. This time is best spent during your working years, while you have the luxury of a regular salary.

9

You also need financial confidence — having investments to provide a buffer. It takes the pressure off making money from your passion immediately. Financial commitments don’t stop — you still have family commitments, school or uni fees, day-to-day expenses and so on.

9

The more you work on your hobby or passion, the better you will get, and the more others will value it and be prepared to pay you for it. Free up time while you are working so you can really hone your skills.

9

Use your current career as a way to ‘earn and learn’ for your real future life.

9

Generally, it’s the simple things that are valued most. Even if you are a highly qualified technical specialist in your current work, this may not necessarily be where your future ventures are. It’s often not that complex. If you happen to love tinkering with kayaks on the river, there will be others who want to rent kayaks from you. If you love tinkering with racing bicycles, there will be others who are happy to pay you to advise them on bikes. People can tell when you’re doing something for the pure pleasure of doing it, not just for the money — and they usually put a higher price or value on it. Your enthusiasm rubs off and it creates repeat customers and new customers from referrals.

10.6 What is your passion? Some people know instantly what their passion is but, up until now, haven’t had a way to put the plan into action. For others it is hard to discover what they will enjoy doing for the rest of their

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lives. You work out pretty quickly what you don’t enjoy, but it may take many changes to find your niche. Normally, it involves trial and error, and sometimes you may need to try several different things.

You’re more than your job When I meet new people socially I never ask them what they do for a living. I’m not really interested in what they do during working hours — that doesn’t define who they are. That’s rarely what they are truly passionate about or where their deep interests lie. It’s a crazy, social ritual, but we have all been programmed into asking and talking about what we you do for a living. Sometimes I can see people visibly annoyed that I haven’t asked them what they do for a living. Usually they want to complain about their job as is customary to do in these situations. They want to get it off their chest, often so they can compare our various degrees of dissatisfaction with our careers. It’s all very interesting but it usually has very little to do with the real person.

‘Just one thing’ For most of us there is probably no ‘one thing’ that is perfect for us. Different things will probably suit us as we change and grow. In the Billy Crystal movie City Slickers the character ‘Curly’, played by Jack Palance, had the answer. He was the wise, old cowboy who had probably seen and done it all over his lifetime of perhaps 80 years. After summing up all his experiences and wisdom he concluded that the secret to the meaning of life was ‘just one thing’. The problem was that he died sitting in the saddle before he could tell us what that ‘one thing’ actually was, so we’ll never know. Of course, the meaning of the story is that the most important thing in life is for each person to discover what their ‘one thing’ is, and then make it their life’s work to pursue it and achieve success.

Look at your current job Even though they may say so, most people don’t actually hate everything about their jobs or careers. What parts of your current job do you like and dislike? Why did you start out on this career in the first place? Has it turned out anything like you imagined when you first started out many years ago?

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Do a course Most local councils run inexpensive courses on all sorts of interesting things. You will soon discover whether you like a course or not. If you don’t like it, then at least you can tick that one off the list and stop dreaming about it. And it will help you narrow down what you really like.

Spare time Sit down and analyse what you do with your spare time. Do you love finding bargains at local markets? Wandering through antique shops? Fixing things around the house? Mucking around in boats? Designing jewellery? In our own case, whenever my wife and I are driving around or walking around anywhere, even when we are on holidays anywhere in the world, we find it physically impossible not to stop and inspect a property for sale if it’s open. We simply can’t walk past a real estate shop window without stopping to look at what’s for sale or rent in the window. It’s not something we consciously do, it’s just hard-wired into our personalities. We compare rental rates, yields, values per square metre, land value ratios, council rates, land tax rates and so on for the various properties we look at, comparing them with others across the street, across the city or in another state or country. Makes very boring conversation if you happen to be listening, but it’s just habit developed over 20 years of doing it. We started doing this even before we bought our first property and we’ll probably do it until the day we die. While we were both working flat out for 20 years in corporate roles, our real passion has always been renovating houses. It is not something we suddenly started doing during the property boom. One of my earliest memories is of painting my room and my sister’s room in our family’s house in Adelaide when I was about six years old. I can still remember to this day the names of the colours I used — ‘primrose yellow’ for my room and ‘opal lilac’ for my sister’s. My family moved house every couple of years and I can remember just about every paint colour we used in every room of every house. We lived in and renovated about a dozen houses. My wife and I have done another dozen, plus a string of investment properties. How you spend your spare time says a lot about you and perhaps it can be turned into a hobby or business.

What subjects did you love at school? Come on, school can’t have been all that bad. There must be some subjects or parts of subjects you really liked. 351

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In my case my favourite subject in primary school was maths. I loved making up and solving problems that involved patterns of numbers. In high school maths became far too theoretical and abstract with complex stuff like differentiation and quadratic equations, but primary school maths was fantastic. Nothing complex — just simple adding, subtracting, multiplication and division. I would spend hours and hours every week in my spare time thinking up new problems for the maths teachers to figure out. Talk about twisted! Decades later I find that the thing I most enjoy about investing is looking for patterns in numbers. Understanding how products work. Picking companies to invest in is mostly about numbers. I don’t read novels — the only fiction I read is company annual reports! In among all the pictures of happy-looking staff and customers, and all the hundreds of pages of numbers, there is the real story that takes some digging to discover. The trick is to find the key numbers and find out what they mean. Also, trading in financial markets is all about patterns in numbers. Nothing complex — just simple adding, subtracting, multiplication and division. In high school my favourite subjects were woodwork, metalwork and physics. They’re all about making practical things and understanding how things fit together and work. This has had two visible effects on my life today. The first is that I love fixing up old houses. The second is that I will never invest in anything unless I know how it works in practice. I pull it apart and try to find out how all the pieces work and how they fit together. I hate complex, structured financial products that I can’t understand. Most of the new products these days are far too complex, with layers and layers of fees. I stick to simple things because I can understand how they work. All the other stuff I learned at school — or didn’t learn but they tried to teach me — was pretty much wasted on me. Yes, I managed to get through high school and get through university, but I was basically on autopilot through those years. I wasn’t doing what I loved doing. After high school I went to law school because that’s what my high school exam score got me into. The decision had nothing to do with my skills or likes or dislikes. So I did law and didn’t enjoy it at all. While at law school I worked for some law firms part time and met a lot of lawyers, which confirmed in my mind that I really didn’t want to be a lawyer! So as soon as I completed the law degree I went into banking and finance instead. It was pure luck. At that stage I didn’t know what I liked or was good at. All I knew was that I didn’t want to be a lawyer. So it was pure luck that I turned out to enjoy the finance game. I learned by trial and error. Try to remember your school days, and what you liked and disliked about particular subjects. Is it anything to do with your current career? The chances are they form a big part of your likes and dislikes today. 352

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Action plan 1

What is your favourite hobby or pastime?

2

If you don’t have a hobby, make a list of the likes and dislikes about your current and past jobs, school subjects, the ways you use your spare time and so on.

3

Start to think about how to turn this into a venture to make money — it doesn’t matter how unlikely it might sound at the start. Anything is possible these days.

10.7 Making the transition It’s unlikely that you will make the transition quickly and smoothly, moving from full-time work one Friday, then starting your real life on Monday, or even after a short break. You will probably need to take some time to research and develop your idea. And you will need funding to be able to do this. When you employer says that your use-by date is up, you may not have everything figured out and be ready to hit the start button, even if you do start planning and preparing for it now.

Consulting Many people enjoy the industry they’re in but they hate the politics and bureaucracy. Their ideal future could be doing consulting work. That way they can just focus on specific projects and not worry about all the other stuff. They can also pick and choose the projects they want to work on.

How much to charge? Most people underestimate the amount they would need to charge. If you are thinking of using your skills as an employee to become a consultant in the same field, you will probably need to charge at least double your current hourly rate. For example, if you are making, say, $100 000 in salary, that equates to about $400 per working day. In order to receive the same net cash you will generally need to charge about $1000 per day in order to compensate for the benefits you will miss out on as a consultant — no employer super, no paid holidays, no paid sick leave, no paid days doing training course, the cost of the courses themselves, no bonuses, no use of laptops, no phone. As a consultant there is always a lot of

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downtime with no income, while you research your market and sell yourself, and this will need to be reflected in your daily rate.

Using a company Generally, if you are consulting through your own shelf company there are no tax savings. If you need the cash to live off, your company will have to pay your consulting revenue as a dividend to you, so you end up paying the same income tax as if your client paid you direct.

Think like an internal consultant Before you leave your employer, one extremely useful technique is to start thinking of yourself as a consultant, even while you are still working in your current job. Doing so will change the way you think about priorities, targets, office politics and your whole approach to work. As a consultant your only aim is to get the job done as efficiently and effectively as possible — you’re on a mission! It will help make you more goal oriented and less process oriented in your current job. It will help change the way you think about the remaining years you stay in your job. From tomorrow you’re no longer just an employee, you’re in business for yourself! This way of thinking will make it much easier to make the transition when you are ready.

Build a business Without a doubt, the best way to create huge financial wealth is to build a business you are really passionate about. Why do you need to be passionate about it? Because that’s the only way to grow a small business into a successful, big business worth tens of millions of dollars or even more. All of the people who build large successful businesses are feverishly passionate about their business. For most, every waking moment of their lives is spent thinking about how to improve and grow their business; they even dream about it as well. It’s impossible to have a rational conversation about anything without them talking about their business. What drives these people to build their business? In all the cases I have seen, successful business owners think about their particular product or service as a way of solving a customer problem, by making their customers’ lives easier, better, more convenient, less expensive or more enjoyable in some way. Often they originally started the business as a way to make money, which is how most businesses start. But they discover pretty quickly that, unless they start thinking beyond the money, their small business will stay a small business forever.

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For successful business owners, success is knowing that their product or service has improved the lives of their thousands of customers in some way. Success is also the satisfaction of seeing the business grow and improve the lives of staff and suppliers. Success means being profitable enough to draw out cash to live on. Success also means being able to hire other people to run the day-today detailed operations so the owner can work on the bigger picture. The ultimate proof of success is the fact that the business has been sold, or can be sold for several million dollars.

Why have a backup plan? If you are one of those people on their way to building a successful business, why would you want to worry about investing? Surely you should put everything — including all your time and money — into the business. After all, wealth comes from success, and success comes from putting all your energy into following your passion, doesn’t it? Why have a backup plan? Surely that would take your mind off the main gain, which is to build the business. Bill Gates (Microsoft) didn’t have a backup plan. Nor did Michael Dell (Dell Computers), or Richard Branson (Virgin), or Gerry Harvey (Harvey Norman), or John Simmonds (Aussie Home Loans). There is a theory that says one of the key reasons behind the success of many of the great business builders is that they had no backup plan. They simply had no choice but to press on — ‘burn your bridges you so you can’t go back!’. It would be great if life was that simple, but it’s not. For every successful big business built, there are hundreds of others that fail, or survive but don’t generate financial wealth beyond a modest salary the owner draws out from month to month. Putting absolutely everything you have into your business and seeing it pay off is a very high-risk strategy — with high rewards if it works. Having no backup plan is fine if you are young. If you fail, it’s not a huge problem. Most great business owners had many failures and false starts in the early years. If you fail, you can learn from it and start all over again. Your only responsibility in the beginning is to yourself. But as you get older, you have more responsibilities and commitments — family, kids, elderly parents, ex-wives. Having no backup plan puts other people’s livelihoods and lifestyles at risk, as well as your own.

Most small business owners have little or no super Many award employees have been benefiting from super since 1987 and all employees since 1992. However, for a large proportion of small business operators and sole proprietors, super contributions for themselves are seen as an optional luxury, or even forgotten altogether. In the busy day-to-day life of a growing a business, the first thing to be forgotten is making super

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contributions. It’s the last priority on the list and often there is very little in the tin on 30 June each year to make a contribution. In other cases, the money is there and the intention is there, they simply run out of time and miss the deadline.

Most small ‘businesses’ have little or no saleable value There are about one million small businesses in Australia. The majority of these operations probably provide enough profit for the operator to draw a small or moderate wage, but there is little actual value in the business itself. What I mean is this — if the owner didn’t turn up to work for a day or a month, the income would stop. If the owner tried to sell the business, there may be a small amount of money for goodwill and stock, but that’s about all. The ‘business’ is really a personal service that the ‘owner’ is performing. When the personal service stops, so does the income. This would be the case for consultants, professionals, retailers, wholesalers and all those ‘service’ businesses like personal trainers, dog walkers and so on. For these business operators, by all means continue to work towards improving and growing your business. But at the same time, try to start investing some money along the way — both inside and outside super.

‘But I can’t spare the money’ In most cases it’s not that the money for investing comes out of what should be reinvested in the business. Most of the big improvements to a business don’t come from money invested in the business. The big improvements in a business are generally from creativity, innovation, marketing ideas, sales techniques and customer-service processes.

Salary and wage earners — stick to what you’re doing, but invest along the way Not everybody can build a successful business and sell it for $10 million or even $1 million. The great news is that building a business is not the only way to become financially wealthy. Almost every salary and wage earner can do so if they know how, and if they start and stick to a plan. It’s not a question of how much money you earn, it’s a question of what you do with it that determines whether you generate wealth or not.

Franchises Buying a franchise is a common practice for people leaving full-time work. It’s often seen as being ‘safer’ than starting your own business. There are 10 000 franchise systems on the market 356

Step 6 — do what you love doing

in Australia but only a tiny percentage of these actually have good brands, support and training that are worth paying any money for. The majority are simply designed to make money for the franchisor, not you, the franchisee. Buying a franchise is not a ‘business’ — it’s a job because if you have a day off or week off or month off you don’t get paid. When you buy a franchise and become a franchisee all you’re doing is buying another ‘job’ because you still have to work every day, only this time you have no holiday pay, no super, no sick days, and it has cost you money to buy into it. If you really want to mow lawns, wash dogs and so on, just put an ad in your local paper and work will come. When the volume of work increases, hire some administrative help — your spouse, a neighbour or friend. When it increases even more, farm out the work to a second operator. Don’t put them on salary — it’s too restrictive, too many regulations and liabilities for you. Put them on a commission, train them properly and charge them some money up-front for joining your ‘system’. Before you know it, you have your own franchise system — but this time you are the franchisor. Now you are the one who can take time off and go on holidays because you’re not the one who is actually doing the grunt work.

‘I should have done it sooner’ When talking to people who have turned their back on their long-term job and career, and started following their real passion, the one thing that almost everybody says is, ‘I should have done it sooner’. Most of them say, ‘I didn’t know I could do it’ or ‘I didn’t know how to do it’. Use the next few years in your current job to research and plan your life after work. It’s the same with investing. The single most common comment I get from readers who email me is, ‘I should have started this years ago!’ Use the next few years to build up your investments so you can start doing what you really want to do, sooner.

Action plan 1

Make a list of friends and relatives who have made the transition from work to life. Call them to ask them how they did it. What lessons did they learn and what regrets do they have?

2

Make a list of things you could do to start getting prepared for life after work.

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10.8 Key points 9

It’s impossible to remain idle for over 30 years in retirement after some arbitrary use-by date set by your employer or your industry. You need to keep active, challenged, motivated, engaged and stimulated — it’s essential for your health, your sanity and for the economy.

9

This plan is designed for you to use the next few years to do two things: 1

Take the money you are making in your current job or business and use it in smarter ways to accelerate your wealth, and build your investments to the point where you can start doing what you really want to do with your life.

2

Develop a picture of what your ideal life would look like. Identify and refine your passion, and do the research and planning to develop this into a satisfying, stimulating and rewarding new life after ‘work’.

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Investments

Super

Putting it all together

House

Chapter 11

Protection

Money sense

11.1. It’s your choice Previous generations didn’t need to think too much about money. People had little choice when it came to a career — they took over the family farm, craft, trade or business. A small minority went to university and almost everybody worked a standard day and had the weekends off. Shops only carried a limited range of goods, and they were only open limited hours. People could only get a loan from ‘their bank’ and only after years of saving money with it. There was only a small chance of anybody living past 65 and if people did reach this age there was always the non–means-tested age pension. Now life is very different. We have choices in almost every aspect of our lives. We can choose a career from hundreds of different careers, most of which didn’t even exist a few generations ago. We can choose what hours we work, how our salary is structured, where we live, how we spend our money, whether we spend or save or invest, how we structure our finances, how our super money is invested and so on. Shops carry thousands of different products and are open all weekend, and

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we can buy almost anything 24/7 on the internet. With a few mouse clicks or phone calls we can get different kinds of loans from hundreds of different lenders that didn’t even exist just 10 years ago. We can now choose from thousands of different loan products and investment products on the market. We have all these choices but even today up to 80 per cent people over 65 still have to rely on the taxpayer-funded age pension for 30 or more years of their lives. Many people will end up relying on welfare for more years than they spent working! Having all these choices is great, but we need to make good choices if we are going to choose the future we really want. If we just drift along on autopilot, doing what everybody else is doing, we will end up like everybody else, always relying on somebody else to provide for us — taxpayers in the case of welfare, or waiting for that rich uncle to die, or hoping for the big lottery win. I am convinced that almost anybody can become self-reliant and financially independent if they just make some good choices throughout their life. You don’t have to earn a lot of money, it’s what you do with the money that makes all the difference.

Many different paths to get there This book focuses on six steps that most people can take to achieve financial security for life: 1

developing good money sense

2

owning your house outright

3

maximising your super

4

investing outside super

5

putting protection measures in place in case things go wrong

6

doing what you love doing and turning your passions into income.

I have stressed all along that it is not strictly necessary for everybody to follow each of these six steps exactly. Everybody is different and will have their own likes and dislikes. There are many different paths to get there. Some people focus purely on renovating houses, others accumulate dozens of rental properties, or trade shares or derivatives, or run bicycle shops, or a thousand other things. Some can do it all by renting and never owning the house they live in, while others

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have done it without ever paying off the mortgage. Some can achieve financial security without ever buying a single listed share, and some do it without using superannuation at all (like the generations before us). All of these things are possible, but working through the six steps will give you the best chance of success. Once you get underway you can adjust your strategies based on your preferences. If you are young and are aiming to make $100 million, then the only way to do it is to build a business and ‘bet the farm’ on it, burn your bridges, take no prisoners and risk everything. There is no need for these six steps, just put every waking moment and every last cent into building the businesses. There will be lots of false starts and near misses, perhaps a bankruptcy or two, and probably some failed marriages along the way. It will be an exhilarating roller-coaster ride, but if you are that one-in-a-million who makes it, it will all be worth it in the end. On the other hand, if you are aiming for ‘only’ $1 million or so, then, given time and these six steps, anything is possible. You can continue in your current career and focus on building your investments on the side while you work on turning your hobbies and passions into a satisfying, challenging and rewarding life for as long as you want. The six steps are there to ensure that you have the best chance of getting there, despite what life and the world might throw at you along the way.

11.2 Seven levels of financial freedom You won’t get to where you want to be in one giant leap. It may take a number of years, progressing through a number of levels on the way. There are seven levels that practically anybody can progress through to reach financial freedom. The amount of money required for financial freedom will depend on each person. My definition is having enough money so that you can do what you really love doing without needing to do it for money, and without eating into capital, so you can help out your family during your lifetime and after you’ve gone. Take a look at table 11.1 (overleaf) to see which level you are on now. If you’re like many people, there is simply no spare money to pay off your debts and start building wealth. There may be lots of money coming in but it keeps going out just as quickly. Don’t get depressed if you look around you and see lots of people living in big houses, driving expensive cars and going on expensive holidays. The chances are it’s all on debt and they’re spending more than they earn. Most of them are probably on the same level as you are, or lower.

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362

Yes

Yes

Yes

Yes

Yes

No

Level 5

Level 4

Level 3

Level 2

Level 1

Yes

Level 6

Level 7

Spending less than you earn

No

No

Yes

Yes

Yes

Yes

Yes

No personal debts or loans (except mortgage)

No

No

No

Yes

Yes

Yes

Yes

Protection (emergency cash fund and insurance)

Table 11.1: seven levels of financial freedom

No

No

No

No

Yes

Yes

Yes

Using surplus cash to build wealth and pay mortgage

No

No

No

No

No

Yes

Yes

No mortgage and no rent

Negative

Negative

Negative

Negative

Negative

Positive — less than $1 million

Positive —more than $1 million

Net investment assets (super plus other investments minus mortgage and all debts)

No

No

No

No

No

Possible — if it generates income

Yes — even if it doesn’t generate income

Ability to stop ‘work’ at any time and start doing what you love doing

25%

20%

20%

15%

10%

9%

Less than 1%

Approx. percentage of households with adults aged 25 to 55 in each level $1 Million for Life

Putting it all together

If you are on one of the lower levels, don’t be discouraged when you think about what you need to do to reach the higher levels. Plenty of people have done it. Don’t forget — it’s not about how much you earn, it’s about how much you keep and invest that counts in the long term. It’s not about earning more money; it’s about using it in better ways. Even if you are on level 1, you are not alone. Probably about 25 per cent of the adult population are with you. However, even though you have no spare cash at the moment, there are a number of things you can do that will start you off on your journey today.

Level 1 — spending more than you earn, but wanting to get started Many people get off to a bad start on their financial journey. Some are lured into expensive ‘buy now, pay nothing for two years’ purchase plans. Others are caught in a spending cycle, aided and abetted by credit cards or personal loans. Often their situation is caused by a variety of reasons outside their control like a divorce or separation, guaranteeing somebody else’s debts, or perhaps a death in the family with inadequate or no insurance. There are people stuck on level 1 who are making $20 000, and there are other people making $200 000 and more. How much you earn has nothing to do with how wealthy you are.

Start with the action items that don’t require money Even while you are on level 1 spending more than you earn, undertaking the following action items will get you on the right track. Most of the steps and strategies require spare money to put into the plan, but there are some that can be started today without spending a cent. Even if you do no more than these first few items, you can get ahead by tens of thousands of dollars, without spending a cent. 1

Develop money sense. (

Find out where the money goes — do a budget (page 35).

(

Start a plan to reduce unnecessary spending (page 30).

(

Set up a small salary deduction or direct debit to pay off a high interest rate debt faster (page 44).

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2

Own your house outright. (

3

Refinance your mortgage to a lower rate basic loan. This can be done at no cost if it is with your existing lender, and can save tens of thousands of dollars and cut years off your mortgage (page 98).

Get your super into shape. (

Make sure you are getting your compulsory contributions (page 120).

(

Make sure your super fund account has your tax file number (page 121).

(

Switch from the ‘default’ option to growth assets (page 142).

(

Switch into a low-cost fund to minimise fees (page 145).

(

Chase up any ‘lost’ super accounts in your name (page 166).

These simple steps can be done at no cost and in most cases can double your super balance at retirement. 4

Invest outside super. (

5

Check the performance of your existing investments outside super and change to better asset choices if you can (page 171).

Protection. (

Check your existing insurance policies so you know what you’ve got (page 320).

Spending less than you earn Each of these steps can get you ahead without spending any money. But to really get the plan underway you need to find ways to free-up cash. The most basic and fundamental principle is to spend less than you earn. This is the basis of all wealth. Go through all the suggestions in chapter 2 (in the section on spending less) and do as many as you can.

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Level 2 — spending less than you earn, but still have personal debts You’ve made it through level 1 and have adjusted your habits so you now regularly spend less than you earn. You now have some free cash each month to tackle level 2. Congratulations, you’ve passed the first big test, but you still have personal debts hanging around and these are costing you big money. I’m talking about credit cards that aren’t paid off in full each month, personal loans, car loans, lines of credit for white goods, furniture and so on. It’s also okay to have a mortgage and some investment loans at this level — because the asset (your home) is increasing in value, unlike the things you bought with the personal debts. The first thing to do with spare cash is pay off all personal debts. Start by paying any bills that are overdue. Next move on to the debts with the highest interest rates and fees like payday loans, store loans and credit cards, and then car loans, boat loans, personal loans and any other loans you have. It’s still okay to have credit cards, but only if you pay the full balance each month (see chapter 2).

Level 3 — no personal debts, but no basic protection By level 3 you have paid off all personal debts except the mortgage. The priority now is to set up an emergency cash fund to make sure there is enough cash for when things break down and need replacing. Unexpected bills always appear out of the blue, so you need a way of paying for them without getting back into debt (see chapter 9). Also, make sure you have basic insurance in place to protect your family’s lifestyle against loss of income caused by death or injury (see chapter 2).

Level 4 — starting to use spare cash to invest, but still have a mortgage You’re looking good. You spend less than you earn, have no personal debts except the mortgage and you have protection in place so that you can handle setbacks like unexpected expenses and temporary reduction or loss of income. You still have a mortgage but you are generating spare cash each month so you are in a position to put it towards building wealth for the long term.

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Which strategy to follow? You can use your spare cash to do three things: 1

pay off the mortgage faster

2

make extra contributions to super

3

build your investments outside super.

Meanwhile, you should also be looking at additional protection measures and continuing to develop your money sense. Additional insurance policies and estate planning measures also start to become more important as your financial affairs get more advanced and complex. There is always a lot of debate and discussion about the three big choices. (And I’m not talking about Porsche, Ferrari or Lamborghini here! Or even Bruno Magli, Manolo Blahnik or Jimmy Choo!) I’m talking about paying off the mortgage, putting it into super or investing it outside super. There are very good arguments for each. I can show you mathematical models that ‘prove’ that each is the best option, depending on a whole host of underlying assumptions and variables. Here are the main advantages of each: 9

Paying off the mortgage. This is the same as getting a guaranteed after-tax return of whatever your mortgage rate is, year after year with no ‘up years’ and ‘down years’ to worry about. It also gives you tremendous peace of mind and a sense of freedom. A great option is to put spare cash into mortgage and then reborrow it to again to invest. This way the new loan is for investment purposes and therefore the interest is tax deductible.

9

Superannuation. Super has the great advantage of being untouchable, as well as some tax advantages that look better than they really are in practice. Salary sacrificing is much more tax effective than making personal after-tax contributions. The most cost-effective solution is to run your own super fund once you have more than $100 000 or so in super.

9

Investing outside super. Investing has the advantages of control, personal involvement, and the ability to focus on our own niche if you want. You can also gear up your investments by borrowing, to accelerate returns.

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It doesn’t really matter which one you start first The most important thing is that you start one or more of the strategies as soon as you are in a position to do so. I know people who procrastinate and spend months debating the pros and cons of making extra payments off the mortgage versus additional salary sacrificing into super or buying shares or an investment property. Months go past and nothing happens. They get distracted by work issues and other priorities, and it gets put off and put off for months or perhaps years. If you are unsure of which strategy to do first, you may want to start with a combination of strategies. If you are planning to commit a regular sum (for example, $400 per month) to build wealth, you could split the money between increased mortgage repayments, a small salary sacrifice, a regular direct debit into an investment plan, and buying life and income protection insurance. It doesn’t really matter which you start first, or whether you use a combination. If you stick to the basic strategies, you will be ahead of the game whichever you choose. Don’t analyse it to death. Bite the bullet and do something — now. Once you are on your way you will want to make adjustments and refinements. Nothing is ever perfect when you first start out. Your particular mix of the three strategies will also depend on the current state of all three. Some examples of households (singles or couples) on level 4 are shown in table 11.2. They have paid off their personal debts but still have a mortgage. At this level they still have negative net investment assets (super plus net investments outside super, less the mortgage).

Table 11.2: examples of households on level 4 Alice

Bill

Charlie

30

40

50

$75 000

$100 000

$150 000

$200 000

$400 000

$300 000

Super balance

$25 000

$90 000

$150 000

Net investments outside super

$20 000

$80 000

$100 000

–$155 000

–$230 000

–$50 000

Age Income Mortgage

Net investment assets

These are fairly typical examples of 30-, 40- and 50-year-old singles or couples. Many people earn more than these figures, but their expenses and mortgages are usually higher as well, resulting

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in similar net figures. The financial situation of Bill’s and Charlie’s households in particular needs some urgent action, because they still have big mortgages, causing big deficits in their net investment assets. These households are going to require some significant steps to get on track and into positive net investment assets territory. 9

Mortgage. The mortgage figures are quite high and it would be wise for each household to at least do something to accelerate payments.

9

Super. The super figures are what you would expect assuming their employers have been making only the compulsory contributions. We have seen how the minimum contributions are nowhere near enough to build a decent retirement income. Salary sacrificing should be a high priority, especially for Bill and Charlie. For Alice, even a very small salary sacrifice would make a massive difference later on in life.

9

Investments outside super. For most people these are usually made up of managed funds and/ or net equity in an investment property or two. All three households could benefit greatly from an accelerated effort in this area.

Prioritise your strategies Within each of the six strategies, there are some things that you must do and there are others that are nice to do, once the must-do tasks are done. 1

Develop money sense. Must-do tasks:

2

(

Spend less than you earn.

(

Eliminate and ban all forms of non–tax-deductible debt.

(

Set up salary deductions and direct debits into the mortgage, super and/or investment accounts.

Own your house outright. Must-do tasks: (

Switch to a low-cost basic mortgage — preferably with your current lender. 368

Putting it all together

(

Set up a plan to pay the mortgage off sooner with extra regular contributions.

Nice-to-do tasks:

3

(

Renegotiate the mortgage to reduce the term.

(

Make additional one-off contributions to accelerate the reduction.

(

Start to research your next house — think about the type and location.

Maximise your super. Must-do tasks: (

Make sure you’re getting your compulsory contributions.

(

Find any ‘lost’ super.

(

Make sure the asset allocation is in the right assets.

(

Switch to a lower cost fund to minimise fees.

Nice-to-do tasks:

4

(

Make additional tax-deductible contributions via salary sacrificing (chapter 4).

(

Make additional tax-deductible contributions if you run a business (chapter 4).

(

Make additional non–tax-deductible contributions to take advantage of government co-contribution and spouse contribution benefits (chapter 4).

(

Set up your own self managed super fund (chapter 5).

(

Choose some optional assets for your fund.

Invest outside super. Must-do tasks: (

Set up an investment plan with regular contributions (chapter 2).

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Nice-to-do tasks:

5

(

Gear up with borrowing to accelerate growth (chapter 6).

(

Investment properties (chapter 7).

Protection in case things go wrong. Must-do tasks: (

Check your existing cover via your super fund.

(

Ensure you have adequate life and/or income protection cover if you have debts or dependents (chapter 9).

(

Make sure you have an up-to-date will (chapter 9).

(

Maintain an emergency fund covering several months’ expenses (chapter 9).

Nice-to-do tasks:

6

(

If there is a significant level of investment outside super (at least $100 000), look at setting up appropriate structures and entities (chapter 9).

(

Upgrade your other insurance cover (chapter 9).

Do what you love doing. Must-do tasks: (

Put some time and energy into discovering what you really want to do with your life.

(

Use the resources available at work to research possible new business opportunities.

Nice-to-do tasks: (

Do some courses and develop your passions.

(

Start researching into new ventures and write up a business plan.

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Level 5 — using spare cash to build wealth, still have a mortgage and negative net investment assets Your financial position is starting to improve and it shows on your balance sheet. You’re making extra repayments off your mortgage, perhaps salary sacrificing a bit more into super and you have started investing outside super. It may be into property trusts or shares, or buying a well-selected investment property or two. Your investments may look small now and the early growth may be slow, but they start to accelerate quickly with the effect of compounding over time. Sometimes one area of your investments goes well (perhaps shares in your super fund) while others are slow (perhaps property trusts in your portfolio outside super). Keep up the regular contributions and make sure your investments are spread over a range of growth assets, time will take care of the rest. Here the net investment assets (super balance plus net investments outside super, but not counting the family house) exceeds the mortgage. Your next goal is to build investments and pay off the mortgage to get out of ‘negative net investment asset’ territory. You have significant investments inside and outside super, and you also have developed a real sense of what investments you like and don’t like. The priority now is to get rid of the mortgage, which will free up much more cash flow to accelerate your investments. Or if you are a renter, concentrate on building an extra $500 000 to take care of the rent.

Renters If you don’t own a house and have decided to rent instead of own as a long-term strategy, that’s fine. But it means that you need to plan to have about $500 000 more net investment assets. To work out how much you need, divide you annual rent by 5 per cent (or multiply it by 20) to find the additional capital sum required. For example, if you plan to rent a home for, say, $500 per week in today’s dollars, that’s $25 000 per year in rent or a capital sum of $500 000. If you invest this (for example, in shares and property trusts), it can generate 5 per cent ($25 000) each year tax effectively, and it will rise each year to stay ahead of inflation and rising rents.

Level 6 — no mortgage or rent, with net investment assets less than $1 million You’re almost there. With no mortgage or rent to worry about and with less than $1 million in net investment assets, this probably isn’t enough to make the transition to the lifestyle you are used

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to, if you also want to buy the car or boat you’ve got your eye on, put the kids through uni or help them with a deposit for a house and so on. The prime focus now is to working on the plan of the life you want to lead for the next 30 or 40 years, so you will be doing what you really want to do, and not have to worry about money. You could probably stop ‘working’ and start on your hobby or passion, but you would need to make sure that you can generate some income from it. In your older years you could probably get by using your investments (supplemented by a part pension perhaps), but you would need to run your capital down, leaving the risk that you will out-live your money. Alternatively, you may need to resort to a reverse mortgage to use the equity in your home to live off in your later years. When you are old and infirm you probably won’t have the resources to hire carers to look after you at home, you may have to go into a nursing home.

Level 7 — no mortgage or rent, plus enough investments to last forever You’ve made it. You have the financial backing to enable you to spend your time doing projects and activities that you love doing and you don’t consider to be work. If they generate income, that’s great. If they don’t, that’s fine too because you have plenty of investments to live off. You can live off the income from your investments while capital remains in tact and even grows ahead of the inflation rate, so it will last forever. You can plan how to use your wealth to benefit your family and others less fortunate while you are alive, and also after you go. Will you qualify for the age pension if it’s still there when you turn 65? It doesn’t matter — that’s a long way off and you probably won’t need it anyway. Why rely on welfare when you can rely on yourself?

Action plan 1

Determine which level you are on at the moment.

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Make a list of the things you will need to do to get to the next level.

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Put a time frame on each action item and set specific goals.

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11.3 Set and forget All good plans to build long-term wealth rely on regular contributions. We have seen how even tiny amounts can add up to big dollars over the long run if you make contributions regularly. In the case of the kids’ plans, you can turn $1 per day into $1 million if you start early enough. Everybody can spare $1 per day, so everybody can start the plan and achieve the goal. For the adult plans, it takes much bigger amounts like $500 or $1000 per month. Most people could spare a few hundred dollars per month if they really tried to find it.

The plan doesn’t need discipline — just one small action and then lots of inaction Nobody has the level of discipline needed to put several hundred dollars into an investment plan every month, year after year for 10 years or more. It’s just too hard and there are too many temptations along the way. You don’t do it for your mortgage, so don’t do it for your investment plans. In the case of your mortgage, every lender these days insists on a salary deduction or direct debit from your bank account to make the payments. Do exactly the same thing for your investment plans so it works like clockwork, without you even thinking about it. If you are planning to make extra payments off your mortgage, don’t just ‘aim’ valiantly to make extra payments off the mortgage ‘when you can afford it’. You may start out motivated and excited, but that will soon fade and other pressing day-to-day needs will get in the way. Instead, reduce the term of the loan from 25 years to 20 years or 15 years, and adjust the salary deduction or direct debit accordingly. If you move from a 25-year loan to a 20-year loan, the monthly repayment amounts will go up by just 5 per cent. That’s a tiny difference — you’ll hardly notice it. But that tiny difference means you will end up saving 14 per cent in interest over the whole loan, and become debt-free five years sooner. That’s a huge impact and it will make a tremendous difference to your overall wealth plans. It will work because the money just goes out every fortnight or month without you ever noticing it or having a chance to spend it. It’s exactly the same for your investment plan. The only way to ensure that the plan works like clockwork is to set up a salary deduction from your payroll, or a direct debit from your main bank account, straight into the cash account linked to your online broker account. It happens every month or fortnight without you even thinking about it. It doesn’t take a lot of discipline — it just takes one small action now to get the process started. 373

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Don’t fiddle with your investments Successful long-term investors will tell you that many of their best investments are the ones they left alone. These are the investments they left in their ‘bottom drawer’ for years and deliberately forgot about. If you are buying into the sharemarket using exchange-traded funds, index funds or passive listed investment companies, or in the listed property market using property exchange-traded funds or the larger diversified listed property trusts, then forget about what the share and unit prices do from day to day, month to month or even year to year. It doesn’t matter. They will just track the general market indices year after year, and will get you to the $1 million target just as you planned. Don’t change them or be tempted to sell just because they have a bad year. The sharemarket always recovers and powers ahead over the long term. It always has in the past and it always will in the future. If you own investment properties, do you constantly look in the back of Property Investor magazine every month to check their value using the median price tables in the suburb they are in? Of course not. The value from month to month or year to year is irrelevant. You’re thinking about more important things like the quality of your tenants, what repairs and maintenance need doing, how you can add value to get more rent and so on. It’s the same with shares and listed property. Think about shares and listed property not in terms of what capital gain you can make, but what income they can generate. Remember that these long-term investments are never to be sold. You are not buying them to make capital gains from sale — you are buying them for the investment income they can produce in 10, 20 or 30 years. You won’t be selling the shares in 10 or 20 years to live off the capital. You would just have to pay capital gains tax if you did sell. Instead, you will be reinvesting the investment earnings for the first 10 years or so, then living off that same income from those same investments when you need it later in life. Never sell. The share prices of even the best long-term investments will always jump around from day to day, month to month and year to year. But the dividends and distributions are much more stable and rise steadily in most years. Forget the share price and focus instead on the earnings and dividends.

Direct shares If you are investing in direct shares as part of your overall plan, forget the share price and concentrate on the company’s business instead. Learn about its industry, get to know its market, 374

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competitors, suppliers and customers, what drives profitability, what the major costs are and so on. Read the annual reports, get to understand the numbers and make sure the earnings are diversified and growing. If earnings are growing, this will flow through to dividends and the share price will follow — eventually. If the business is healthy and the earnings are growing, keep the shares no matter what happens to the share price. If the business is sick and the earnings are poor and declining, then sell the company even if the share price is high, and look for better companies. In our case we have lots of shares that we bought 10 to 15 years ago that we will never sell. The share prices go up and down all the time but that’s irrelevant. We live off the earnings and the dividends keep growing at 10 per cent or more each year. Even in the economic slowdowns the dividends stay flat at worst. If we sold, we would just have to pay capital gains tax and find new companies to invest in. Never sell shares in great companies.

Focus on the big picture It’s all very well to say ‘Don’t look at the share price’, but it takes nerves of steel not to think about the share price, and dream about selling and spending the cash on a new car or holiday. You’re an investor now, so naturally you are thinking about shares, properties, returns and yields. So how do you stop thinking about these things all the time? The answer is this — it’s not about the money. Your investment plan is just a means to an end. You only go around once and you’re not getting any younger, so you want to live the best possible life you can. This is why you’re investing and building wealth. Forget the share prices and focus on developing your hobbies and passions to the point where you can do what you really want to be doing with your life, instead of doing what you are doing now. Keep your mind focused on the big picture and that will put everything into perspective.

Action plan 1

Set up the first salary deduction to pay off debts such as the credit card or a line of credit — the one with the highest interest rate.

2

If you have a mortgage, increase your regular salary deduction of direct debit by a couple of per cent. You can always increase or decrease it later on as things change.

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11.4 Who to turn to for guidance Inside the ‘financial shopping centre’ there are accountants, stockbrokers, financial planners, solicitors, banks, mortgage brokers, insurance agents, real estate agents — the list goes on. Inside each ‘shop’ there are people who know their particular product and they are paid to sell you their product. But before going into a particular financial shop you need to be clear about what you’re looking for and what each shop is selling.

Financial planners The financial planning industry in Australia is flawed and unworkable. If you had a cut finger or sore throat you could go to the doctor and get an opinion and solution for under $20 or $30 and it would take just a few minutes. If you had a leaking tap you could call a plumber, who would come around and fix it for less than $100. If you needed a dent on your car fixed you could take it to a panel beater and get a quick, low-cost solution. But in the finance industry it is illegal for somebody to give you a quick, simple, low-cost opinion on a particular issue. If you took a Westpoint or Fincorp PDS to a financial planner, he or she is not legally allowed to do the sensible thing and tell you it’s rubbish. Or perhaps you want them to check your pension entitlement or the fees on your super fund. Financial planners are not legally allowed to provide a quick, simple opinion on a particular matter. They must legally go into every detail of your whole financial situation. They are required to first collect all sorts of information and data from you including lists of all your assets and liabilities, details of your income and expenses, copies of your tax returns, details of any tax liabilities, details of all your insurance policies and wills, details of your superannuation accounts, details of your welfare entitlements, ages of you and all the members of your family, and other matters that may have an impact on your family in the future such as health needs or problems. Financial planners are also required to ask you to complete surveys to determine your attitude to risk, and to ask you about your future cash needs and your financial objectives, needs, priorities and commitments. Then they are required to prepare a comprehensive plan for you and your family that covers your entire financial situation, objectives and needs, and to provide you with lengthy legal documents including the financial services guide, statement of advice and product disclosure statements for all the products in the plan. They need to employ an office full of people to do this work and to

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generate all this paperwork. In order to pay for the support staff and paperwork they need to charge a fee of at least $3000 or $4000 per plan. And that’s for a simple plan. Financial planners charge so much because of all the regulations and laws governing what they do and how they do it. That’s why most only want to deal with clients who have $100 000 or so to invest.

The cost adds up If you had $100 000 to invest and your planner charged you $4000 for advice, while this may seem expensive, it’s a lot cheaper than paying sales commissions. If you had to fork out a $4000 fee you would need to put your hand in your pocket and actually write out a cheque, which would be painful. On the other hand, if you opted for the ‘normal’ fee structure attached to a managed fund, you would pay a fee of, say, 4 per cent (of which the planner would get about half) plus an annual fee of, say, 2 per cent (of which the planner would also get about half each year as well). So the cost to you would be $4000 up-front and then $2000 per year for as long as you held the investment. This could be 10 or 20 years or even longer. It gets worse. The annual fee is based on the size of the fund each year, so the fee grows each year that the investment grows.

Most financial planners are in-house sales representatives for fund managers Most financial planning groups are owned by banks and fund managers. The financial planners are merely a sales arm paid to sell their products. These planners are not independent. They sell only a limited range of products — normally their own in-house products run by their owner. Many also sell other fund manager’s products as well as their own. They are not independent. They are owned and paid by fund managers to sell the fund manager’s products. If you went to your doctor and were prescribed a medication, you would want to know that the medication the doctor chose was the best available on the market for your needs, regardless of what drug company was paying him or her to sell it. Fortunately, doctors are independent professionals, but most planners are not.

Chasing lump sums Most planners are paid commissions for selling managed funds, so they are interested mainly in the types of business that makes them the most commission, which are one-off lump sums like inheritances, switching super funds, lottery wins, and retirement and retrenchment payouts. These provide big commissions quickly. Not only that, financial planners can lock you into an annual ‘trail’ commission as well.

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Paraplanners Here’s a big surprise — financial planners don’t actually prepare financial plans! In most cases the financial planners sitting in the financial planning office are merely there to find potential customers and gather their details (income, expenses, assets, liabilities and so on). They then send the details back to a team of junior paraplanners in the ‘back office’, who put the numbers into a computer that then spits out your ‘plan’ — plus reams and reams of other paperwork. This paperwork is sent back to your ‘planner’ who then tries to sell you the products specified in the computer plan. The Australian Securities & Investments Commission (ASIC) is the industry ‘watchdog’. ASIC regularly undertakes investigations that reveal that planners give poor advice and primarily push their own products and/or products that pay the highest sales commissions. Hundreds of planners have been caught switching clients from their existing super funds into in-house funds, without first analysing the performance of their existing fund. Often planners get blinded by the sales commissions paid by the funds. In the case of the Westpoint collapse, many planner firms put their own money into the scheme and lost it, on top of the clients’ money they also put in. This shows that these planners didn’t understand risk. They were blinded by the high returns and the high sales commissions. Most commission-based planners don’t recommend industry super funds, index funds, exchange-traded funds or listed investment companies because they don’t pay sales commissions. These types of investments may invest in exactly the same underlying assets as the expensive managed funds sold by the planners, but the commission-based planners won’t recommend them because they don’t pay sales commissions.

All wrapped up Over the past 10 years fund managers came up with a concept called ‘wrap accounts’, also called ‘master trusts’ or ‘platforms’. Financial planners will talk about them for hours because they are so good — for them! There are two main reasons. The first is because these accounts are designed to ‘wrap’ you up — that is, lock you into that planner for as long as they can. Often they are structured so that if you want to leave that planner and take your investments elsewhere, you are forced to sell the underlying investments and trigger capital gains tax. That’s nasty. The second reason planners love wrap accounts is that they provide them with another layer of fees (which come out of your pocket) over and above the fees they already charge for your investments (which also come out your pocket). For example, if you go to an AMP financial planner and you are recommended an AMP managed fund (surprise, surprise!), you will pay commission of, say,

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4 per cent up-front plus 2 per cent per year. That’s bad enough, but then the planner will recommend that you invest in the fund via AMP’s in-house wrap service, master trust or platform, so you can access special ‘wholesale’ funds with slightly lower annual fees. But then you discover that the platform has its own annual fee on top, so you’re back where you started or worse. Wrap accounts are almost all called a different name by fund managers to make them look more independent — but they’re not. Wrap accounts are just another way to get money out of your pocket into their pocket. A small minority of planners don’t take up-front commissions and instead charge hourly fees like other professionals. But many still take the ongoing annual commissions from the managed funds and from the platforms, which is where most of the money is made.

Why use a planner? In light of all these problems, why would you use a financial planner? Because nobody else is legally allowed to provide you with personalised financial product advice. The law says that anybody carrying on a business in Australia who provides financial product advice must hold an Australian Financial Services Licence. ‘Advice’ is defined as any statement that is intended to influence a person to buy, sell or hold a financial product or class of product.

How to choose a planner I would strongly recommend that you get advice from an independent, fee-based licensed financial planner if you can. These are the only planners who are ‘professionals’ in the true sense of the word. A ‘professional’ is someone who is bound by law and ethics to put your interests ahead of their own — who are obliged to give unbiased advice without fear or favour. There are some great financial planners out there, but it takes a bit of time and effort to find them. The best way to find a good financial planner is by word of mouth from your accountant, your family, friends or colleagues you trust. Make sure that the person recommending a particular planner has a long-term relationship with the planner over several years. There are four minimum requirements and several optional requirements. The minimum requirements of a ‘professional’ financial adviser or planner are: 9

independent — that is, not owned or controlled by a fund manager

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fee based, not commission based. The planner must rebate 100 per cent of all commissions received by fund managers for selling their funds. This includes all up-front sales commissions and annual ‘trail’ commissions. There must be no ‘soft-dollar’ commissions 379

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in the form of free holidays, overseas conventions, golf (sorry, ‘training’) trips paid for by fund managers 9

the fees must be based on the work actually done for you, not on a percentage of your funds

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hold an Australian Financial Services Licence

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be able to recommend any product on the market if it is appropriate for your needs, including industry super funds, index funds, exchange-traded funds and listed investment companies, and not be restricted by some head-office-approved ‘recommended list’. The products they use must be based on merit, not on the sales commission they receive.

These basic, minimum conditions will help ensure that the planner’s ‘advice’ is not tainted by fund managers pulling the strings behind the scenes. These tests would put them on the same footing as other professionals like accountants, solicitors and doctors. Once these minimum mandatory conditions are met, then you can move on to the optional requirements, which are still very important: 9

Market experience. A planner should have seen the good times and the bad. I have met some really switched on young planners who are highly educated and highly skilled but simply haven’t been through anything but good times. They need to have been though all sorts of market conditions such as the stock market crash of 1987, the unlisted property trust collapse in the early 1990s, the bond market collapse in 1994, the Asian currency crisis between 1997 and 1998, the dotcom mania and collapse between 1999 and 2000. Don’t settle for anything less than 20 years’ experience. This experience need not necessarily have been as a planner. There are some fine planners who spent the first decade or so of their careers as accountants or stockbrokers. This is just as good as long has they have had first-hand experience with several market cycles.

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Hands-on experience. Your planner should be a long-term, hands-on investor. You want somebody who can answer detailed practical questions to help you on your way as you put the plans into action.

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Educated. Your planner should preferably have a broad education in addition to the narrow financial training required to get a licence. This could be a degree in accounting, economics, commerce, finance or law. 380

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9

Wealthy. Most financial planners are ex-bank staff or ex-life insurance salespeople — who often have big mortgages and little or no investments of their own. Would you go to a dietician who is fat? Or would you hire a personal trainer who is unfit? Of course you wouldn’t. You would want one who is fit and healthy — and well trained and knowledgeable. You would want to know that your planner’s wealth came from wise investments — not from charging huge commissions. You will get a feel for this when you ask about the planner’s best and worst investments, and investment philosophies and principles. Ask the planner to provide real examples from personal experience, not just hypothetical examples.

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Ask the planner whether you are the target client profile. Many planners specialise in particular types of clients — for example, medical professionals, pre-retired executives, business sales and succession planning, and families in debt. The trick is to find a good planner who specialises in your particular needs.

Unfortunately, there is no public register of independent fee-based planners. The Financial Planning Association (FPA) is a national body that looks after financial planners in Australia. It is a lobby group funded by financial planners to promote and protect their interests, not the interests of their victims. The FPA website and phone service can provide you with a list of registered planners in your area, but it can’t vouch for quality. Check out these websites: 9

Financial Planning Association of Australia — or phone 1800 626 393. The FPA can help find a local planner, but won’t, or can’t, tell you who is independent.

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Imperator Financial — or phone 1300 788 501.

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Australian Investors’ Association — .

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Australian Consumers’ Association — . Search for ‘financial planners’.

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Australian Securities & Investments Commission — . Search for ‘financial planners’. (If you search for ‘independent financial advisers’ you won’t find any results!)

The bottom line is this — most financial planners are probably nice, honest people who are just trying to make a living. They are probably genuinely trying to do the right thing, but are under enormous pressure to make their monthly managed fund sales budgets.

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It is well worth the time and effort to find and get to know a good planner, but understand that it might take a few years and a few false starts along the way.

Tax agents Tax agents can be very good value. For $100 or even less in some cases they transform your shoebox full of paperwork and receipts into a tax return and then lodge it. Even though most people should probably be able to lodge their own returns in theory, in practice it is not always that easy. The government is constantly changing the rules and regulations and it is impossible for anybody to keep up with all the changes. The tax office’s own website is an absolute nightmare to use. Make sure your tax agent belongs to one of the major well-known national chains. They have extensive training courses and their software is usually up to date with all the latest changes. Their systems can also pick up most of the specific items that may affect your particular circumstances. The main problem with tax agents is that their systems and processes are set up for people with relatively simple financial affairs. Once you start to get into different kinds of investments it may be worthwhile looking for a good accountant.

Accountants Once you move beyond the early stages of your financial journey, it makes sense to have an accountant. Accountants can play a vital role in your financial plans — preparing accounts and tax returns, establishing entities like companies, trusts and self managed super funds, and then doing all the paperwork required on an ongoing basis such as minutes of meetings, lodging annual returns, audits, BAS forms and so on. Accountants are professionals in that they charge fees for services rather than rely on sales commissions from selling products. You can expect to receive opinions untainted by the promise of sales commissions. Most accountants can help put clients with complementary needs together. For example, if you are thinking about selling your business, your accountant or other partners in the firm will probably also have clients looking to buy businesses. The same applies to putting investors with businesses looking for capital. Most accountants are not licensed to provide financial advice, which means they can help set up a company, trust or self managed super fund, but they can’t actually advise on the investments

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they should make. Many accounting firms have relationships with local financial planners, to whom they can refer you. They usually also have relationships with local solicitors who may be called in to work on particular aspects of your affairs like drafting trust deeds, wills, property purchases and sales, businesses sales and so on.

Big or small firm? Accounting firms come in all shapes and sizes — from tiny one-person bands to giant global firms. The size of the firm has nothing to do with whether a particular accountant is good or bad. In small firms, each accountant sees a wide variety of work — a bit like a general practitioner — whereas in larger firms each accountant tends to specialise in a particular area. In the larger firms, most accountants with at least 15 years’ experience will have spent several years in each of the major areas and will have good all-round experience and expertise.

Costs Accountants generally charge for each transaction. The cost of each transaction is based on an hourly rate. The cost of a basic tax return is probably double what a tax agent charges, but accountants provide a much wider range of services and can help structure your financial affairs. You can usually ring up your accountant from time to time with specific questions and you won’t be charged for it. A certain amount of general, ad hoc advice is built into the charges for the fees each year, so you don’t need to feel as if the meter is running whenever you ask a question. In the case of my family, we have used the same accountant for over 20 years. It’s a small citybased firm with only a couple of partners and half-a-dozen accounting staff. Our accountant acts as the ‘hub’ of the relationship and calls in other professionals from time to time when they are required — the solicitor next door, independent auditor up the road, tax specialist across town and other clients who have complementary needs. The total cost each year — including fees for accounts, returns, BAS, minutes of meetings, audits and so on for the individuals in our family, plus companies, discretionary trusts, unit trust, super fund, and a charitable foundation, plus countless hours of tax advice and guidance — comes to a total of about 0.2 per cent of the value of our investments per year. A couple of years ago I was having a casual chat with my accountant over a coffee and I mentioned that I might have a potential tax problem with a particular investment. Off the top of his head he came up with a simple idea that ended up saving me over $100 000 in tax. So I paid for the coffee!

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Stockbrokers If you build your long-term growth portfolios using shares and property and following the plan outlined in this book, you are probably using the simple, low-cost ‘passive’ investments like ETFs, unlisted index funds, listed investment companies and listed property trusts. The selection and purchase of these is very easy and cheap using any one of a number of online broker accounts. For this you don’t need a full-service stockbroker. If you move into the optional area of buying individual stocks, there is a huge amount of research and information available through the online broker websites and on other websites. Stockbrokers can also provide one-off advice on particular shares, and they charge around 1 per cent or so of the value of the buy or sell order. You can also use a stockbroker to manage your portfolio. For this a broker generally charges either an annual fee based on the whole portfolio value (for example, 1 per cent or 2 per cent) per year, or brokerage per transaction, or a combination of the two. Paying a stockbroker to pick stocks for you is a bit like paying a fund manager in a managed fund. It is expensive and the chances are that brokers will underperform the general stock market index over the long term, because of the impact of their fees. Some do better than the index, but most won’t over the long term. Your stockbroker can also help you develop an investing style that matches your risk tolerance and preferences, which a fund manager can’t do. Using a stockbroker becomes viable if you have a couple of hundred thousand dollars in a fund (either inside or outside your super fund). If you are going to use a stockbroker, I strongly recommend that you give them only a portion of your portfolio. Put the rest into passive share investments, so you can benchmark the stockbroker’s performance against it. Tell them you need them to beat the All Ordinaries Accumulation Index, after all taxes and fees each year. This will ensure that they minimise stock turnover (that is, minimise buying and selling of stocks, which can generate capital gains tax and incurs brokerage costs). Finding a good stockbroker is the same as finding any other professional — always rely on recommendations from people you trust.

Lawyers Lawyers also play a key role in executing parts of your overall financial plan — wills, estate planning, conveyancing, trust deeds, contracts, sales and purchases of businesses, and so on. They charge fee for service rather than receive sales commissions. Like accountants they can also introduce clients with complementary needs. They are not licensed to provide financial product advice or 384

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sell financial products. Beware of solicitors’ mortgage schemes, which have been outlawed in some states. These are schemes in which clients lend money to other clients who borrow the money, all organised by the solicitors. In our case, we have used the same conveyancing solicitor for 20 years. For the first few properties we used another lawyer. He was extremely knowledgeable and pointed out every possible theoretical outcome, but he wasn’t practical. You need someone who will point out all the detailed points, and then provide balanced commercial judgment and recommendation. Lawyers can save you a lot of money. A couple of years ago a neighbour of ours bought a property for development but signed a contract with the ‘Land tax adjustment — yes’ box ticked, instead of the ‘no’ box. This was not picked up by his solicitor and ended up costing him over $40 000 for the previous two years unpaid land tax, which the vendor should have paid prior to settlement had the ‘no’ box been ticked.

Mortgage brokers A mortgage broker is an important person to have on your team. Not just for fixing up your home mortgage, but also for financing your future houses, investment properties, loans to buy shares or businesses and so on. Refer to chapter 3 for more tips on what to look for and where to find a good mortgage broker.

Banks The days when your local bank manager understood your needs and had a good range of products to offer are long gone. For your lending needs, a good mortgage broker will be much more useful. For deposit products, the major banks no can no longer compete with the new online accounts. The big banks have copied the new players and tried to catch up, but they are still miles behind. For investment products, the bank will just refer you to their in-house managed fund financial planner. I have been a ‘private banking’ client of one of the ‘big four’ banks for the past 10 years and the service I have received has been patchy at best. It tends to favour complex, highly structured, multilayered products put together by expensive investment banks, presumably because the fees and commissions are so attractive — for the bank. It usually takes me a couple of weeks to dig through all the layers to find out how they work and where the money goes. Meanwhile, the offer period has usually closed and I end up missing out. Somehow I think it’s just as well.

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Action plan 1

Make a list of people you can call to ask for recommendations on professional advisers.

2

If you have an accountant, find out whether he or she has a relationship with a local financial planning firm or vice versa.

11.5. Stay positive and take action Every generation is nervous about the future, and looks back nostalgically at how easy things appeared to be for previous generations; for example: 9

Depression-era people are generally nervous about the future and worry about things like personal safety and health care. They look back to the simpler times before things like deregulation, road rage and the rise of technology. They think the baby boomers have had it easy, with their optimism, health and economic good fortune.

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Baby boomers are generally nervous and uncertain about the future because of their high debt levels, low super and declining pensions, and look back nostalgically to the simpler age of their parents, when everything was so certain and ordered — jobs for life, less crime and violence, more homogeneous society, cheaper housing.

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Generation Xers tend to think the boomers were spoilt by their free university and decades of global peace and growth. They look to their own futures with angst because they have been forced out of the housing market, and because every aspect of society and the economy is dominated by the ageing boomers.

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Generation Ys generally think gen Xers have had a free ride with their compulsory super and long economic boom. They look to their own future nervously — burdened by huge university debts, threats of global warming, increasing ethnic and religious violence, impending energy crisis and so on.

Looking back is easy. Looking forward is hard and fraught with uncertainty. Fear of the unknown is natural.

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The good old days? We all look back at the ‘good old days’ where everything seemed so easy. But was the ‘good old’ 20th century that good? There were two world wars in which hundreds of millions of people died. Countless racial and ethnic wars, and the resulting famine and disease killed hundreds of millions more. There was the rise of murderous dictators, and of the communist and fascist regimes. There was the rise of AIDS, which is still killing millions of people each year. The 1950s to 1970s were dominated by a ‘cold war’ that could easily have erupted into full scale nuclear war threatening the whole planet. Just imagine for a second what would have happened to the world if George W Bush had his finger on the red button instead of John F Kennedy — all we would have left today are cockroaches that glow in the dark! That’s how close it got. In Australia we were invaded by Japanese bombers and we even had submarines torpedo ships in Sydney Harbour, then we had crippling inflation, 15 per cent unemployment and interest rates up to 20 per cent at times. Would you really want to go back there? I would take the future over the past any day. It may be uncertain but that’s the beauty of it. We can’t change the past but we can build whatever future we want for ourselves. We may think we are doing it tough now compared with previous generations, but in 50 years our kids and grandkids will be asking us about the ‘good old days’ in the early 2000s when everything was so certain and simple — low inflation; low interest rates; low unemployment; cheap, safe drinking water; safe streets; cheap power; and all the other great things we take for granted while we pine for the ‘good old days’.

Even the ‘experts’ have no idea about the future At the start of each year all the stock market analysts and economists — who are all on salaries of half-a-million dollars or more — forecast the year ahead. They gather all their research, scratch their heads, frown and come out with exactly the same prediction for the year ahead. They all say something like, ‘The coming year will be volatile and uncertain, and will probably produce moderate returns in the high single digits’. Almost every market analyst and economist says this and they do it every year. Then the year goes past and the market produces returns of 25 per cent (or negative 25 per cent). At the end of the year, the very same analysts and economists scratch their heads, frown and announce wisely, ‘Ah, yes, but we didn’t know that X or Y would happen last year, and that explains

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why the return was 25 per cent (or negative 25 per cent). Now we know that, it’s easy to look back and understand the results. Looking to next year … (a pause as they scratch their heads, frown and try to look wise) … next year will be different. The coming year will be volatile and uncertain, and will probably produce moderate returns in the high single digits.’ (Don’t forget that you’re paying for all those economists and analysts with your managed fund fees!)

Focus on what you can control You and I have no control over interest rates, the stock market, inflation, house prices, or any of those other things, so it’s pointless worrying about any of it. What we can control is what we do with the money that comes into our possession this month. We can control how much we invest, how much we save and how much we spend. Where and how we live now is a direct result of how we spent our money 10 years ago. Where and how we live in 10 years will be a direct result of how we spend the money we have this month. Concentrate on getting it right this month and set up the mechanisms so that it happens like clockwork — without you even thinking about it. Get it right this month and then every month in the future will get you further and further along the path to wealth, and the future will take care of itself.

Start small Yes, your task may seem big. You have to get out of debt, but still live well and pay all the bills that keep coming in, free up some money from somewhere to start investing, and in the meantime figure out how you get out of your existing career and get on with what you really want to do with your life. You also have to build enough wealth to help your kids out financially during your life and after you’ve gone. Don’t let the apparent size of the overall task put you off starting a plan of action. Start with small steps now, they can make a huge difference over the long term. There is nothing new or revolutionary about the principles used in the plan — they have been around for years and even centuries. The problem is that few people actually do something about it to get the plan started, so they find themselves in the same position 10 years later. If you start with a few small steps now, you will look back in a year and ask yourself why you put it off for so long. The first few steps may look hard now, but they will appear easy when you look back after they have been done, and you will wonder what all the fuss was about.

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The plan needs action, not just motivation If you look in any bookshop you will see shelves full of books about wealth creation, motivation and success. In addition, there are all sorts of CDs, tapes and seminars advertised in magazines and direct mailers. Many of them contain some very sound principles of motivation like ‘wanting success enough’, ‘persistence’, ‘discipline’ and so on. There is no question that principles like these are vital for success in any field. But too often people read them and get excited and motivated, but fail to act. No doubt there are some people who, after reading one of those books or attending one of those seminars, are suddenly inspired and actually go out and create a brilliant new business that makes them rich. But I don’t think it happens very often. I have seen many people spend their lives bouncing from one motivational book or seminar or CD series to the next, in the endless search for the next motivational ‘fix’.

Action leads to motivation All of these books, CDs and seminars are built on the assumption that motivation leads to action. The more motivation, the more action. If you say enough motivational ‘affirmations’, listen to enough motivational CDs, and put up enough posters with glib motivational phrases on your walls, somehow your life will suddenly change because all this motivation will lead to action. I happen to think that it works the other way around. Let me explain. I have had a small gym at home for the past 20 years. (Why? Because it costs a fraction of an annual gym membership and it’s right there whenever I want to use it.) I know that I should do a workout half-a-dozen times a week. I have plenty of motivation — I know it will keep me healthy, I know it’s good for strength, I know it’s good for the heart. I know it will probably let me live a longer and more active life. On top of all that I know that I will feel guilty if I don’t do the workout and also that I will feel great after it. That’s a lot of powerful motivation. But it’s not the motivation that’s the problem. The problem is that I just can’t do it right now. There are always 100 other things to do instead. Or I might be tired or have a headache. So I tell myself, ‘Okay, just two minutes — and I’ll just do one set with light weights’. Or, ‘I’ll just do some stretches or a quick warm-up, that’s all’. In fact, I can do the stretches and warm-ups anywhere in the house and I can do them while watching the news or reading the mail. I don’t even need to be in the gym to do them. So I start to do a quick stretch or warm-up, and guess what happens? Almost every time the same thing magically occurs. After just one minute of stretching or warming

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up I start to find myself getting in the mood to do the next step, and that leads to the next step, and I end up doing a full work-out and I feel great. Sounds crazy but it works every time. The fact that I am doing some simple, small activity turns motivation into real action. It might be a small insignificant activity that doesn’t achieve much by itself. But that small action starts a chain reaction that triggers the motivation I need to it achieve the goal. It was the same when I used to jog (years ago when I was still young and silly!). I would start by promising myself I’d just do a stretch or a warm-up, and then it was just the first lap around the block or the park. Before I knew it I had done the full trip and I felt great. If I had followed the pattern of the self-help books, CDs and seminars I would have become motivated and designed a fantastic two-hour workout full of great exercises, or a fantastic running session with all sorts of sprints and sand-hill runs. They would have been brilliant plans and I would have been tremendously motivated, but I probably would never have got around to actually doing them.

Don’t procrastinate Almost every day I receive emails from readers who say things like, ‘Loved the book, can’t wait to get started’. Some of them say that they have decided to set up a salary deduction into an investment account (or the mortgage, or super fund and so on), but they can’t decide whether to start with $50 per month or $100 or $200. Then they get themselves tied up in knots with all sorts of mathematical calculations, projections and rates of return. I tell them it’s better to start out small and stick to it, than start out with a grand plan and then give up. Many readers enter into detailed debates about the relative merits of paying off the mortgage versus increasing their superannuation contributions versus starting an investment plan. I remind them that all three approaches can be very powerful ways to get them closer to their goal of financial freedom. The trick is to start with the one they feel most comfortable with, and start today. In some cases I have asked readers how it was all going six months or a year later, thinking that they had bitten the bullet and started, but they were still stuck on the starting line, debating which strategy to start and/or how much they should start the plan with. The truth is that it really doesn’t matter which of the strategies you start first, or what amount you start it with. Just start with a small amount that you can afford easily. You will very quickly see how easy it is and be motivated to try the next steps. 390

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No psychobabble, just practical steps Many motivational books on success and wealth-building talk all about the grand principles like ‘think like a winner!’, ‘break through barriers!’ and ‘conquer your fears!’. These glib phrases may make good reading they but leave many people saying, ‘Yes, that’s all very well, but what should I actually do today to get started?’. The problem is that many people need to know exactly what the small practical steps they can take right now are, to start the whole chain reaction working.

Make it easy Most of us spend too much, borrow too much and invest too little. I believe that the problem is not that most of us actually intend to do this. But spending and borrowing is just too easy these days, and finding the right things to invest in is too hard. For every good, low-cost, tax-effective investment that we can use to build wealth, there are hundreds of others that are inappropriate for a whole range of different reasons — exorbitant fees, hidden sales commissions, high risks, false advertising, biased advice and get-rich-quick schemes. The finance industry is plagued by complex legislation, continuous government changes and conflicts of interest, and everything is laden with mountains of paperwork. It’s just too hard and we’re all too busy to take the time to search through it all. In this book I have tried to set out practical steps so you can start on the path to success. There is no right answer for everyone because everyone’s situation and needs are different. But I hope that you will find dozens of useful, practical steps that will set you on the right path to wealth and financial security, and to a productive and rewarding future. Each step requires very little effort and, once it is set up, it works like clockwork over many years. You don’t need to constantly think or worry about them. Set up these things so they look after themselves, and provide you with peace of mind and time to think about what you really want to do with the rest of your life, and how you want to use your wealth. Good luck on your journey. Please let me know how it’s going. You can email me at . You can also visit for the latest updates and further information on the plan, products, interest rates, returns, useful tips and ideas.

391

References Aspect Huntley Association of Superannuation Funds of Australia Ltd (ASFA) Australian Bureau of Agricultural and Resource Economics (ABARE) Australian Bureau of Statistics (ABS) Australian Commonwealth Treasury Department Australian Retailers Association Australian Securities & Investments Commission (ASIC) Australian Stock Exchange (ASX) Australian Tax Office (ATO) BIS Shrapnel

392

References

Centrelink Economist.com Family Assistance Office (FAO) Fido (ASIC’s financial tips and safety checks) Financial Planning Association of Australia (FPA) Financial Services Institute of Australasia (FINSIA) Insurance Council of Australia International Monetary Fund (IMF) National Centre for Social and Economic Modelling (NATSEM) Organisation for Economic & Cultural Development (OECD) Property Investment Research (PIR) Reserve Bank of Australia (RBA) Sydney Futures Exchange Taxation Institute of Australia The Australian Financial Review Times Online UNICEF United Nations Wall Street Journal Online World Health Organization (WHO)

393

Index

$1 million target 22, 168–169, 338 $1 per day plan 45–46, 373 $500 per month plan 47–48 $1000 per month plan 48–49 $2000 per month plan 49–50

—diversification 200–201 —fees 194–196 —investment performance 183–184, 198, 199 —managerial style 199 —managers 201 —master trusts 201 —short-term focus 199–200 —strategy 184–185 —tax effectiveness 198–199 active unlisted funds 219–220 Adelaide Bank 300 Advance (St George) 201 agents —commercial 278 —property managers 246, 269 —tax 382

ABN Amro 201 absolute return funds 307 accountants 382–383 —costs 383 —financial advice 382–383 active ASX-listed managed funds 218–219 active managed funds 182, 193–202, 224, 236 —advantages 185–186, 194 —advertising 202 —disadvantages 185–186

394

Index Australian Stock Exchange (ASX) 172 —20 largest stocks 205 —300 Property Trusts Index 280 Australian Super 151 Australian Unity 280 Australian Wheat Board (AWB) 207 AXA 190, 201, 280

age pension 116 —reduced 19 —reliance on 10–11, 12–13, 14, 168 AGEST Super 151 agricultural, shares 222 All Ordinaries Accumulation Index 176, 180, 193, 215, 271, 273, 384 All Ordinaries Index 176 allowances 54 American Express 42 AMP 201, 299, 300 analysing stocks 213–215 Andrew West Online 303 appreciation (land) 77–78, 84–85, 112–113, 114 Artog 323 asset allocation —driving performance 142 —subclasses, choosing too many 143–144 —superannuation and 138–145, 169, 369 assets 306–307 —capital gains 53 —company 335 —gearing, impact of 234 —growth 70, 155 —joint tenants 332 —not covered by a will 330 —protection 317–318, 336, 360 —tenants in common 332 Asset Super 151 auction firms, commercial 33 AUSfund 166 Australia —annual inflation rate 63–64 —debt x–xi —housing costs, factors influencing 109–110 Australian Consumers’ Association 381 Australian Health Cover Advisors 326 Australian Investors’ Association 381 Australian Securities & Investments Commission (ASIC) 378, 381

baby boomers 386 backup plan 355 Bank of Queensland 292, 301 banks 385 —bank-owned finance company debentures 292 —cash management accounts (CMAs) 296 —cash management trusts (CMTs) 296 —fake bank websites 57 —high-rate internet accounts 295–296 —mortgages see mortgages —shares 172 —term deposits 291, 320 Bank West 299 Barclays Australian Equity Index Fund 190 Barclays Bank 220 body corporate 83 bonds 69, 70, 291–295 —Australian 294–295 —cash 64, 66 —corporate 69 —different age groups 294 —government see government bonds —international 69 —preference shares 69 —reliability 293 —superannuation asset allocation 138 bonuses 32–33 borrowing money 391 —luxuries, for 35 —residential property investments 258–261

395

$1 Million for Life brokers, online 225, 301 —account operation 306 —cash accounts and 296–297, 298, 302–304 —unhelpful and expensive 305–306 —what to look for 301–302 BT (Westpac Bank) 152, 201 budgets 35–38, 363 —credit card 37 —petty cash 35–37 —zero-based 34 Buffett, Warren 189 building materials, shares 173, 222 buildings 247 —depreciation 77, 79–80, 83, 246–251 bulky goods investment 276, 277 business —building a 354–355 —insurance 327 —starting a 18 —stresses 23 —taxation 51 buying —investments, timing 58–59 —real estate, timing 87–88, 114

capital gains tax 53, 62, 67, 153–154 —wills 330 —wrap accounts 378 careers see employment Care Super 151 cars 33–34, 39 case studies 343–349 cash 69, 70 —emergency fund 70, 295–296, 318–320, 337, 370 —management accounts (CMAs) 296 —management trusts (CMTs) 296 —petty cash budget 35–37 —superannuation asset allocation 138 cash accounts 296 —credit facilities 298 —examples 299–300 —fees 298 —interest 297–298 —internet 319–320 —ongoing balance 298 —online brokers and 296–297, 298, 302–304 —opening balance 298, 300–301 —statements 298 Catholic Super Fund 151 CBFC (Commonwealth Bank) 292 Cbus 151 Centro Properties Group 280 Challenger Financial Services Group 201, 280 CHESS sponsorship —online brokers 302 child care 1, 21, 29 children —board, paying 105 —costs 15, 17 —housing, helping them with 18 —investments, ownership 55 —living at home 16–17 —taxation 55

calls, margin 228–229 CANNEX 296, 300 capital —business, starting a 18 —growth 62–63, 67, 70, 155, 268, 287 —guarantees 293 —maintaining, importance of 7 —requirements, estimating 6 —risk 65 —safety 64 —spending 14, 34 —20 times multiple 290 —value 65–66, 270 —yield, chasing 291

396

Index choices 359–360 churning 144–145 Citibank 299, 300 Clearview 152 clothing, shares 173 Colonial First State (Commonwealth Bank) 201 commercial auction firms 33 commercial property investment, 276, 277 commissions, sales 67 Commonwealth Bank 299, 303–304 CommSec 303–304 communications shares 173 companies —administration costs 336 —consultancy 354 —‘dud’ 210–211 —family 334–336 —taxation 55 compounding 47 consulting 353 —charges 353–354 —companies 354 —thinking like a consultant 354 contracts for difference (CFDs) 66, 290, 310, 312 —self managed superannuation funds and 164 controlling your life 23, 388 costs —accountants 383 —companies 336 —discretionary trusts 333–334 —financial planners 377, 378–379 —holding 66 —management 66 —property transactions 256–257, 269 —refinancing 106 —renovating 255 —sales commissions 67 —self managed superannuation 162–163 —transaction 66

crashes 179–180 credit cards 41, 103 —budgets 37 —debit cards versus 41–42 creditors, protection from 335 currency —international 222 —risk 216–217 —trading 312 death —debtor, of 328 —superannuation 136, 167, 330–331 —tax 331 —wills see wills debentures —bank-owned finance company 292 debit cards —credit cards versus 41 debt x–xi, 6, 339, 363, 375 —‘bad’ 38–39, 71 —consolidation 101–103 —credit card see credit cards —debt-reduction schemes 105 —‘good’ 38–39, 71 —investment 39 —non-deductible, paying off 40–41 —‘okay’ 38–39, 71 —passing on 328 —personal see personal debt —stress 23 —superannuation, repayment with 12 deductions 54 —non-residential property investments 268 defined benefit funds 117 depreciation 38–39, 61 —capital expenditure 248–251 —land versus buildings 77–78 —residential property investments 246–248

397

$1 Million for Life depreciation (cont’d) —schedules 247, 286 —units and flats 82, 83, 114 depression 23 derivatives 66, 289, 310, 312 —see also trading —self managed superannuation funds and 164 Diners Club 42 direct shares 182, 202–215, 224, 374–375 —advantages 185–186, 202–203 —cost savings 206 —disadvantages 185–186 —‘dud’ companies 210–211 —‘ethical’ funds 206–209 —expertise, using your 212–213 —finding the ‘next big thing’ 211–212 —how much to invest 213 —international 222 —investment performance 183–184, 208–209, 215 —minimum transactions 203 —picking stocks 210 —strategy 184–185, 203–204 discipline 373 discretionary trusts 333–334 diversification 68 —active managed funds 200–201 —listed investment companies (LICs) 191–192 —residential property investment 265–266 dividends 173–174 —family companies 335 —final 174 —franking credits 67, 154, 174–175 —interim 174 —wealth planning 175 divorce 18, 19 ‘dud’ companies 210–211

earning capacity 4 eChoice 323 economic forecasting 387–388 economic management 182 education 182 —costs 15–16, 39 —courses 351 —favourite subjects 351–352 —private schools 15–16 —professional development and training 39 —university 16 —voluntary contributions 16 Elders Rural Bank —cash account 299 emergency cash fund 70, 295–296, 318–320, 337, 370 employment —duration 9 —earning more money 20–21, 28 —job satisfaction 3–4, 339–340, 350 —job security 19 —parents returning to work 29 —participation rates 78, 91 —productivity 78, 181 —professional development and training 2 —self-employment see self-employment —stresses 23 —superannuation see superannuation —working ‘till you drop’ 20 —‘work test’ 131 entities 331 equities 69, 70 —superannuation asset allocation 139, 170 equity release loans 14 Equity Trustees 190 Esanda (ANZ) 292 E-Shares (Grandbridge) 305 ‘ethical’ funds 206–209 —managers 209

398

Index E*Trade (ANZ) 305 exchange-traded funds 182, 186–188, 193, 223, 236, 378 —active 188 —advantages 185–186, 187 —disadvantages 185–186, 187 —how to invest in 188 —index 186 —investment performance 183–184, 188 —property 279, 284 —strategy 184–185 executors, nomination of 329 exercise 28, 29, 389–390 expenses —debts 39 —household see household expenses —income versus 5–6, 7 —retirement 17–19 exports and imports 28

financial freedom 22, 24, 62, 110, 372 —levels 361–372 —steps towards 360–361, 391 financial planners 376–377 —choosing 379–382 —education 380 —experience 380 —fees and costs 377, 378–379 —independence 377, 379 —lump sums 377 —paraplanners 378 —personal wealth 381 —qualifications 379–381 —target clients 381 —why use 379 financial planning 21–22 —basics 23–24 —plans 45–50 Financial Planning Association (FPA) 381 financial services licence 379, 380 Find My Super 166 first-home buyers 90 fixed interest rates 104 —borrowing against property 229 —margin loans 228 —residential property investment 259 —term deposits 291, 320 fixed-term deposits 67 flats and units 82–84 —control 83 —depreciation 82, 83, 114 —unlimited future supply 82–83 —views 83–84 food and beverages, shares 173 forecasting, economic 387–388 foreign-listed index funds 220–222 franchises 356–357 franking credits 67, 174–175 fundamental share analysis 213–215

fake bank websites 57 false sense of security 97 fear and greed 58–59 fees —accountants 383 —active managed funds 194–196 —cash accounts 298 —exchange-traded funds 187 —financial planners 377, 378–379 —foreign-listed index funds 221 —index funds 189 —‘interest-free’ loans 42 —listed investment companies (LICs) 192, 193 —online brokers 301–302 —residential property investment loans 259 —superannuation funds 145–149, 156–157, 161, 170 financial advice 376–386

399

$1 Million for Life funds —absolute return 307 —active managed see active managed funds —‘ethical’ 206–209 —exchange-traded see exchange-traded funds —geared 230–234 —hedge 307–309, 316 —index see index funds —long-short 307 —private equity 309–310, 316 funds (superannuation) 139–141 —aggressive 139, 144 —choice, right of 142–143 —choosing 149 —conservative 139 —corporate 145, 150, 152 —industry 145, 146, 149–151, 378 —public sector 145, 152 —retail 145, 152 —self managed 146, 162–165, 170 —sole purpose test 163 future, looking to the 386–388 futures 66, 310, 312 —self managed superannuation funds and 164

growth —capital 62–63, 67, 70, 155 —economic, drivers of 78 —fundamental share analysis 214 —share 181–182 happiness 22–23 HBF 326 HCF 326 health and medical —insurance 324–326 —shares 173, 223 hedge funds 307–309, 316 HESTA 151 high-rate internet accounts 295–296 holidays 61 home and contents insurance 326 homeownership 72, 77, 110, 360, 364, 366, 368–369 —affordability 85–86 —appreciation and depreciation 77–80, 83, 84–85, 112–113, 114 —buying and selling, timing for 87–88, 114 —buying your first house 88–92 —children, helping your 18 —creditors and 332 —downsizing 105–106, 111–112 —entry price 88–89 —first-home buyers 90 —inner-city 84 —investing see residential property investments —locations, choosing 84–85, 112–113 —median house prices 86–87, 88–89 —prices 91–92 —renting 73–77, 113 —replacement versus current value 80 —residential investment versus 266 —security for investing 110, 113 —‘trading up’ 96–97

gearing 230, 238 —advantages 234 —disadvantages 234 —performance 231–234 generation X 386 generation Y 386 global demand 182 goals, achieving 24–25 Goldman Sachs JBWere (US) 201, 306 government bonds 69, 294 —risk 64, 65–66 Graham, Benjamin 189 Great Depression 64, 181, 386

400

Index inheritance 13, 19 insurance 320 —business 327 —health 324–326 —home and contents 326 —income protection 324 —landlord 241, 244 —life assurance 321–323, 337 —shares 173 —shopping around for 31 —total and permanent disablement (TPD) 321–323, 337 —trauma cover 323 interest —cash accounts 297–298 —debts, on 40–41 —gearing, impact of 233 —high-rate internet accounts 295–296 —residential property investment 259–260 ‘interest-free’ loans 42 international shares 216, 224, 237 —active ASX-listed managed funds 218–219 —active unlisted funds 219–220 —Australian listed 222–223 —companies, choosing 216 —countries, choosing 216 —currency risk 216–217 —direct shares 222 —foreign-listed index funds 220–222 —investing in 217–223 —taxation 217 —unlisted (passive) index funds 217–218 intestate, dying 328 investing 44, 71, 318, 356, 360, 364, 365–366, 369–370, 391 —$1 per day plan 45–46 —$500 per month plan 47–48 —$1000 per month plan 48–49 —$2000 per month plan 49–50

—units and flats 82–84, 114 —wealth building 91–92, 109, 112–113 HOSTPLUS 151 household expenses 31, 39 HSBC —cash accounts 299, 300 —Stockbroking 306 Imperator Financial 381 income 28 —business 335 —dealing with 43–45 —earning more 20–21, 28 —income protection insurance 324 —investment deductions 44–45 —retirement 6 —returns 62–63, 64, 65–66 —salary sacrifice 122–130, 161, 169, 170, 366, 369 —superannuation 124, 136, 159, 168 —taxation 51–53, 67 income products 288 —wealth-building 288–289, 291 income versus expenses 3 —comparative table 5–6 —living off your investments 7 index funds 182, 188–190, 193, 224, 236, 378 —advantages 185–186 —disadvantages 185–186 —fees and costs 189 —foreign-listed 220–222 —investment performance 183–184 —managers 189–190 —running your own 204–206 —strategy 184–185 —unlisted (passive) international 217–218 industrial property investment 276, 277 inflation 63–64 Infochoice 296, 300 ING (Netherlands) 201, 299

401

$1 Million for Life investing (cont’d) —borrowing 227–234 —costs and fees 66–67 —mortgage repayment and 93–109 —principles 62–70 —saving versus 44–45 —self managed funds 165 —small amounts 45–50, 71, 388 —trading, distinguished 310–311 investments —buying and selling 58–59 —capital requirements 6 —cash accounts 296–301 —check before you commit 57–58 —companies, held by 335 —cycles 58–59 —debt from buying 39 —economy, and the 11 —leaving alone your 374 —living off 7, 372 —mixed 155–157 —negative net 371 —objectives 62 —online brokers 296 —ownership 54–55 —performance 183–184 —property see property —retirees 290–291 —returns 62–63, 64, 65–66 —set-and-forget 373–375 —shares see shares —superannuation, outside 155–162 —taxation 51–53, 54 —time share 58 —20 times multiple 290 —types 68–70 —understanding your 59 —what to avoid 56–59 iSelect 326

James Hardie 207 job satisfaction 339–340, 350 job security 19 joint tenants 332 land —appreciation 77, 78–79, 84–85, 112–113, 114, 242, 244 —house and land together 80–82 —value ratio, changing 81 landlords —insurance 241, 244 —rights and responsibilities 245 lawyers 384–385 lessons 348–349 life assurance 321–332, 337 Lifebroker 323 life expectancy 9–10 —medical expenses 15, 19 Life Insurance Australia 323 life planning 340 liquidity 67–68 listed companies 172–173 listed investment companies (LICs) 182, 190–193, 224, 236 —active 191 —advantages 185–186, 191–192 —disadvantages 185–186 —diversification 191–192 —fees 192, 193 —investment performance 183–184, 193 —passive 191, 192 —strategy 184–185 Listed Property Trust Accumulation Index 271, 273 loans see also debt; mortgages —borrowing against property 229–230 —interest-only 259–260 —investment 227, 259–260 —margin 227–228

402

Index modern portfolio theory 208 money, importance of xii money sense 26–27, 360, 363, 368 Morrison Securities 304 mortgage brokers 107, 385 —finding a good 108 —who pays 107–108 mortgages 39, 89 —additional payments 100 —bank, relationship with 95 —‘basic’ loans, benefits 98–99 —competition between lenders 90 —consolidation of debts 101–103 —debt-reduction schemes 105 —first-home buyers 90 —fixed-rate 104 —forced savings 74–75, 113 —fortnightly repayments 100–101 —funds and property finance 292–293 —increasing repayments 100 —industry, deregulation of 89 —investing versus paying off 93 —long-term 104 —owning versus renting 73–77, 113 —paying off 93–109, 114, 366, 368, 375 —payout penalties 42–43, 103 —redraw facilities 94, 101 —refinancing 106 —reverse 14, 110 —shared equity loans 90 —shopping around 99 —taxation 75–76 motivation 389–390, 391 MSCI World (ex Australia) Index 217, 218 MTAA Super 151

—payout penalties 42–43, 103 —principal and interest 259–260 —protected equity 230 —residential property investment 259–260 —shared equity 90 loan to value ration (LVR) 228 Lost Member Register 166 luck 317–318 luxuries, buying 34–35 Macarthur Cook 280 Macquarie Bank 152, 301 —DirecTrade 305 magazines 30–31, 34 managed funds 194, 377 —active see active managed funds —passive see exchange-traded funds; index funds managing agents 246 —non-residential property investments 269 Manchester Unity 326 margin loans 227–228, 238 —approved lists 228 —calls 228–229 —fixed or variable 228 —online brokers 302 —where to find 229 marketers, property 264 master trusts 201 MBF 326 means-testing 10, 11, 54 media shares 173 Medibank Private 325 medical expenses 15, 19 Medicare levy 159, 324, 325 milestones, spending on 34 mining, shares 173, 212, 222 MLC (NAB) 152, 201 —lost superannuation 166 mobile phones 32

NAB 299, 305 names 332–333 negative gearing 54, 105, 260, 261 News Corp 210

403

$1 Million for Life —ethical funds 208–209 —exchange-traded funds 183–184, 188 —gearing, impact on 231–234 —hedge funds 308–309 —listed investment companies 183–184, 193 Perpetual Trustees 201 personal debt —eliminating 43, 365 —estimating 38 —payout penalties 42–43 petty cash budget 35–37 population growth 78–79, 91, 109, 181 positive cash flow 261–263, 286 positive thinking 386 possessions 32, 111 power of attorney 336–337 preference shares 69 price targets 226 private equity funds 309–310, 316 Privatehealth.com.au 326 procrastination 390 productivity 78, 181 property 67, 69, 70, 290 —booms 254–256, 257–258, 263, 270 —borrowing against 229–230 —long-term investment, as 244 —marketers 264 —non-residential see non-residential property investment —residential see residential property investment —shares and 273–274 —superannuation asset allocation 139, 170 property syndicates 68 protection 365 —asset 317–318, 336, 360 —income protection insurance 324 —wealth 318, 360, 364, 370 public health 19

NIB 326 Nigerian scam 56 non-residential property investment 268, 284–285 —advantages 268–269 —direct investment 278, 279 —disadvantages 269–270 —information, gathering 278 —listed property funds and trusts 279, 281–284 —property exchange-traded funds 279, 284 —property index fund 280–281 —property syndicates 279, 281 —returns 271–273 —tax 268, 275–276 —types 276–277 —unlisted property funds and trusts 278, 279–281 nursing homes 14–15 offsets 54 online brokers 225, 301 —account operation 306 —cash accounts and 296–297, 298, 302–304 —unhelpful and expensive 305–306 —what to look for 301–302 options 66, 289, 310, 312 —self managed superannuation funds and 164 Orchard Funds Management 280 outsourcing 28–29 paraplanners 378 participation rates 78, 91 passion 342–343, 358 —discovering your 349–353, 370 —living your 343–349, 360 payout penalties 42–43, 103 performance —active managed funds 183–184, 198, 199 —direct shares 183–184, 215 —‘dud’ companies 210–211

404

Index —management agent’s fee 244, 245–246 —negative gearing 54, 105, 260, 261 —nightmare tenants 241 —positive cash flow 261–263, 286 —profit margin 257–258 —renovating 253–258 —rental yields 240 —repairs and maintenance 244 —returns, total 241–243 —self managed funds and 164 —tax 243 —transaction costs 256–257 —units 239–244 retail property investment, 276, 277 retirement 340–341, 358 —age 20 —expenses 17–19 —income 6 —investing in 290–291 returns 62–63 —non-residential property investment 271–273 —property and shares together 273–274 —‘real’ rate 64 —residential investments 241–243 —shares, from 176–182, 236 —variable rates 65–66, 140–141 reverse mortgages 14 risk 64–65 —active managed funds 195 —currency 216–217 —diversification 68 —failure of investment to achieve 66 —loss of capital 65 —owing more than original investment 66 —superannuation funds 144 —varying rates of return 65–66

real estate see property rebates 54 references 392–393 renovations 39, 61 —holding costs 256 —rental property 253–254, 286 —sale, for 254, 286 rent 240 —expenses 244, 286 —guarantees 264 —holiday rentals 251–253, 286 —increases 240 —non-residential property investment 268 —rental yields 240 —secret deals 277–278 renting 371 —advantages 74 —‘dead money’ 73 —disadvantages 75–76 —owning versus 73–77, 113 —renting and investing theory 73–74, 76 research —online brokers 302 Reserve Bank of Australia (RBA) 64 residential property investments 239 see also property —borrowing 258–261 —business, as a 258 —council rates 244 —depreciation 246–251 —diversification 265–266 —holding costs 256 —holiday rentals 251–253, 286 —houses 239–244 —investing in 239 —investing with friends 266–268 —landlord insurance 241, 244 —land tax 244, 245 —legal costs 256 —location 265–266, 286

St George 201, 299, 300, 302–303 salary see income sales commissions 67

405

$1 Million for Life Sanford Securities 305 saving x, xi, 27, 43, 44, 318 —economy, and the 11 —fixed-interest products 291–292 —investing versus 44–45 scams 56–57 schools, private 15–16 self-employment —superannuation 131–132, 133 self managed superannuation 146, 162–163, 170 —advantages 163 —derivatives 164 —disadvantages 164–165 —how to set up fund 165 —management of fund 163 —residential property 164 —trading 164 selling —investments, timing 58–59 —real estate, timing 87–88, 114 separation and divorce 18, 19 shared equity schemes 14 —loans 90 shares 69, 70, 171, 235–238, 290, 374 —approved lists 228 —business, focusing on 226–227 —direct see direct shares —dividends see dividends —expertise, using your 212–213 —finding the ‘next big thing’ 211–212 —gas 173 —geared fund 230 —gold 222 —growth 181–182 —international 216–223 —investing in 182–183 —liquidity 67 —listed companies 172–173 —oil 173

—online brokers 225, 296 —optional extras 224–225 —passive core 223–224, 237 —preference 69 —price targets 226 —property and 273–274 —resources 173, 222 —retail 172 —returns from 176–182 —scams 56–57 —steel 222 —stop loss orders 226 —strategies 223–227 —subclasses 69 —superannuation asset allocation 139, 170 —trading 312 —value, changing 171 —worrying about 225–226 shopping around 31, 33 —interest rates, for 99, 259–260 simplified tax system (STS) 51 small businesses —saleable value 356 —superannuation 13, 355–356 SMHP Super Members Health Plan 326 sole traders 335 —superannuation 13 Spanish lottery scam 56 spare time 351 specialisation 68 specialist property investment, 276, 277 spending 27–28, 70–71, 318, 364, 388, 391 —bonuses 32–33 —government encouragement 14 —kids’ inheritance 13, 19 —more than earning 363 —new way to look at 60–62 —retail, buying 33 —specific funds for specific needs 291

406

Index spending less 30–35 —buying retail 33 —luxuries, buying 34–35 —new versus used 33–34 —10-year test 30 stamp duty 256–257 State Street Global Advisors 186–187, 220 —Tax Enhanced Index Fund 190 stockbrokers 384 stocks —analysing 213–215 —‘bucket shops’ 56 —expertise, using your 212–213 —liquid 67 —picking 210, 237 —worrying about 225–226 stop loss orders 226 subscriptions 34 Suncorp Brokering 304 Sunsuper 151 superannuation 8, 67, 115 —access to 134–135 —accumulation funds 117 —after-tax contributions 130–131, 153–162 —age pension and 12–13, 116, 168 —asset allocation 138–145, 169 —balance 8–9 —basics 144 —benefits 118, 136 —choice, right of 142–143 —choosing a fund 149–153 —churning 144–145 —complexity and regulation 13 —compulsory contributions 8, 19 —consolidation 166 —costs 13 —death of member 136, 167, 330–331 —debt, repaying 12 —defined benefit funds 117

—direct investment versus 155–158 —disadvantages 167 —employer contributions 119–121 —exit fees 148 —facts and figures 118–119 —fees 145–149, 156–157, 161, 170 —funds see funds (superannuation) —future trends 169 —government co-contributions 132–133, 137, 161, 169, 369 —hedge funds 309 —how it works 117–118 —income 124, 136, 159, 168 —knowing your own 116–117 —life assurance 322, 337 —lost 166–167, 170, 369 —lump-sum payments 135–136 —maximising performance 138, 360, 364, 369 —mortgage, paying off 104–105 —net wealth, distinguished 11–13 —pensions 135–136 —problems associated with 13 —rebalancing assets 143 —reweighting assets 143 —risk 144 —salary sacrifice 122–130, 161, 169, 170, 366, 369 —sale of small business 132 —scams 134 —self-employment 131–132, 133 —self managed funds 146, 162–165, 369 —small businesses 13, 355–356 —sole traders 13 —spouse contributions 132, 137, 161, 169 —taxation 118, 120, 131–132, 135, 136, 153–162 —total and permanent disablement (TPD) insurance 322, 337

407

$1 Million for Life superannuation (cont’d) —‘transition to retirement’ scheme 123 —volatility 144 —wealth plan and 167–170 SuperSeeker 166 syndicates, property 279, 281

technical analysis 213 Telstra 210 tenants —nightmare 241 —phantom 277–278 —rights and responsibilities 245 tenants in common 332 term deposits 291, 320 testamentary trusts 329 time share 58 Tishman Speyer Office Fund 280 total and permanent disablement (TPD) insurance 321–323, 337 tourist property investment, 276, 277 trade deficit 28 trading 310–314 —investing, distinguished 310–311 —method 312–314, 316 —self managed superannuation funds 164 —what you can trade 312 transition, making the 353–357 transport shares 173 trauma cover 323 trustee company —wills, drafting 329 trusts 333 —cash management (CMTs) 296 —discretionary 333–334 —non-residential property investment 278, 279–284 —self managed superannuation funds 163–165 —taxation 55 —testamentary 329 —unit 334 TWUSUPER 151

tax 29–30, 50–51 —active managed funds 198–199 —agents 382 —allowances 54 —business owners 51 —capital gains 53, 67, 153–154 —children, on 55 —companies, on 55 —death 331 —debtor, death of 328 —deductions 54 —depreciation see depreciation —extra income 21 —franking credits 67, 174–175 —gearing, impact of 233 —hedge funds 309 —homeownership 75–76, 111 —international shares 217 —investors 51–53 —land 244, 245 —minimising 67 —negative rates 175 —non-residential property investment 268, 275 —offsets 54 —rebates 54 —residential property investment 242 —superannuation 118, 120, 131–132, 135, 136, 153–162 —tax-based investment schemes 57–58 —training and professional development 39 —trusts, on 55

units and flats 82–84 —blocks, buying 243–244 —control 83

408

Index —council rates 244 —depreciation 82, 83, 246–251 —holiday rentals 251–253, 286 —investing in 239–244 —landlord insurance 241, 244 —land tax 244, 245 —management agent’s fee 244, 245–246 —nightmare tenants 241 —off the plan 263–264 —rental yields 240 —returns, total 241–243 —unlimited future supply 82–83 —views 83–84 unit trusts 334 university fees 16, 339 unlisted investment trusts 68 unlisted (passive) index funds 217–218, 236 unlisted property funds 278, 279–281

warrants 230, 290, 310, 312 —self managed superannuation funds and 164 water usage 31–32 wealth building xi, 62, 367–368 —$1 million target 22, 168–169 —homeownership 91–92, 109, 112–113 —income products 288–289, 291 —non-residential property investment 284–285 —shortcuts 24–25 —superannuation 167–170 wealth, protection of 318, 360, 364, 370 welfare 19–20 Westpac 152, 299 —Brokering 304 Westscheme 151 wills 327, 337 —assets not covered 330 —challenging 328 —death of two people at once 328 —death tax 331 —dying intestate 328 —preparing 329–330 worrying about stock market 225–226, 375 wrap accounts 378–379

Vanguard Australia 189, 190 Vanguard Index Hedged International Shares fund 218 Vanguard Index International Shares fund 217–218 Vanguard Index Property Securities fund 280 variable loans —borrowing against property 229 —margin loans 228 —residential property investment 259 voluntary simplicity 21

xLife 323 yield, chasing 289–291 Zurich (Swiss) 152, 201

409

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Inside you’ll learn how to: • save money and pay off debts quickly • use low-cost, tax-effective ways to invest in shares • invest in residential and commercial property • maximise the performance of your superannuation • protect your investment plans and your lifestyle. There are no get-rich-quick schemes or trading systems — just practical steps almost anybody can take. $1 Million for Life gives you the tools to build enough wealth so you can start doing what you really want to do for the rest of your life.

Ashley Ormond

Ashley Ormond is a successful investor and former senior executive at major global finance and banking groups. He has degrees in economics, law and finance, and has been a director of several companies. He is the principal of Investing 101 Pty Ltd, which holds an Australian Financial Services licence, and lives in Sydney with his wife and two children.

$1 MILLION FOR LIFE

Want to build wealth that will last you a lifetime? Then $1 Million for Life is the book for you! In this step-by-step guide to financial freedom, investor and best-selling author Ashley Ormond outlines dozens of practical ways to increase your wealth by tens of thousands, or even hundreds of thousands, of dollars. It doesn’t matter how much you earn — it’s what you do with the money you have that makes the difference.

$1 MILLION FOR LIFE

How to make it, manage it, maximise it

Ashley Ormond The best-selling author of How to Give Your Kids $1 Million Each!

www.johnwiley.com.au/trade

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