Some financial terms explained
The six terms described below are Allocated Pension, Transition to Retirement Pension, Pension Phase, Hybrid securities, Price/Earnings Ratio and Dividend imputation.
What does it mean?
An allocated pension is a product purchased by retirees to convert their super savings into a regular income. Retirees use allocated pensions to pay themselves an income over a time period roughly equivalent to their life expectancy. Pension payments can be made monthly, quarterly, half yearly and yearly and are deposited directly into a retiree's bank account.
Allocated pensions are by far the most popular product around for retirees looking to live off their super savings in retirement.
So why are allocated pensions so popular? Why don't retirees just withdraw their funds out of super and dump the lot into a term deposit or savings account, or even use their super to buy other investments such as an investment property or shares?
The major reason here is tax. Allocated pensions save you tax compared to most other strategies in retirement. That's because any investment earnings in an allocated pension - interest, dividends, capital gains - are tax free (age 60 and above). In comparison, interest made on a term deposit or rent received on an investment property held outside the super environment are subject to tax at the retiree's marginal tax rate.
When a retiree buys an allocated pension to house their super savings they don't have to say goodbye to the money forever. At any time, you can opt to withdraw all, or part, of your money from an allocated pension by simply filling in a couple of forms (check to see if there are any restrictions on the number of lump sum withdrawals allowed each year). You may use the money to buy a business or property, or to go on an overseas trip. Some retirees assist their children to buy a house. The allocated pension offers this needed flexibility.
So how much does an allocated pension pay? Well, that depends on how much you have to start with, and how old you are. The Government sets minimum limits, which are calculated when the pension is established and recalculated at the beginning of each financial year.
You can change the amount and frequency of your pension payments whenever you need to, but you can't turn an allocated pension on or off like a tap. Once started, you must receive at least the minimum payment each year. The pension ceases when the account balance hits zero.
Allocated pensions aren't just cash accounts. Retirees have a raft of investment choices at their fingertips including Aussie and international shares, managed funds, listed property, fixed interest and cash. The aim of an allocated pension is to not simply eat into your capital, but to actually make money in retirement as well. Retirees drawdown a combination of capital and investment earnings to live on. Clearly, the more money you make on your investments, the longer your retirement money will last - and the more holidays you can enjoy.
Allocated pensions are not just popular with retirees (those who are permanently retired and have reached preservation age). Pre-retirees, over age 55, looking to boost their super before retiring completely often buy allocated pensions in order to undertake the transition to retirement strategy. You can read more about this popular strategy below.
Transition to Retirement Pension
What does it mean?
A transition to retirement pension is a flexible way to move from work to retirement. On reaching your preservation age (generally 55, but is increasing over time and may be 60 if you were born after 30 June 1964), you can start accessing super (including the preserved portion) via a super pension while maintaining or reducing work hours.
Many individuals nearing retirement are looking for ways to boost their super savings. With the introduction of government’s simpler super reforms in July 2006, it is now possible to do exactly this by making the most of transition to retirement (TTR) rules.
You can take advantage of the transition to retirement rules by salary sacrificing part or all of your employment income into super, while at the same time beginning an allocated pension from your existing super funds. The pension provides an income while you continue working, and is tax free for individuals over 60, and carries a 15% tax rebate if you're aged between 55 and 60.
At the same time you're getting considerable tax benefits from salary sacrificing your income into super, paying only 15% contributions tax, as opposed to PAYE income tax rates of up to 45%.
So at what age is this strategy of most benefit? Most advisers agree that it best suits someone aged 60 or more, or at the very least age 55. Between now and 30 June 2012 an individual can take a pension income stream tax-free and make contributions (both salary sacrifice and employer contributions) up to $100,000 per annum.
To begin a TTR strategy, you must have reached ‘preservation age’, in order to access super benefits. This is age 55 if you were born before 1 July 1960, phasing to age 60 for those born after 30 June 1964.
Due to the reduced cash flow, anyone thinking about the TTR strategy should have no debt.
Not all super fund providers offer TTR arrangements.
The fees of setting up a TTR arrangement should be minimal – and if you are able to set up the scheme yourself, no costs should be incurred at all. Once you reach retirement age, the commutation of the TTR pension back to accumulation phase is also allowed and should be at a minimal cost.
Before deciding on whether to set up at TTR strategy, you firstly have to find out what your pension is worth, then check the numbers on your living costs and see if the after-tax income of the pension will cover your needs. Then you need to make an application to the super fund for the pension to commence, and notify your payroll office of your decision to salary sacrifice to superannuation.
The TTR strategy has the Australian Taxation Office stamp of approval, which has stated that it will not apply anti-avoidance provisions where this strategy is employed. The ATO notes: "We would only be concerned where accessing the pension or undertaking the salary sacrifice may be artificial or contrived."
his information is of a general nature only and doesn't constitute personal investment advice.
What does it mean?
Many retirees convert their retirement savings to a pension upon retirement due to the considerable tax benefits available in the pension phase.
Once retired, you have the choice of retaining your funds in super (in the accumulation phase) or converting your funds to a pension, such as an allocated pension.
Taxation payments will be higher if you leave your assets in a super fund compared to a pension. In the accumulation phase, earnings on a super funds are taxed at up to 15 per cent. But once a fund converts to paying a pension, there is no tax payable on the earnings. Additionally, if you are aged over 60, any pension drawdowns are also tax free.
Let's say that your account balance is $500,00 and generates 8 per cent ($40,000) assessable earnings. Assuming half of this is income, and the other half realised capital gains, then the tax payable would be around $5,000. If the account had been converted to the pension phase, then the tax would be nil.
One possible downside of commencing a pension is that you may not need the minimum level of income that you must draw down. For instance, you may have income from other sources, such as investments in your names or employment income.
And once a pension is commenced, it is no longer possible to add extra contributions.
The costs charged by the product provider when making the switch from accumulation to pension phase will vary, but are impossible to avoid once you've decided to cash in your super assets. But it is vital that you shop around when looking for a retirement income product, as fees and charges can range enormously.
What does it mean?
Hybrids are products that combine the characteristics of shares and fixed interest products..
Hybrid securities are “higher yielding” investments, generally paying regular income to investors a couple of basis points above the bank bill rate. Such investments are popular with retirees seeking higher yields than they’d normally receive from a cash account.
As with most investments, riskier hybrids pay a higher interest payment (otherwise called a coupon or preferred dividend) to compensate investors for the added risk.
When buying a hybrid security you are typically lending money to a bank, insurance company or large corporation, known as the issuer. In return for the loan, the issuer pays a given interest rate (called the coupon) for the life of the security, repaying the principal at maturity (more on this later).
As the name suggests, hybrid securities are a mix between a debt and equity instrument. Before changes to the International Accounting Standards, most hybrid securities issued were reset preference shares (RPS).
RPSs act like traditional bonds to begin with – paying investors a fixed or floating interest rate (often franked) – but at maturity, or the reset date, can be converted to ordinary shares, cashed in, or rolled over into a new security.
This means that investors in hybrids get it both ways; they receive regular coupons for a set period (usually five years), but also receive the equity twist. In the event of bankruptcy, investors in hybrids rank after bondholders but before shareholders in the carve-up of the company’s assets.
All things considered, perpetual step-ups are not as attractive as the old reset preference share. Investors in the new step-ups no longer retain the right to convert their securities to shares, or redeem them for cash. Instead, this right will lie at the feet of the issuer. Basically, the step-up clause means that, in the event that the securities are not converted or redeemed for cash, interest payments are increased (stepped-up) after a specific date. Steps-ups are regarded as marginally inferior to the old reset preference shares since investors are no longer guaranteed the right to cash out at maturity in order to receive their money back.
What does it mean?
The Price/Earnings ratio is how much money you are paying for $1 of the company's earnings. So if a company is reporting a profit of $2 per share, and the stock is selling for $20 per share, the P/E is 10. In other words you are paying ten-times earnings.
P/E Ratio = Price Per Share / Annual Earnings per Share
A favourite tool of the contrarian is the price/earnings ratio (P/E), which is calculated by dividing the current share price in cents by the company’s earnings per share, or EPS. Thankfully, the historic P/E on stocks is readily available, so you don't have to manually do this calculation yourself.
The P/E ratio is rather useless on its own, but is a handy comparison tool. You can use it to compare one company against its peers, to the overall market, or sector, as well as to track historic performance.
Let's say that one company (Company A) has a P/E of 12 and another company in the same industry (Company B) sports a P/E of 20. For every $1 of current earnings, the investor is effectively paying $12 a share for Company A and $20 a share for Company B.
It's clear that Company A is cheaper than Company B because for every $1 of earnings, you're paying $12 a share instead of $20.
Contrarian investors use this as a guide for finding stocks that are going cheap. They particularly like stocks that are trading on a low P/E relative to their peers and the overall market.
But does that mean that Company A is a better buy than Company B?
As we all know, earnings are the basic ingredients of share price growth, and the best stocks to buy are those exhibiting a trend of increasing earnings (we like to see earnings growth for five years or longer).
Remember, earnings refer to “net profits” and not revenue.
When investors spot a company with a trend of increasing earnings, they get excited and buy shares. As more shares are purchased, the share price is bid up, and so is the P/E ratio (since the current share price is the numerator in the ratio). The more popular the stock, the higher its P/E.
So Company B could in fact be a better buy than Company A if its earnings are growing at a faster pace.
There are times however when markets get out of wack. External shocks such as the recent financial crisis send share prices into a spin, and stocks that were once expensive (on a P/E) basis can be suddenly looking pretty darn cheap.
It's times like these that contrarian or value investors come to the fore. With their toolkit in hand, bargain hunters set to work.
A bargain means that you are getting something that should cost $10, for $5. You buy a leather couch on special for $2,000 that a week prior was holding a price tag of $4,000. This is what most of us call a true bargain without thinking too much about it.
But just because the coach was priced at $4,000 the week prior, doesn’t necessarily mean that it's a bargain at $2,000. (It could be old stock, its design could be going out of fashion).
Likewise, just because your favourite stock was trading at a P/E of 10 many months ago, doesn't necessarily mean that it's a steal at 6 today. Basically you have to consider whether the fundamentals have changed.
For example, as consumers tighten their purse strings, will the company struggle to sell its goods and services? If the company has a lot of debt on its books, will it battle to get funding? If it's an importing company, will the fall in the AUD/USD impact its sales?
Sometimes a fall in the P/E can be justified, sometimes not. And getting this right is the true test of whether a contrarian investor spots a bargain or not.
What does it mean?
Dividend imputation is a company tax term in which some or all of the tax paid by a company may be attributed to shareholders in the form of a tax credit to reduce income tax payable on the income distribution (dividend).
Before 1 July 1987 corporate profits were subject to two lots of tax. Firstly, companies paid company tax on their earnings. Only the "after tax" earnings were then available for dividend declarations. Secondly, individual shareholders paid personal income tax on any dividends received by them, despite the fact that the companies paying them had already paid tax on the underlying profits. This unfair approach has now been replaced.
Under the current system, which is called "dividend imputation", companies still pay tax on their earnings and then declare dividends, if they wish, out of their "after tax" incomes. However, these transactions no longer involve double taxation.
Such dividends are known as "franked" dividends. The company tax which was paid by the company on the portion of the gross profit relating to the dividend is called the "imputation credit".
With a company tax rate of 30 per cent each $100 gross profit becomes $30 tax and $70 net profit. Each dollar of net profit thus has associated with it 30/70 dollars of imputation credits.
Individuals receiving a franked dividend are then treated, for tax purposes, as having received as assessable income both the dividend and the associated imputation credit, and as having already pre-paid as tax a sum equal to the imputation credit.
Individuals on marginal tax rates which are less than the company rate of tax thus become entitled to a refund of the amount overpaid. If not required as an offset to tax this refund is now available in the form of cash.
Some dividends are unfranked - for example, when the relevant company profits were earned overseas and did not result in tax payments to the Australian government.
Some dividends are only partly franked. The franked portion divided by the whole is known as the "franking ratio".