NFB Proficio Issue 66

NFB FINANCIAL UPDATE Issue66 February2013

FROM THE CEO’s DESK

W

elcome all to 2013, and congratulations on surviving the End of the World, as predicted by the Mayans for December 2012.

However, before we go back into the New Year celebrating this lucky break, we need to reflect on the environment both in sunny S.A. and abroad, from a markets, politic and broad societal perspective.

2012 was in some cases gentle, in most cases generous and in a few cases remarkable in rewarding investors in a broadly bankrupt world, with broadly inflation beating returns. For those brave enough to remain or venture into equities, the local market returned 25%, the balanced funds which we favour, between 15% and 20%, bonds delivered a remarkable 16%, given the state of government's indebtedness, but undoubtedly the star of the show was listed property, again eclipsing all comers with a return for the year in the mid thirties. Lagging well behind the peer group, and narrowly losing out to inflation was cash, returning a meager 5% before tax!

The rand, having been somewhat of a global bully over the last number of years, retreated over the year, bouncing around and settling weaker against all comers.

And so on to the year and, indeed, years ahead. NFB seldom lapse into the predictive space, although requests to provide investors with reasonable forecasts are usual and most often takes pride of position in reviews and when applying new funds. The art to successful investing relies rather heavily on a few trump cards. These include, in no specific order: ! A clear understanding of the investor's goals and a reduction of these to writing in the form of an investment objective made measurable through expression in the form of a benchmark. For example: an investor's goal might be to have funds available in retirement, their objective would be to provide for retirement income through retirement savings and their benchmark might be to ensure that their retirement savings generates a return over meaningful periods (we would suggest periods between three and seven years) in excess of inflation; ! A clear understanding of the correlation between risk and return; ! Defined time lines, i.e. how long the funds can be deployed without needing to be switched, loaned against or redeemed; ! Understanding volatility in returns, both between styles of managers and asset classes; ! Real and after tax returns. Far too often we see

examples of folk being satisfied with a return on a cash or money fund, which at first blush appears superior to another fund. However, on reflection, the other fund delivers dividends, which may enjoy a far superior after tax return; ! Optimization of tax efficiency. Using products, wrappers and strategies which look to minimize the tax and cost drag on returns.

I, and all of the advisory teams at NFB, continually wrestle with these intertwined issues and others, in seeking to deliver to clients, each with their own unique set of circumstances, gratifying returns. In these times of low yields, crazy volatility in markets and asset prices, and generally acceptable returns, the importance of repeatedly reflecting on these criteria cannot be overstated.

Overseas bonds, particularly investment grade non-government bonds have enjoyed a great rally.

Whilst other yields still remain much lower, it is prudent to watch this asset class for signs of becoming oversold, resulting in the switching of the funds to lower yielding cash, property or high dividend paying equities. Parties never go on forever and typically, the longer they do, and for the stayers, the risk is big of a serious hangover!

In the local market, as seen in the returns noted above, our property sector appears more than a little heated. It must be said that this same comment could easily have been made a year ago, but now we are at record highs with little room for the key players to misfire without triggering a material sell-off. When confronted with these tough choices of staying the chase or baling out into less choppy waters, I tend to believe that if the unexpected gain already accrued is rather important in upping your access to income, bank some. If this is not true, i.e. it is excess to requirements, then one can choose to stay, brace everything down and hopefully enjoy the ride.

Turning to matters domestic, we are witnessing a rather disturbing level of social unrest, particularly in the Western Cape, perhaps not by fluke, the home of the DA ruling Provincial Party. The violent nature of the so-called strike worries me, and when seeing the levels of intimidation, destruction of uninvolved property, I run scared. This is not good for SA Inc. and we need to respect the vast alternative choices available to investors, both the very important long term industrialists and property investors, as well as the more flighty portfolio flows which have funded our national “overdraft” or government borrowings. If this was to materially continued on the back page...

IN THIS ISSUE From the CEO’s desk Inflation and retirement: the silent killer

A new chapter in offshore investing The Old Mutual International Investment Portfolio

financial services group

INFLATION AND RETIREMENT THE SILENT KILLER The effects of inflation on both retirement assets as well as retirement income requirements. By Andrew Duvenage & Grant Magid, NFB Gauteng, Private Wealth Managers

W

hile many of us sit and contemplate the reality that

economy. One's personal household's inflation will be different from

we may have to retire at some point in the future,

official CPI and is determined by what that specific household

statistics show that in reality not many South Africans

consumes. In many instances, CPI may in fact understate the rate of

can actually afford to retire when that day does

price increases that households experience. For the purpose of this

arrive. This is often because of:  not starting to save early enough for retirement

discussion, we will stick to the official CPI measure.

 not saving enough during our working careers

So why is inflation a problem?

 using previously saved retirement assets for living expenses

We all know that the cost of living increases every year as a result of

before retirement

increases in things such as food prices, electricity prices, fuel prices,

 poor investment returns

and the like. Thus it is logical that in retirement, our income needs to

 poor financial planning strategies

increase in line with inflation to ensure that we can afford to meet

 with increased life expectancies, funds available at retirement

our expenses as they increase every year. And this is where the

need to provide income for longer periods.

problem lies.

The focus of this article is to illustrate the effects of inflation on

If we were to subscribe to the logic of drawing at a level that

both retirement assets as well as retirement income requirements.

equals the rate of return, we would have the same amount of

The points mentioned above are a few reasons that can

capital invested at the end of the year. But in reality, the value of

significantly impact the amount of income that can be drawn

that investment, when adjusted for inflation, has in fact decreased.

during your retirement years. In many instances, the impact of

Similarly, while the amount of income that is drawn may stay the

inflation on investment returns and the future cash flow that your

same each year, after the effects of inflation are taken into

retirement portfolio can generate is not well understood, or is

account, the “real” (or inflation adjusted) value of the income

completely ignored. This lack of understanding of the impact of

diminishes year on year. This is illustrated by the example below:

inflation during retirement can be disastrous as it can result in an unrealistic expectation as to what type of income a portfolio can

Client age

generate and sustain. This in turn lulls investors into a false sense of

Initial investment

security prior to retirement in terms of the amount of money investors

Rate of return

10%

save, and can result in unsustainably high drawings during

Drawing Rate

10%

retirement.

Inflation

When reviewing and recommending retirement and investment products and anticipated investment returns for these vehicles, we often come across the question of “how much income can an investment generate, without eroding the capital of the investment?”. The answer to that question is simple. If one draws at a rate equal to the return on the investment, the capital value of the investment will remain intact. There is, however, a massive problem with this line of thinking in that it doesn't take inflation into account – and this is one of the biggest problems that a retired investor faces.

Let's start off by explaining what inflation is When we talk about the rate of inflation, this refers to the rate of inflation based on the consumer price index, or CPI for short. The South African CPI shows an indexed level of the prices of a standard “basket” of goods and services which South African households purchase for consumption. In order to measure inflation, an assessment is made of how much the CPI has risen in percentage terms over a given period compared to the CPI in a preceding period. If prices have fallen this is called deflation (negative

Image credit: 123RF Stock Photo

inflation). So if the rate of increase in the CPI is 5%, this means that the price of the basket of goods and services (as determined by Stats SA) has increased by 5%. It is important to note that this is simply a barometer to indicate general price increases in the

55 R4,000,000

5%

As can be seen by the two graphs above, while the value of both the capital and income stay constant (in what we call nominal terms), the real (or inflation adjusted) value falls year after year. In this example, the real value of the investment, as well as the real value of the income that it generates halves in 12 years.

Thus it is clear to see that while at face value, drawing at the rate of return will protect the capital and income, this is not the case when inflation is taken into account. Mathematically this is

What does this tell us: The most important lesson that we learn from all of this is that the rate of return on our investments is not the same thing as the sustainable drawing level on the investment. In fact, to determine the sustainable drawing level of an investment, one needs to take the expected return and subtract the expected rate of inflation. This will allow the net growth on the investment to be in line with inflation, thus protecting the real capital and income levels of the

explained as follows:

investment.

Nominal Return Less: Drawing = Net Nominal Return Less: Inflation = Net Real Return

10% 10% 0% 5% -5%

If one assumes an expected rate of return is 10%, and inflation of 5%, a sustainable drawing level is at maximum 5% per annum.

In practical terms, this means that R1,000,000 of capital can sustainably generate around R50,000 of income per annum. While this is far lower than many investors would like to believe, it is a reality that we need to face.

It is clear then that in order to protect both income and capital against inflation, it is necessary to draw at a rate that is lower than the return. In fact, if one wanted to fully protect an investment and the income it generates against inflation, it is logical to suggest that the rate of return less the rate of drawing, should be equal to inflation. Using the same assumptions as above:

In order to increase this income, one would have to achieve higher rates of return. To achieve this, higher levels of risk need to be taken within a portfolio. Investors, however, need to carefully consider and understand the implications of risk – especially once retired, as the consequences of capital loss are exacerbated by the fact that during retirement income is being drawn from the portfolio.

That is to say that if one draws 10%, and the investment loses 15%

Nominal Return

10%

Less: Drawing

5%

= Net Nominal Return

5%

Less: Inflation

5%

= Net Real Return

0%

(by virtue of being in an aggressive portfolio), the capital value will be down by 25% in nominal terms, and 30% in real (inflation adjusted) terms (assuming inflation of 5%). To then get the same amount of income in rands and cents, the drawing rate has to be pushed up to around 15% as a result of the lower capital value of the investment. This scenario can result in massive capital erosion in

In this instance, while both the capital and income levels grow from year to year, when inflation is taken out, the values in real terms stay constant protecting the client against inflation. Thus the initial R4,000,000 investment is maintained (in real terms), while the sustainable income level of R18,000 per month is protected. This scenario is illustrated below:

a very short space of time.

How much is enough So back to the issue of “how much do I need to retire?”.

Unfortunately, there is no universal answer to this question, as it is specific to one's personal circumstances and needs, and is reliant on uncertain factors such as expected rates of return, and future inflation rates.

While the discussion above is sobering, it does, however, empower us with knowledge that we can apply, in that it informs us of what a sustainable drawing rate is. So when answering the “how much is enough” question, we need to consider some of the following factors:  What is the value of your current investable assets?  How much does one contribute to these assets on a monthly

basis?  How much income do you need in retirement to meet your

monthly requirements?  What are the current and expected rates of return on the

portfolio?  What is the expected level of inflation?

Prior to retirement these questions can help investors with decisions around savings rates, the risk profile of their investments, as well as around managing their expense levels more effectively so that at retirement, their expenses and sustainable income are commensurate.

When closer to retirement, understanding the impact of inflation on capital and drawings can help investors carefully consider the level of drawing they select to ensure that their savings are managed in such a way as to provide income sustainably into the future.

Retirement planning and the impact of inflation are vitally important aspects of financial planning. We strongly suggest that you discuss these issues with your NFB advisor.

A NEW CHAPTER IN OFFSHORE INVESTING THE OLD MUTUAL INTERNATIONAL INVESTMENT PORTFOLIO After a decade of disappointing returns, offshore investing is once again in the spotlight.

By Mikayla Collins, NFB Western Cape, Private Wealth Manager As funds with foreign exposure start to outperform their domestic

automatically come to an end upon death of the contract holder.

counterparts, and economists warn that domestic markets are

The investment can continue for up to 99 years unless it is fully

overpriced, investors seeking maximum returns are starting to test

surrendered by the contract holder, or by his/her executors

foreign waters again. Old Mutual International has responded by

following death. You can also nominate beneficiaries to whom the

offering a new product, called the Investment Portfolio, which offers

contract will be transferred upon death, rather than to your estate,

incomparable benefits.

and this will avoid probate, reduce delays and costs in wrapping up your estate, and gives you the assurance of knowing what will

ONE WRAPPER FOR ALL YOUR ASSETS

happen with the investment. In the past, many investors have seen

The product itself is a life wrapper designed to hold offshore assets

fit to appoint offshore trusts in order to carry out their wishes in terms

such as share portfolios, unit trusts, exchange-traded funds, currency

of their offshore portfolios after their passing. This can be a costly

accounts and structured notes. There are a number of benefits for

and time consuming task, and the Investment Portfolio takes care of

using the wrapper, the most impressive being tax efficiency.

this.

TAX-FREE RETURNS

RESTRICTIONS

Most products that were previously used for offshore investment

The only drawback is that only a restricted amount may be

involved the appointment of the contract holder/s as lives assured

withdrawn within the first five years of investment. This is a small price

under the policy, and company tax rates (currently 30%) were

to pay considering that offshore investing should only be

applied to all returns. The Investment Portfolio is structured so that it

undertaken with a long term view of five years or more.

does not have lives assured and there is no tax in South Africa in respect of returns earned. Buying and selling assets within the

In essence, the Investment Portfolio is a simpler and more efficient

portfolio will not attract a Capital Gains Tax liability, and the final

product for offshore investment than has been offered in the past. It

proceeds received on redemption of the contract will be tax-free,

allows you to combine a number of different assets within one

provided they are received by the original beneficial owner of the

portfolio and lifts the burden of administration and reporting from

policy.

your hands. In addition, the fact that your returns are not reduced by income tax ensures that you will benefit from the maximum

ESTATE PLANNING

returns possible.

Because there are no lives assured, the investment will not

Image credit: 123RF Stock Photo

FROM THE CEO’s DESK slow down, never mind reverse, we could witness a dramatic weakening of our currency. This in itself is a double-edged sword, aiding the efforts of our industrial, mining, commodity and tourism sectors, but bedeviling the borrowing costs of the government as it strives to inject capital into the development of infrastructure and our broader budget spend. Of critical importance is the delivery of services and improved standards of living to the broader population. Suggestions that these people should look after themselves is a non-starter as they haven't got a dog's chance of even getting into the game. They need a hand up, and in South Africa, as is the case around the world, this is where it starts from.

One agrees that a successful state is not created by taking from the rich to sort out the poor, but if we are to avoid the risks faced in the north of our continent over the last year or two, we need to take ownership of these issues. They will not go away by us denying they exist. I have listened to leaders in politics and business debating

continued from page one... these issues and it is somewhat reassuring that they are enjoying lots of attention, although as is often the case, this positive news doesn't sell newspapers and is therefore not aired publically. I must say that Mr Ramaphosa being elected into the number two seat in the ANC makes me happier. He enjoys popular support, has a sound following beyond our borders and certainly knows his way around business South Africa and beyond. Every cloud………..

To all of our clients and supporting peers in the life of NFB we wish you well for the year ahead. As one wag was reported to have twittered, one day before the Mayan Doomsday, “my wife got us tickets to The Nutcracker for tomorrow night, so at this point I'm rooting for the Mayans”.

Thank you for your continued support.

Mike Estment, BA CFP® CEO, NFB Financial Services Group

A licensed Financial Services Provider

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