.... flexibility to tailor strategies," says Angus Crennan.

For advisers servicing income-focused clients, including many trustees in the rapidly growing SMSF market, increased choice means flexibility to tailor strategies. Zurich’s Angus Crennan looks at the options.

On August 6 the Reserve Bank of Australia (RBA) pulled the trigger on another rate cut. Our cash rate, the primary tool of Australian monetary policy, is now 2.5 per cent. For those using cash, or cash-like instruments, to generate income for basic expenses another cut in income makes budgeting a little tougher.

Two-point-five per cent is smack bang in the middle of our targeted inflation rate. It’s one to be careful of because generally we have a higher tolerance for real loss of purchasing power than we do for nominal changes. Would you be happier earning 2 per cent when inflation is 3 per cent or losing 1per cent when inflation is zero?

Income investors also need to consider the impact of minimum super income streams in retirement. Low interest rates could mean some investors are de-cumulating faster than expected, even before considering the impact of rising costs in the future.

In this environment income diversification is more important than ever before. To that extent the latest cut from the RBA might just be that final catalyst some investors need to reassess their portfolios and their ability to meet and potentially exceed financial objectives.

Income and peace of mind

The good news is choices in income generation have grown. For advisers servicing income-focused clients, including many trustees in the rapidly growing SMSF market, increased choice means flexibility to tailor strategies.

A base level of income for usual expenses is clearly important. Cash and annuities are usually the tools of choice here, as well as perhaps some short duration fixed interest. The limitation with cash and fixed interest of course is the prevailing interest rate and inflation expectations. Equally, all these instruments are not risk-free so selecting the right investment is important, especially in the case of annuities being relied on for potentially decades to come.

Once the non-negotiable basic expenses are dealt with, then the remaining assets in portfolios can be targeted to suit investors’ remaining objectives and aspirations.

Optionality in income generation

For income investors, a second sleeve of income generators will likely be required to meet slightly different expectations given basic expenses have already been covered. Here, investors working with their advisers can tailor portfolios to introduce the potential for capital and income growth over time as well as accept some volatility into the portfolio. Longevity risk can be managed with this sleeve.

Equally, stretch goals could mean a part of the portfolio is established for a specific objective. For example, a conservative investor with a robust income portfolio could feasibly allocate a small part of it to a high-growth investment, such as small caps, with the aspiration that money has the potential growth to pay for a grandchild’s education.

Staying with an income focus, however, core requirements of a second sleeve in a diversified-income strategy include the liquidity to access capital if needed and the certainty of income.

Generating income from international shares

One asset class usually thought of as growth-only is international shares. Within international shares are included some very well placed companies with strong and sustainable profit margins, trading on different fundamentals to our market, as well as sector exposures difficult to get locally.

Given the outlook on the Australian dollar and some uncertainty over domestic economic activity in the medium term, considering an allocation to international shares, whether large or small, makes sense.
However, for a diversified income strategy, a long-only exposure to international companies will not at present generate an attractive yield. For example, as at June 30 the yield on the MSCI World Index for financial year 2013/14 was forecast at 2.8 per cent, according to Bloomberg.

The good news is that an equity income structure can improve the yield on shares, exchanging some volatility for additional income. In this way investors can gain some exposure to international shares, yet manage the elements they are less comfortable with.

Australians have embraced equity income-style funds in recent years for good reason, although the funds available have mainly utilised Australian shares in the underlying portfolio. The appeal is straightforward: an equity income strategy can supplement a dividend yield with option premium. This premium is earned by selling the unknown and potential share-price upside via a strategy known as a covered call or buy-write.

The strategy can also utilise a variety of protection strategies to manage volatility. Taken together, an equity income strategy seeks to participate in some share price movement and enhance income while concurrently managing volatility.

Angus Crennan
Investment specialist at Zurich Investments
12th August 2013
Source:  Professional Planner    www.professionalplanner.com.au