Funding retirement warrants some investing

Rob Hay looks at how using ASX-listed self-funding instalment warrants could help pre-retirees build a tidy nest egg in a low interest rate environment.

According to the Retirement Standard for the June 2015 quarter released by the Association of Superannuation Funds Australia (ASFA), one of the peak superannuation bodies in Australia, the average couple needs to accumulate $640,000 in retirement savings in order to have a comfortable retirement in their sixties — an increase of nearly 25 per cent from this time last year, and a figure which could still depend upon the receipt of a full Age Pension.

To put this into context, the comfortable retirement for those between 65 and 85 would see the annual household budget (assuming no debts) limited to $1,887 for council rates, $6,834 for domestic/overseas holidays, $4,196 for social lunches/dinners at restaurants, and $1,473 for repairs or improvements to the family home.

For some people contemplating what life might look like after work, this standard of living may seem difficult to achieve, particularly if life events such as divorce (where the average age for males is 44 and 42 for females — typically the age of peak earnings), accident/injury or lifestyle factors (such as raising a family) lead to time out of the workforce or an unexpected redundancy or career change have diminished one's ability to generate wealth through savings.

For others (especially those who live in large cities where the cost of living is typically more than in regional areas) the bar may need to be set even higher than what has been proposed by ASFA.

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Indeed, in a ‘lower for longer' interest rate environment, an investor seeking a retirement income stream from superannuation of $100,000 per annum (without dipping into their capital) in order to fund a more active lifestyle in their earlier retirement years might find themselves needing substantially more as shown in the table below.

What could people do?

One strategy that is becoming increasingly popular, particularly for pre-retiree investors in the 40-55-year-old age bracket with either a self-managed superannuation fund (SMSF) or the capacity to build wealth in their own name, involves the use of Australian Securities Exchange (ASX) listed self-funding instalment (SFI) warrants in order to build a portfolio of Australian shares.

Take, for example, the situation of Bob and Mary, both aged 52 with a SMSF balance of $500,000 and a desire to retire at some stage before their 60th birthday so they can enjoy an active lifestyle for as long as their health allows them to do so.

Bob and Mary are a single income household (Bob earns $70,000 per annum) and have the standard superannuation contribution guarantee payments made on their behalf.

Their current investments are in a balanced portfolio with an assumed real rate of return of 5.7 per cent per annum (according to the Australian Securities and Investments Commission's (ASIC's) Money Smart retirement planning calculator).

At retirement, Bob and Mary are projected to have $605,140 in superannuation — representing a gap of nearly $35,000 below what the ASFA Retirement Standard would suggest they need to be comfortable.

If Bob and Mary were to allocate 20 per cent ($100,000) of their retirement savings within the SMSF to SFI warrants, they could potentially gain access to:

• Capital growth based on approximately $180,000 of leveraged exposure to the underlying portfolio of stocks;

• Excess franking credits, which may be able to assist in reducing (or even eliminating) tax on $13,000 more income (or concessional contributions) than what they would have been able to achieve if they held the same stocks outside of the warrant structure;

• A dividend stream (initially applied to reduce leverage in the warrant) that is almost $5,000 higher than if the same stocks were held outside of the warrant structure (that is, without using borrowed funds); and

• A simple, flexible and transparent investment structure tradeable on the ASX that does not require credit checks, does not impact upon either their private cashflow or the cashflow of the SMSF, has no risk of margin calls but does contain increased investment risk due to the impact of gearing.

Under this strategy, Bob and Mary's SMSF will, from day one, have a diversified portfolio of ASX listed SFI warrants (invested in either blue chip companies with high market capitalisation or passively managed index based exchange traded funds) with a loan to value ratio of about 55-60 per cent.

Based on current market conditions (and depending on which stocks/exchange traded funds Bob and Mary invest into), some of the stocks in the portfolio may even be positively geared by two to three per cent per annum before taking into account the potential added benefit of franking credits.

Throughout the life of the warrant (usually five years) Bob and Mary are able to rebalance their portfolio of warrants at any time through buying and selling on-market (in much the same way as any other share portfolio they may have), and the dividends received from the various shares are used to automatically pay down the loan, with any interest payable being capitalised back into the warrant structure.

Over time, as Bob and Mary approach retirement, if the warrants have performed well with both the capital value rising and the loan being reduced, there is always the option of paying out the loan in full (perhaps with surplus superannuation contributions that have been built up over time) and taking ownership of the shares on an unencumbered basis, leaving Bob and Mary to enjoy the potential income stream from a portfolio of large cap blue chip shares over the years ahead.

Alternatively, if Bob and Mary's SFI warrants have decreased in value, or if the value of the loan outstanding is greater than their equity, they can simply walk away without being liable for the outstanding loan balance.

How could they go about doing this?

Bob and Mary could buy the SFI warrants like any other share through an online trading platform of their choice.

It is important to note, however that before they can buy the warrants they first have to have a ‘warrant agreement form' in place and that they fully understand the nature of the product they are getting into and the pros and cons of obtaining exposure to shares through instalment warrants.

The ASX has some excellent and independent resources available to investors on their website about the different forms of warrants and, along with the relevant product disclosure statement (PDS), is one of the first things Bob and Mary should read before embarking on this type of investment strategy.

When buying the warrants, it is important to note that the code used for the purchase/sale is slightly different to a normal stock code.

The first three letters will be the same as they indicate which stock Bob and Mary are going to buy the warrant for; however the fourth letter ("S" for SFI warrants) indicates the type of warrant, the fifth letter (for example "W" for Westpac) indicates the issuer and the sixth letter (A-Z) indicates the series of warrants (different warrants are issued at different times and will have different series codes).

Another option for Bob and Mary to consider is purchasing the warrants through the paper application contained in the PDS.

This process can be slightly more involved than if the warrants were purchased on market due to the investor identification process involved (much like opening up any other account), however the benefit is that there would most likely be no upfront brokerage, so a potential cost saving could be in the hundreds of dollars, depending on which online trading platform they use.

On the downside, if Bob and Mary purchased their warrants through an application rather than buying them on-market, and they subsequently wanted to sell their warrants, they would have to transfer them to a trading platform of some type (unless they had previously settled their purchase to a holder identification number (HIN) attached to a trading platform), or incur the costs associated with doing a ‘one-off trade' with the warrant issuer and paying a potentially higher than usual level of brokerage.

What might the outcome be?

Forecasting future returns is fraught with danger and the end result for Bob and Mary will depend upon a range of factors.

However, based on the sensitivity analysis in the table below, it can be seen that the original $100,000 investment has the potential to either grow or decrease in value significantly, in line with what would be expected from a leveraged exposure to Australian equities.

*The total annual average return figure combines the effect of capitalised interest/dividend payments and also capital movements but excludes consideration of franking credits or other tax outcomes.
** The equity figure has been calculated assuming a five year warrant term.

That being said, if Bob and Mary achieved a total annual average return in the six to eight per cent range over a five-year period, they could potentially make up the additional $35,000 they need in order to have a comfortable retirement.

Whether or not this rate of return is achievable will depend upon a range of factors (which are outlined further in the section below), however all things being equal, an investor should expect a higher rate of return on a leveraged portfolio (compared to an unleveraged portfolio) in order to compensate them for the additional risks they are taking on.

What are the risks?

Given the wide range of outcomes that could eventuate from an investment into the SFI warrants, Bob and Mary would be prudent to allocate only a portion of their portfolio (20 per cent in this example but the right amount will vary from one person to the next) into SFI warrants.

There are many risks Bob and Mary should be aware of before purchasing the SFI warrants, including the potential for leverage to magnify losses as well as gains.

Take the case of an investor who placed $100,000 into one of Westpac's older SFI warrants over ANZ back in 2006 (ANZSWB).

As you can see from the graph below, the original price of the warrants were $15 each, however in the 10 years post purchase the price went as low as $3.50 in March 2009, before gaining in value to nearly $29 in July 2015.

Performance of ANZSWB over 10 years

Clearly this has been a volatile time for markets, and for that reason, it is critical that investors like Bob and Mary have an investment time frame and risk profile that genuinely allows them to ride out the peaks and troughs. Therefore, SFI warrants will probably not suit an investor for whom retirement was imminent.

Additionally, many of the key variables that impact returns of a warrant, such as interest rates, dividend rates, tax legislation, corporate structure and macro-economic factors can change markedly over time and have the potential to produce both negative and positive outcomes.

Finally, as past performance is no guarantee of future performance, Bob and Mary need to ensure that the strategy they embark on makes sense to them and that it has been formulated and implemented in a manner mindful of their personal goals and objectives and the financial outlook over their investment time frame.

Conclusion

The definition of a comfortable retirement will be different for each of us and the vast complexities of life can make the realisation of dreams after work more readily achievable for some than for others.

However, for investors who want their SMSF/non-superannuation investments to work harder for them over the medium to long-term leading up to retirement, a conservative allocation to SFI warrants is something to consider as part of the overall investment solution to try and boost retirement savings and prepare people for their best financial future.

Rob Hay is the specialist, investment sales, BT Investment Solutions, at BT Financial Group.