How to build a bulletproof income portfolio

Excerpt Below

Edited Transcript 

James Marlay: Hello and welcome to this special thematic episode of Livewire’s Buy Hold Sell. It’s part of our 2021 Income Series, Solving the Income Puzzle. My name’s James Marley, I’m a co-founder of Livewire Markets, and today I’m doing something a little bit different. Rather than getting the fundies on the hook, I’ve got two superb financial advisers that know all things creating income portfolios, they’ve answered every question you could possibly have. So I’m joined by Charlie Viola from Pitcher Partners and Hugh Robertson from Centaur.

I’m going to start with a contentious issue, how much do people really need to retire? What’s the magic number that comes up? There’s industry research that says $640,000, which seems awfully precise to me. Charlie, I’m going to hit you with this one first, how do people think about the right amount that they need to retire off?

Charlie Viola: One has to question what that number’s actually based on, to be honest. Everybody’s lifestyle is their own. I would argue that everybody needs, certainly in the first five to eight years of retirement, probably 100% of your pre-retirement discretionary income to live off. After 10 or 12 years of retirement, then naturally your expenses are probably going to fall away. But I would suggest that any portfolio needs to be big enough and sufficient enough, because when you’ve got plenty of time on your hands, what do you do? You spend money. If you think you can go from earning or spending $100,000 or $120,000 while you’re working, to living off $40,000 or $50,000 in retirement, that’s just irrational in my view.

James Marlay: Hugh, have you got something to add to that, is there a magic number that you speak to clients about?

Hugh Robertson: For the majority of people, it’s a good starting point, this number, to start to try and engage what retirement actually looks like for them. Charlie’s spot on when we talk about a U-shape spending pattern in retirement, the first 10 years are the most important years of their retirement, certainly when they’re going to be the most active and they’re going to travel the most. In the early years, there’s certainly a higher expenditure need there. We often joke that the next decade is about cups of tea and babysitting, and the last decade’s important because we need money for healthcare. So the ASFA retirement standard is a good starting point for the majority of people. However, that’s all it is, it’s just a starting point. From there they can go on and try and create their own, look at the budgets, if they want to, to try and decipher what retirement actually looks like. I think that’s more the conversation people need to have. What does their retirement look like to them?

James Marlay: Well, it’s a good point because it segues into my next question. When do people start switching from accumulating in the growth phase? A lot of people, myself in my early forties, haven’t really thought about retirement just yet, when does it need to start factoring into your planning? When do people start thinking about that switch?

Hugh Robertson: Probably about five years out. Ideally, we’d love people to start 20 years out. However, in terms of a portfolio and allocations, in terms of what you do with reinvesting income versus paying cash to build up enough money for your retirement income, in terms of what you do with your contribution strategies, I feel that around five years is probably what the rule of thumb is with most people. A lot of people might be in second marriages, a lot of people might be paying off debt still, so there’s a conversation around debt versus salary sacrifice contributions. So there are some really meaningful points that could make a really big difference for your retirement nest egg five years and beyond out from retirement.

James Marlay: Charlie, what about you in terms of a runway for people having a successful retirement, what’s the timeframe that you like to see?

Charlie Viola: I agree with Hugh. The planning process is a reasonably long one, it’s a five or six-year process so that people can really understand what they think they’re going to spend in retirement, what retirement will look like. What I counsel everybody, and to Hugh’s salient point there, liquidity becomes really important in retirement, being able to get your hands on money, because you really don’t know what retirement holds, right? You’ve never done it before, it’s not going to be linear, some years you’ll spend more than others. Again though, what I counsel everybody, is that even when you’re retired, your investment time horizon is 25 or 30 years plus. Which means that pulling all the money out of growth assets and sticking them into defensive assets is mental, it’s just not the thing to do. Growth assets will still produce the best return and it’s going to produce the best long term income streams, therefore you really still need to be invested with that really long term time horizon attached to it.

James Marlay: We all want to have a solid nest egg. I’d say even though retirement seems a long way away for me, I still have in the back of my head ticking away, how am I going to get that number up so that I can do some trips and all that sort of stuff, support my kids. Charlie, I’ll start with you, what are your top two tips that can have a big impact on people getting ready for that nest egg; to maximise it.

Charlie Viola: Can I have three James? I’ve got three really quick ones. The first one is to start earlier. The second one is to buy more risk assets. Risk assets are those assets that are going to generate a better return over time. And the third one is, everybody should be using their balance sheet. So use the balance sheet that’s available to you in your own situation so that you can grow your wealth properly. Putting a dollar on a dollar in a bank account is just never going to get you to the point where you can have the retirement that you want – unless you’re one of those very fortunate people like you, maybe James, who are earning a couple of million bucks a year.

James Marlay: I’m sending my application to be one of your clients next week, Charlie. Hugh, Charlie’s given us three points, is it possible you could stick to the script and give us two or do you need a bit extra?

Hugh Robertson: From Charlie’s comments before, it’s to stay in growth assets. You should be leaving 60%-70% in risk assets, growth assets through retirement. And that’s really to counteract your longevity risk, we’re probably going to live a lot longer than we expect to, certainly a lot longer than the previous generations did. And also inflation risk. Although this is such a conversation point right now, long term we know the price of everything goes up, especially healthcare-related things. So growth assets to counteract those two risks. The second tip would be around sequencing risk. So from my perspective, it would be having enough cash set aside for maybe year one, year two, and even maybe year three of retirement, but really not a lot more sitting in cash than that. If you’ve got some large expenses coming up, then great, money for that. But you still have to have a really good balanced portfolio throughout retirement. After the last 12 months, that is what we really saw. People saw the value in having a well-diversified balanced portfolio, away from just term deposits or just growth assets wholely.

James Marlay: So Hugh, just on that point about having some liquidity, you are talking about having something to tide you through those first few years of retirement, so that if there is a drawdown in growth assets, it’s got time to come back, is that what you’re talking about?

Hugh Robertson: Spot on. I didn’t want to use the third tip, but yes, exactly right. Because the challenge there is – think about a year like last year with COVID. We don’t want our clients to have to sell down their equities portion of their portfolio when there’s volatility that really, was an unprecedented year, but the recovery was great. So you didn’t want to have to sell CBA shares at $50 if you didn’t need to. So by having some cash set aside, you were okay to get through that dip. If you look at the long term numbers, from peak to trough, the market’s been negative for about five years 10 months, that was the worst period ever. So with distributions and some cash reserves, most retirees can get through while still having a good allocation of growth assets. Would you agree Charlie?

Charlie Viola: I do. And to that point, I’m of the view that cash is really only an asset that’s sitting there waiting to be invested in something else, to be honest. Growth assets are what’s going to drive returns, they are what’s going to drive income and people should look at the risk in their portfolio around the risk of impairment, not the risk of volatility. Remember these timeframes are 30 and 35 years long, so volatility’s going to happen, let’s just worry about the risk of impairment and not buy assets that become impaired.

James Marlay: Charlie, I’m just going to hit you with a follow-up question on that comment you made around using your balance sheet. When I hear those sorts of terms, immediately my head springs to maybe using some gearing or some leverage, but I’m keen for you just to give me a little bit more detail on what you mean by using your full balance sheet.

Charlie Viola: Everybody’s situation is their own and everybody’s risk profile and attitude to risk and appetite for risk will certainly be different. But I’m certainly a big believer in if you have a really strong balance sheet, you’re in a great job, you’re generating more income than you need, then taking on gearing, using your balance sheet, using the equity in your home to help you build wealth is a good way to do it.

James Marlay: You’ve also been asked to bring along a common mistake that you see people making that you think you can help our readers avoid, a couple of potholes. Hugh, let’s start with you. What’s something that you see investors consistently get wrong that you can help by calling out?

Hugh Robertson: Opportunity cost, by having too much in cash, is a big one from my point of view. They think that cash is safe. And probably the theme of both what Charlie and I are talking about is that cash actually isn’t safe. In a real return after tax, after inflation world, you’re usually losing money, and in this current environment, you definitely are. And so (it’s important to) work to a plan and really going through what your goals are to evaluate what level of risk you need to undertake to reach your goals. Because share market volatility isn’t the risk that we see. We see not hitting your goals as the risk. So I’m with Charlie in terms of the previous comment as well on, using equity can be a smart strategy with professional guidance. So for me, it’s just the opportunity costs, especially early on when you could get compound returns and start getting that snowball working for you earlier. So that would be the big thing that I’ve seen. If I see clients with regret, it’s typically because they didn’t invest earlier.

James Marlay: Charlie, what’s your tip? What’s the common mistake that you see people making?

Charlie Viola: The common mistake that some retirees make is thinking that just because they’re in retirement, that life’s pretty much over and they’ve got to hold everything in defensive assets. People need to remember that those timeframes are really long. The other piece is, make sure any asset that you ever buy meets the quality matrix, make sure that any asset that you ever buy fundamentally has got three things that are attached to it. One, it has the ability to produce income. Two, there’s a low chance it’s going to blow up, so that risk of impairment becomes a big one. And thirdly, we want to see assets grow over time because that’s what’s going to protect the buying power of money over the long term. Again, retirees shouldn’t be looking at their portfolio and thinking, I’ve got to have 50% or 60% or 70% or 90% of this money sitting in defensive assets because what happens if the market turns, I’m not going to be able to earn it back. Remember you’ve got 25 or 30 years of investment to go.

James Marlay: Now listen, the next question was going to be about the must-have asset class, but I’m going to skip over that and bring us straight to your portfolios and ask you for the first asset class picked in your portfolio, that’s going to be your star player. Charlie, I’ll get your portfolio up first. My first question to you is just on return expectations, we actually haven’t talked about it. What sort of expectations do you set for your clients? And if we bring that portfolio up, you can see 50% to 60% in shares, 15% hard assets, 10% in quality private debt, 10% fixed income, 5% in pure alternative and small caps and some cash, which you’ve said to deploy elsewhere. So hit me with that return target and maybe talk me through it.

Charlie Viola: What we say to everybody is that a good quality balanced portfolio with a mix such as this, our medium to long term expectations, are 7% to 9% to 10% annually, of which probably half of that’s going to be income. We’re a big one for showing the client their revenue production over time, and even the way that we report to them, is what was the revenue last year? What do we expect the revenue to be this year from each and every asset, and what does it total to at the bottom? We’re of the view that capital growth will be whatever it will be depending upon equity markets, but the bit that we can control is the revenue production. So we really want every portfolio to be punching out 4% or 5% of income annually, which is why, we’ve always got a reasonable percentage to those hard assets and the quality of private debt and private syndicate style investments.

But the key driver of virtually every portfolio, and we’re probably no different to anybody else, will be equities. It’ll be large-cap, good quality, defensive, blue-chip equities, where we know what the business does, we know where the revenue comes from, we know how it makes a profit, we know what their market is, we know what their market share is, we know that it can gobble up its competitors. We want to generate revenue for the clients because ultimately that’s what they’re going to live off, is the revenue that their portfolio was producing.

James Marlay: Charlie, could you tell me a little bit about this fixed interest, these short duration bonds, because I know if you’re sort of stepping out of cash, which is sort of negative real return at the moment, and people being forced out of it. I’m imagining those short duration bonds is kind of the next step along from that, what’s the role of that asset class in the portfolio?

Charlie Viola: We probably use those short duration bonds where you’re probably looking for 100 or 150 (basis points) over cash, very much as somewhat a cash alternative. We make it clear to clients, it’s not cash, there’s some risk attached to it. That two or three-year term money, that kind of Hugh talked about previously, we agree with that. We think the clients need to have access to that capital, if the roof falls in or the kids get sick or their kids want to buy a house or they want to buy a new car, in retirement, we do actually want to have a level of liquidity. We think those short duration bonds or those cash enhanced style strategies are a good place to park some money for a short period of time until you’re either utilising it for that purpose, or there’s an opportunity to go invest in something that’s a little more meaningful and a little more long term.

James Marlay: Just a final point, 10% cash, you’ve said that that’s sort of a tactical allocation?

Charlie Viola: In reality, that’s an absolute maximum, and it’s really money that’s sitting there waiting to be invested in something else. But we’re a big one for trying to help the clients find weaknesses in the market or find opportunities that exist, whether it’s in alternates or it’s just in general risk assets, we always want to have a little bit of powder dry in the client situation so that we can take advantage. During the COVID period last year, we actually did a fair bit of buying through that period, because we saw a lot of those good quality companies that we really like and just equities generally, that we could buy and really fix our return at least for a period of time from those assets.

So it’ll wax and wane, right? These things are never exact because our equity allocations would’ve gone up over the last three years because the equity market’s gone up 35% or whatever it is over that timeframe. And we’re not a big one for rebalancing, but as the money generates its own cash, we want to make sure we deploy that cash in the right way, over a period of time.

James Marlay: Thanks very much for that Charlie, really appreciate the detail there. Hugh, your turn in the hot seat, I’m going to give people a quick run through what they can see on the screen. You’ve got a 60% allocation to equities between domestic and globals, 15% real return strategies, which I’m going to get you to tell us what’s under the lid there, 12% alternatives, 6% in bonds and a small allocation to cash. Talk us through how you think about that portfolio, and maybe you can hit that same question on return targets that I asked of Charlie.

Hugh Robertson: Similar in terms of Charlie’s view of it, 7% to 9% – that keeps the client at around a 5% drawdown after inflation and fairly low levels of risk there in the way that we draw down from the cash ladder of risk from where we drawdown. Then going from there 4% income, some franking credit benefit there. So we feel that that’s still conservative and still achievable in this world. Equity has been the main driver for us, Aussie on the dividend and franking credit, and global for growth, to keep pace with inflation. Probably similar to Charlie on short duration bonds. Alternatives I’ve got as an allocation, that’s alternative fixed income strategies. So we are looking at different ways of managing fixed income risk there. So that can be called unconstrained bond funds that have the ability to shorten or lengthen duration and arbitrage their way through to reduce risk in that space, especially if interest rates rise, there could be some issues.

The real return strategies are really around four key things: return-seeking, diversifying opportunities, portfolio protection and inflation hedge. So utilising something like that via a way of an investment fund of sorts, so that it’s dynamic by nature. So if I think about the ‘do it yourself investor’, they might have a somewhat static portfolio and not look to do a lot of changes. So you’re going to need some dynamic asset allocation capabilities within your own personal portfolio. Obviously, as Charlie mentioned, last year we did the same thing, we were buying in the lows last year because we had conviction, we understood what was happening. So we can do that, regular, quarterly rebalancing of portfolios, we can do all those things. But for the DIY investor or maybe the self-directed investor, they can really benefit from having some of those real return strategies. They don’t have a set asset allocation, it’s dynamic by nature, so they can really move the needle to more or less risk with the number one goal always being to protect your capital.

James Marlay: So just specifically on those, when you talk about those real return strategies, are these long/short funds, market neutral funds, or are these those really diversified, real return, inflation plus style targeted funds?

Hugh Robertson: We might remember prior to the GFC, there wasn’t much of this, as an investment option. And after the GFC, we had a really rough run in investment markets, but we’ve got an ageing population that wants to draw down their income for retirement. So from that perspective, it’s given rise to these real return funds, which might be a CPI plus five, or CPI plus three, CPI plus seven. But they warrant a place in people’s portfolios where the manager can do the heavy lifting on that for you. And there are starting to be a number of providers in the marketplace now that can do that, certainly.

James Marlay: Well, ladies and gentlemen, that wraps up a look under the bonnet of these two portfolios that Charlie and Hugh have brought along for us today. Hope you really enjoyed the transparency that they’ve provided on their allocation and remember.