Navigating self-funded retirement is a hornet's nest

There are more self-funded and semi-funded Australian retirees than ever before. The ability to retire with limited reliance on government support should be celebrated and governments and corporates have a responsibility to support those quiet Australians in anyway they can.

But right now, for most, navigating self-funded retirement is a hornets nest.

We looked on with great concerns for retirees as the RBA made consecutive cuts to the cash rate over the last few years. Then came the recent COVID-19 share market rout and now we’re faced with an unexpected recession.

It will come as no surprise to many, but we still believe the share market can provide a good source of income for retirees looking to make ends meet.

According to our internal research, when adjusting for the likelihood of dividend cuts, the approximate gross yield (including franking credits) from Australian equities over the next 12 months will be around 5%, still substantially higher than the returns from cash investments.

But unfortunately the share portfolios of many retirees lack diversifaction away from the banks and there is a very real possibility that the big 4 will significantly reduce, defer, or even cut their dividends completely at their next results, in order to maintain or even increase their capital ratios.

We estimate that the big 4 banks paid 30% of the gross dividends (cash dividends plus franking) of the entire S&P200 index in 2019. So, even investors with a broad index-like exposure will see substantial falls to the income if the big 4 withhold their dividends or make significant cuts.

On the 7th of April, the Australian Prudential Regulation Authority (APRA) stated: 

“APRA expects Australian Deposit-taking Institutions (eg. Banks) and insurers to limit discretionary capital distributions in the months ahead, to ensure that they instead use buffers and maintain capacity to continue to lend and underwrite insurance. This includes prudent reductions in dividends, taking into account the uncertain outlook for the operating environment and the need to preserve capacity to prioritise these critical activities”.

We think it is prudent for APRA to take such an approach in these uncertain times, however, there is a simple solution that will enable the banks to continue paying dividends, while maintaining capacity.

How? Well, APRA have left the door open for banks and insurers to pay dividends - “Dividend payments should be offset to the extent possible through the use of dividend reinvestment plans and other capital management initiatives.” It is common for companies to have dividend re-investment plans (DRPs) so investors are able, if they choose, to immediately re-invest their dividends back into the company. If an investor chooses to elect this option, then the company keeps the dividend of this investor and issues the investor new shares.

However, given some shareholders (probably a majority in the case of the banks) desire the dividends, this option would still result in a reduction of capital for the company.

But there is another option for companies who have a strong desire to maintain their dividends but also need capital.

These companies can choose to underwrite those DRPs, which effectively means that new shares will be issued matching the dollar value of all the dividends that they pay. For all those investors electing cash rather than the DRP, the company will still issue new shares which a broker will sell on market during the DRP pricing period. This allows the company to completely preserve its capital as well as paying dividends to those who would still like to receive it.

Banks should be commended on the way they’ve responded to the COVID-19 pandemic thus far, but we emplore the big 4 to now step up to support the quiet Australian reitrees that rely on them by utilising underwritten DRPs if they are unable to maintain necessary capital ratios.

Significant reductions or cuts to bank dividends will have a devastating impact of the budgets of self-funded and semi-self-funded retirees, putting further pressure on the Australian economy, which will likely fall into a deep recession in the June quarter of 2020.

Retirees in strong financial health are an essential part of a stronger Australian economy. 

Want to learn more about income?

Plato Investment Management is an Australian owned boutique equities fund manager specialising in maximising retirement income for pension phase investors and SMSFs. To find out more click contact below.