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CPD QUARTERLY Income generation

Historically, Australian shares have provided a higher level of dividends especially with the tax advantages of franking credits compared to international shares.

Another important factor when determining the weighting of a client’s exposure to international and Australian shares is the need to generate an income from their portfolio. This may include: • Retirees and pre-retirees planning for their income needs – intending to generate income from both super and ordinary money investments; • Retirees and pre-retirees with substantial funds outside of super and/or with insufficient assets in super to generate the required level of income; and • Accumulators who need to generate a level of income from their non-super (ordinary money) investments.

The Australian share market has historically provided a dividend yield of approximately 4.5 per cent (excluding franking credits) with telecommunications, utilities, banks and property trusts providing above market yields. On the other hand, the US market provides a yield of around 2 per cent and international shares yield around 2.6 per cent. Australian shares have franking credits which increase the grossed up (before tax) income generated by Australian companies. Financials (ex property), for example, can provide a grossed up dividend yield of approximately 9 per cent

and telecommunications have provided grossed up returns of 13 per cent. The attractive income returns offered by Australian shares need to be considered in light of the highly volatile nature of the Australian share market, as has been demonstrated by the recent global financial crisis and more recent downturns in markets. Clients need to understand and accept the higher risk inherent with this asset class and should have an investment time horizon of at least five years. Table 2 takes into account franking credits for different dividend yields and marginal tax rates. The conclusion is that Australian shares provide attractive after tax income returns, especially relative to international shares.

Investor investment profile

Table 2: Different dividend yields and corresponding grossed up dividend yield and after tax yield Dividend yield (%) 4.0 4.5 5.0 5.5 6.0

Grossed up divident yield (%) 5.2 5.9 6.5 7.2 7.8

After tax yield MTR = 30% (%) 3.6 4.1 4.6 5.0 5.5

After tax yield MTR = 45% (%) 2.9 3.2 3.6 3.9 4.3

After tax yield MTR = 15% (%) 4.4 5.0 5.5 6.1 6.6

Assume: Franking level = 70%, company tax rate = 30%

Table 3: SAA mix Client/portfolio investment drivers Income generation Potential for capital growth Tax benefits Diversification

May favour Australian shares Combination of Australian and international shares Australian shares International shares

Questions 1. When the Australian dollar appreciates relative to other currencies, it is best if the client’s international investments are: a. Fully unhedged. b. Fully hedged. c. Partially hedged. d. It doesn’t make a difference. 2. If Australian shares have a yield of 4.5 per cent (70 per cent franked), then the relevant income level to be considered for a retiree on a zero marginal tax rate is:

a. 4.5 per cent. b. 4.1 per cent. c. 5.9 per cent. d. None of the above. 3. Clients seeking diversification in their portfolio should consider the following: a. Investing in an Australian share managed fund. b. Investing in an Australian ETF. c. Having some exposure to a broad based international share fund.

d. None of the above. 4. If China’s economic growth slows, then the greatest negative impact on returns is likely to be on a portfolio: a. With a high exposure to international shares. b. With a high exposure to small companies. c. With a low exposure to international shares. d. With a high exposure to Australian shares.

The client needs to understand that international shares are considered a high risk and high return investment. As such, they are suited to investors with longer-term investment horizons (five to seven years plus) with an appropriate risk tolerance.

Step 3: Determine the client’s investment drivers The client’s investment objectives for all or a portion of their portfolio may include certain attributes such as: • The need for competitive levels of income or a minimum level of income; • The importance of the potential for capital growth over the long-term; • Greater levels of diversification within the portfolio and the client’s exposure overall; and • Tax benefits in the generation of the income returns from investments. The above investment objectives or drivers may have an impact on the appropriate mix between Australian and international shares.

Step 4: Adjust the SAA The SAA suitable for the client’s risk tolerance provides the allocation between Australian and international shares. This mix may be tweaked according to the guidelines in Table 3. Assyat David is a director and co-founder of Strategy Steps. financial planning | SEPTEMBER 2011 | 33

Profile for John G Raciti

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