Wednesday 21 November 2012 by Kieran Quaine Legacy

The perfect security - An aged based investment strategy (Nov 2012)

This article explains a simple yet very effective way to build capital pre retirement with a view to receiving a quarterly $20,000 payment, indexed to grow with inflation, for 15 years during retirement

What if there was a security that:

  1. Compounded capital at a rate greater than inflation pre retirement
  2. Slowly repaid capital and interest post retirement, still compounding outstanding capital at a rate greater than inflation

Wouldn’t that be great? Yes it would!

It would be great because investors would have no reinvestment risk as this strategy accumulates capital pre retirement, and could drip feed a defined $20,000 quarterly payment post retirement, again with no reinvestment risk of outstanding capital, protected the whole time against the vagaries of inflation!

Whilst there is not one singular security that does this, by making a few realistic assumptions we can achieve the same result by investing in available capital indexed bonds (CIB’s) and then selling the bond at the point of retirement (or buying a CIB that matures near the date you plan to retire) and then investing the proceeds into an inflation indexed annuity (IIA).

Setting aside the assumptions that price changes as a function of credit risk for different issuers, and presuming we can purchase the IIA out of the forward date at the same credit margin it currently trades at, then because the CIB and the IIA prices are both linked to inflation, the CIB will provide a perfect hedge for the change in price of the IIA.

Additionally the CPI assumption can be subsequently applied to current retirement cashflow estimates, to determine and safely lock in a pension payment amount. And further, whatever the subsequent CPI outcome (assuming the company remains solvent) the investor is protected and will receive that inflation adjusted pension!

See the link below for the actual cashflow example that will help you to understand the strategy. However, before doing so, please review our previously published articles explaining the advantages of these two main ILB product structures.

 

Some inflationary history

The Reserve Bank of Australia’s charter targets monetary policy that will achieve annual inflation of between 2.00% and 3.00%, over the economic cycle, and the RBA usually targets measures of underlying inflation not headline inflation. Since September of 1992, the average has been 2.61% (see Figure 1 below).

Figure 1

Now that fixed interest rates have fallen to historical lows is it really worthwhile taking a non inflation hedged risk?

At the time of writing, the Australian Commonwealth 4/2029 fixed bond was trading @ ~3.50%, whilst the CIB from the same issuer was trading at 0.90%! A 2.60% differential, pretty much the average CPI rate over the last 20 years. These are the base benchmark rates over which corporate ILB’s trade. Is it worth locking in fixed rate exposure at such low rates for such a length of time?

Both pre and post retirement, the risks of re investment and volatility of total return are a constant

Pre retirement, capital held in superannuation vehicles cannot be withdrawn for consumption. Indeed, while working, contributions are building and the requirement to invest is constant.  Collectively, this capital accumulation phase is also a delayed consumption phase and it extends at full throttle to the pension phase, and then some more.

During the pension phase, which can commence from around 55-65, if the capital held is not sufficiently large to generate sufficient income to meet consumption (pension) requirements, then either the actual capital accumulated will need be consumed to meet the unchanged pension, or, the planned consumption (pension) will need be reduced.

In summary: if you haven’t accumulated enough capital pre retirement, it will compromise the size of your pension. And the return on your capital balance during the pension draw down phase, will determine the length of the pension.

CIB’s and IIA’s alleviate re investment risk concerns. Additionally, the total return of the ILB’s, being comprised of both inflation and the ‘real return’ above inflation, using an inflation assumption within the range of RBA targeting, can be used to calculate the present value of the investment required to achieve that pension.

Our example below has two only securities. I am not proposing an investor consider these two products solely for their investment purposes. A well balanced portfolio will diversify risk by exposure to a broad spectrum of both asset classes and products within each asset class. However, for the purposes of explaining the advantages of these assets to investors, let us pretend the portfolio is comprised of one CIB and, upon maturity, one IIA only.

How would the investment profile look at every point in time going forward?

 

Example

Our example ‘investor profile’:

  1. Currently aged 57 and has an intended retirement age of 65
  2. Estimates that if they were to retire today they would require an income of $64,000p.a. ($16k per quarter) indexed to grow with inflation
  3. Given a CPI assumption of 2.61% per annum, that means retirees will need approximately $79,000p.a. income from 2020, if that is when they wish to retire

For simplicity sake, let’s just call it an annual requirement of $80,000 or $20,000 per quarter, again, indexed to grow with inflation.

 

The investment strategy

Question: Given current asset prices, how much capital does this investor require at their current age, invested into which assets, at what prices, to achieve their pension requirement of $80,000 per annum, indexed to CPI, payable quarterly at age 65?

The answer has one further dependency:

“How long they require the pension to be paid, or somewhat insensitively, for how long do they expect to live”

Rather than discuss life expectancy let’s continue with a simplistic example and state that our investor lives to the age of 80. Or for 15 years after their retirement commences.

I have chosen this date to conveniently explain how our investment strategy of buying CIB’s now, and investing the maturing proceeds into an IIA out of their forward maturing date (2020 in eight years) at the commencement of pension phase (65), can achieve the required pension. The 15 year IIA, that is invested in 8 years’ time, is the longest available IIA currently issued in the Australian market place, although we expect others may be issued in coming years.

To answer the question

Given the assumption of CPI at 2.50% and a reinvestment rate of coupons at bank bill (3.60% average is the swap rate to 8 years), the answer is $566,850.

An investment of $566,850 will buy $460,000 notional face value Sydney Airport 2020 CIB’s, at a real yield of 4.00% being a total yield of 6.50% with CPI at 2.50%, currently index adjusted to a FV of $580,360  which will have a maturing value on 20/11/2020 of $704,000. Additionally, if the coupons that are paid by this bond are reinvested at the assumed reinvestment rate, this additional cash will compound to a value of $199,500 on 20/11/2020.

The subsequent total value of assets held at the completion of the capital accumulation phase, pre the commencement of the pension phase, is $903,500.

This amount will buy $960,660 notional face value of the JEM Southbank June 2035 IIA at a real yield of 3.80% being a total yield of 6.30% assuming CPI is 2.50%, which will entitle the investor to 15 years of quarterly payments of $20,000 each, indexed to CPI.

In summary, given the assumption of a CPI rate of 2.50%, an investment of $566,850 today in the Sydney Airport 2020s, with the funds invested at maturity into the JEM Southbank IIA, will together yield a total return (of 6.06% p.a. through to June 2035. This will deliver a net positive cashflow of $854,800.  From 2020 the investment will begin to pay an annuity worth $20,000 a quarter, which could be higher or lower depending on inflation. If CPI is higher, the yield to maturity will be higher.

Importantly, it does not matter what inflation is, as the investor will receive the equivalent of their required $64,000 pension (original requirement in today’s terms).

Conclusion

The selection of ILB product provides both capital accretion and amortising cashflow profiles, benefiting investors during the accumulation phase pre retirement and the pension phase post.

The beauty of the IIA product is the ability for investors to extract sufficient cashflow to meet their budgetary requirements in pension phase, knowing that the balance of principal invested will always compound higher than the CPI.

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