Wealth Building Strategies Limited

                                     Financial Planners, Insurance & Investment Advisers

What does a credit rating mean ?

Have you ever seen a bank, insurance company, finance company or financial institution advertising their ‘credit rating’? Given the plethora of information and all the different types of ratings, it’s hardly surprising many people are confused about what they actually mean (it’s certainly not as easy as ABC!)

However, with several finance company failures recently, it has never been more important to understand it all. So, let us try to explain.

Put simply, a credit rating is an objective, independent assessment of an institution’s ability to meet its financial commitments (which might include interest payments and the repayment of your investment capital). Effectively it tells you how financially secure the company is (and therefore the likelihood of you getting your money back when you invest it).

This is important for three reasons:

1. Almost every investment carries risk, and credit ratings allow you to gauge the level of that risk.

2. You can work out whether you are comfortable with the given level of risk.

3. We can then work out what sort of return would be appropriate for the investment.

This is often reflected in the margin that the investment provides over and above the ‘risk-free’ rate.

For example, let’s say you can invest into New Zealand Government bonds (which have the highest possible credit rating of AAA from Standard & Poor’s) at 7.5% p.a. before tax (effectively, this is the risk-free rate). And let’s say you are thinking of investing in a company like South Canterbury Finance, which is rated BBB- and is offering say 9% p.a. before tax.

Through the credit rating, the investor/adviser is able to assess whether the extra 1.5% offered by South Canterbury (over the risk-free rate) is sufficient return for the extra risk - because BBB- is a lower rating than AAA.

And how do you quantify the extra level of risk?

The best way to do this is to look at what the credit rating means in terms of the probability of default (i.e. the risk that the company will be unable to pay interest and/or principal). This is shown in the following table from S&P.

So, as you can see, over a 12-month period, the investments that are rated AAA have a risk of defaulting of between 0.00% and 0.01% (or a one in 20,000 chance).

Meanwhile, a company like South Canterbury (BBB-) has a somewhat higher risk of default (a one in 3,333 chance). However, the risk tends to increase exponentially once you get to a rating of ‘single B’ and below.

Generally companies rated below BBB- are considered to be ‘sub investment grade’, which basically means they carry a higher degree of risk. It does not mean that you should never invest in these securities, but it is important that the return is commensurably higher in order to justify the extra risk.

So what should you do ?

1.         Contact us for advice.

2.         Invest in fixed interest investments with a minimum of investment grade rating (BBB or better).

3.         Make sure you are being rewarded for the risk you are prepared to take.

4.         Talk to us Contact Us about investment management platforms which can report on all of your investments and take care of all the tax work for you.

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How do the tax changes work and how do they affect you ?

There has been a huge amount of attention on the changes to legislation regarding the taxation of investment income. Much discussion has focused on the changes being a ‘tax grab’ by the government. In reality, the changes have substantially leveled the playing field and in many cases, they mean you will be paying less in tax.

Do the new rules apply to you ?

The new rules apply principally to international equities. Investments in New Zealand and certain Australian shares are excluded. All other international investments will be subject to a new Fair Dividend Rate (FDR) tax calculation, unless your investments qualify under the following exemptions/thresholds:

•           The total cost of all your offshore shares is NZ$50,000 or less (or $100,000 for a couple). Please note this threshold does not apply to trusts. If you are unsure as to how to calculate the cost, please call us for a two-page guide.

•           Investments in Australian-resident companies (which are listed on an approved index and maintain a franking credit account).

•           Australian Unit Trusts (AUTs) that provide a Resident Withholding Tax (RWT) facility and meet certain other criteria. If you have AUTs, we can talk this through with you.

•           There are certain other exemptions including GPG, New Zealand Investment Trust and venture capital companies.

•           Investments in New Zealand tax resident unit trusts are excluded from your personal KOR calculation (even if they invest in international shares).

How does the Fair Dividend Rate Work ?

If your investment in international equities does not qualify for an exemption as outlined above, you will be taxed each year on a maximum of 5% of the opening market value of your offshore shares.

If the total gain (dividends and capital gains) on your offshore share portfolio is less than 5%, tax is payable on the lower amount, with no tax payable if the shares make a loss.

For example:

The most you will ever pay in tax for international equities is whatever your marginal tax rate of 5% of the opening market value. There is a Quick Sale Adjustment (QSA) if you buy and sell shares during the year.

So why is this positive ?

1.         Any gains you receive over 5% are effectively tax free (in the first example this is $20,000).

2.         If you are an individual or family trust investor and you make a loss, you will not pay any tax (although you can't carry the loss forward).

3.         In most cases, you will have certainty of your overall tax liability at the start of the year.

4.         Overseas dividends are no longer taxable by themselves unless an exemption applies.

5.         Previously, if these investments were held in a non-grey list country, your entire gain would have been taxable.

What about managed funds ?

The tax changes have really enhanced the appeal of certain managed funds. These funds are the ones which are going to register as Portfolio Investment Entities (PIEs). The PIE will pay tax on behalf of the investor based on the Fair Dividend Rate (FDR) at their marginal rate, capped at 33% (i.e. either at 19.5% or 33%).

So 39% taxpayers will generally have an additional tax saving. In addition, managed funds which register as PIEs (some will continue to be taxed as they are currently) will take care of all the taxation work for you (if you are an individual or a family trust who elects to have tax deducted at 33%.

PIEs which invest into Australasian equities (New Zealand equities and qualifying Australian equities) will have no capital gains tax and will only be taxed on dividends.

The changes effectively mean there may no longer be a tax advantage in investing into direct equities over using a managed fund and PIEs provide an excellent tax effective method of investing going forward.

 So what should you do ?

1.         Contact us for advice.

2.         Invest in managed funds likely to become PIEs (we can help you recognise which ones will fall into this camp).

3.         Make sure your fund managers have your correct marginal tax rate.

4.         Talk to us Contact Us about investment management platforms which can report on all of your investments and take care of all the tax work for you.

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Are we getting richer ?

The result of a recent survey into the net wealth of New Zealanders provides some interesting reading. The survey has revealed:

Household net worth increased 14.7% during 2005

Liabilities increased by 15% over the same period

The increase in net worth was driven primarily by a strong price appreciation in the housing market.

While ostensibly the survey is extremely encouraging, if you dig a little deeper there are actually some areas that are cause for real concern. For example, although total net worth (assets less liabilities) increased by nearly 15%, financial net worth (excluding non-monetary assets such as property) only increased by around 5% over the year. This tells us that the increase has been driven almost solely by capital gains in the housing market.*

Why is this a concern?

Most people who own a house, also live in it. Therefore, in most cases, a property is not an income-producing asset. So although it feels good to have an increase in the value of your house, unless you sell or downsize, the increase in value is of little tangible financial benefit.

It creates a ‘wealth effect’ whereby people feel rich and then in some cases begin to make poor financial decisions based on the fact they feel more wealthy. Evidence of this is found in the fact that overall debt has increased by 15% over the year (so in real terms, there is no net gain).

Real financial savings in financial investments such as term deposits, managed funds, etc. show little sign of any growth. There is nothing fundamentally wrong with property as an asset class. However, the danger lies in people making ill-advised decisions because they feel they are better off, when in pure financial terms they actually are not. If you would like to discuss your own financial position with a view to increasing your financial net worth, we would be glad to help you.

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Asset rich cash poor ?

When you are retired and your only source of income is NZ Superannuation you don’t have a lot of spare cash available for paying the escalating power bills, car repairs, appliance repairs let alone a annual holiday or buying birthday or Christmas presents for the grandchildren. Often retired folk have poured all their savings into paying of the house and becoming debt free, which leaves them with a house which has been escalating in value and no spare cash.

There are several options the retiree can consider to enhance their cash position.

All solutions could work, however each option needs to be carefully considered, hopefully with consultation with your professional Advisers and the support of your family.

Downsizing

Downsizing works best when it involves a move to a nearby, cheaper area. However it can be a wrench moving further away from friends and family who may in the case of illness be providing much needed support. If you happen to own a large family home in Wellington moving to a smaller unit in a cheaper suburb may release substantial equity and give you the cash to make life easier.

 Inheritance

 Some retirees may be reluctant to sell the large family home because they want to leave the house as an inheritance to their children. In this case the children may want to protect their inheritance by providing Mum & Dad with an ongoing weekly income. Two or three children getting together and providing Mum & Dad with an extra $50 a week can sometimes make all the difference.

Most banks would not entertain lending Mum & Dad money if Mum & Dad’s only source of income is NZ Superannuation. In this case the children may want to protect their inheritance by servicing the mortgage for Mum & Dad.

Another option is for the children to lend Mum & Dad the money secured by a mortgage over the family home. When Mum & Dad pass on, the estate settles the mortgage.

Reverse Annuity Mortgage

Over the last several years there has been huge growth in the popularity of the reverse annuity mortgage. This involves Mum & Dad agreeing to mortgage their house for an unknown final amount, in exchange for a monthly payment, of say, $1,000, tax free. 

The annuity is not repaid until Mum & Dad pass on, at which time the amount paid out, plus interest, compounded monthly, gets taken from the proceeds of the final sale of the house. The power of compounding interest means the debt doubles every 8 years, at an annual interest rate of 9%. If Mum & Dad receive around $1,000 per month for 10 years, the estate would be charged $120,000 of capital, and around another $90,000 of interest at today rate of 9%.

This method quickly spends the children’s inheritance, but doesn’t matter if there are no children or the children are wealthy in their own right.

Home Equity Release Mortgage

Similar to the reverse annuity mortgage in regard to the compounding effect, but Mum & Dad receive a lump sum of say $100,000 instead of the monthly payment. The amounts Mum & Dad can borrow are very much dependant on their age and the house value. This type of loan doubles the debt about every seven years. So if Mum & Dad are around 80 years of age, by the time they are 90 years of age the debt is around $245,000.

Both the reverse annuity mortgage and the home equity release are sold on the basis that if historical house inflation continues there will be some value remaining for the children’s inheritance.

Deferred Settlement Loans

A company agrees to buy Mum & Dad’s house, with the settlement date deferred for up to 10 years. To qualify Mum & Dad have to be over 60 years of age and the house is worth at least $300,000and another long list of ongoing requirements as to maintenance and insurance cover. The company essentially buys the house, but will not take ownership for up to 10 years.

In this case the company pays the seller $30,000 and then pays $10,000 per annum for each year till the sale occurs. On the original sale date the house is valued, by the vendor (Mum & Dad) and the company and a sale price set at the halfway point of the two valuations.

When possession date comes, the house is valued again and the company then pays the original sale price, half of the capital gain that has occurred minus the money paid out (say $120,000 - $30,000 plus nine years of $10,000). So say the original price was $300,000, the price agreed after 10 years was $400,000, then the pay out will be $300,000, plus $50,000 minus $120,000. That is $230,000.

Mum & Dad do not have to move out of the house after 10 years. They have the right to rent the house indefinitely, at market rentals, which they pay out of the income from the $230,000. The result is the company has bought a house, sacrificing interest on $120,000 in return for half of a capital gain.

Payment for Guarantee

The children wish to buy a residential investment property through a company. They use Mum & Dad’s house as security for borrowing the funds. Essentially Mum & Dad receive a monthly guarantee fee from the children for the time they use Mum & Dad’s house as security. The major pitfall is if the residential property investment goes sour the lender may force a mortgagee sale of Mum & Dads house to get their money back.

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The true value of seeking advice

 “”more people obtain advice from friends and relatives (36%) than from a    

  specialist investment advisor (21%)”””

A survey released recently by the ANZ and the Retirement Commission has uncovered some fascinating findings regarding those who have sought financial advice. The survey was New Zealand’s first-ever financial knowledge survey targeted at New Zealand adults only.

The Ministry of Economic Development supported a section of the survey focused on understanding behavior in relation to superannuation, life insurance, shares and other securities products.

A summary of the results:

Financial knowledge in general was reasonable, but there were some significant gaps

There was a strong correlation between financial knowledge and socio-economic situation

Very few people have a documented financial plan

85% of those who had sought advice about superannuation or life insurance found it very useful or useful, and 94% of those who sought advice from an independent financial adviser on these same products found it useful or very useful

54% of respondents thought fixed interest would offer the best returns over an 18 year period

Only 20% of respondents currently held share investments

30% of respondents could not cope financially for three months if they had a major loss of income

Regarding NZ Superannuation - 35% incorrectly believed it was income tested and 28% thought it was asset tested

36% of respondents had received advice about superannuation, life insurance and shares from friends or relatives

Some people think it is all right to divulge their internet banking password to bank staff.

The key things that these results tend to underline is that the public has a degree of financial knowledge, but the lack of understanding of key areas like retirement savings, risk and investment understanding is disturbing.

Of major concern is that more people obtained advice from friends and relatives (36%) than from a specialist investment advisor (21%).

The percentage of people obtaining advice about superannuation and life insurance from a professional (insurance company agent or advisor) was slightly higher (38%). However, specialist investment advisors were the primary source of advice for collective investment schemes and debt securities (56%).

The key things that these results tend to underline is that the public has a degree of financial knowledge, but the lack of understanding of key areas like retirement savings, risk and investment understanding is a major concern.

Please Contact Us you will benefit from a initial free consultation.

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Prudent trustee decision making - more than just a rubber stamp

We believe that with the massive proliferation of trusts in recent years, it is timely to provide a reminder about the importance of the Prudent Person Rule contained in the 1956 Trustee Act (and more specifically in amendments to the Act in 1988).

One of the key tenets of the amendments to the Act in 1988 was the replacement of the long list of authorized investments with an ‘open door’ policy, which allowed trustees to invest in any form of investment, subject to “the care, diligence and skill that a person of business would exercise in managing the affairs of others”. This duty of care is known as the Prudent person Rule.

In summary the Prudent Person Rule means that trustees making investment decisions may need to exercise the same level of scrutiny as professional investment managers. Some trustees do not follow anywhere near this level of detail in their decision-making process, and are often there purely to ‘rubber stamp’ decisions, rather than thoroughly investigate what is in the best interest of beneficiaries.

Some important things you as a trustee need to consider in regards to the trust’s investment decisions are outlined below:

1.         The value of the investments are protected against inflation.

2.         The investments are diversified to protect capital and minimize risk.

3.         The likely amount of income. Will this meet beneficiary needs?

4.         The likelihood of capital gain or loss and how this fits with the risk propensity of the beneficiaries.

5.         The duration of the trust.

6.         Taxation liability.

7.         Managing the cash flow needs of the beneficiaries in accordance with the Trust Deed.

A common mistake trustees make is placing all their investments into fixed income investments. This may seem like a sound investment strategy and the allocation could be appropriate for the beneficiaries, however:

1.         The Act requires trustees to protect the real (i.e. after inflation) value of the trust.

            If the trust is distributing the income produced from these investments, the real value is actually being eroded.

2.         It conflicts with current mainstream investment theory, which

emphasizes the importance of diversification across asset classes.

3.         It is usually the result of trustees failing to understand the risk

            characteristics specific to the trust. For example, when assessing

the degree of risk the trust is prepared to accept, it should be the

trustees’ assessment of the beneficiaries’ risk propensity, not their

own comfort with risk.

4.         It may mean the trust underperforms a similar investment strategy with

a balanced asset allocation over a period. Certainly, if you had placed

an entire portfolio into fixed income investments in late 2002 as a result

of the downturn in international equities, you would have

underperformed a diversified strategy over the past three years. It is

important that the trust makes investment decisions based on long

term, proven investment theory, rather than responding to fluctuations

in the market.

The importance of this is highlighted by the often quoted, but nonetheless important, Mulligan case (1998) in which the husband left a life interest in his estate to his widow.

The trustees (including the widow) invested solely in fixed interest investments from 1965 to 1990.

During that time the value of the trust property fell from $108,000 to $102,000. If instead, the real value of the estate had been maintained it would have been worth $1.368 million at the time of the trial in May 1996.

The court found that the trustees knew the effect inflation was having on thereal value of the assets and that they should have diversified into growth assets. It was not a balanced approach and the court held the trustees negligent.

From an application perspective, the Prudent Person Rule is not concerned so much with the results of investment decisions, but how those decisions were arrived at. Any action may be judged based on whether the defendant has met a standard, commensurate with a professional fund manager.

In doing this the court will ask three questions:

1.         Was the investment decision consistent with the prevailing academic

 consensus at the time on portfolio theory, investment management

and the basic rules of prudent investment ?

2.         Was the investment decision consistent with the rules, standards and

            procedures laid down by relevant professional bodies ?

3.         Was the advice based on researched, quality information ? As you

can see, there is a lot involved and if trustees are not prepared to

analyze all of these issues, either they should not become trustees

or they should employ a professional trustee to assist in this process.

The risk of not taking it seriously is likely to be larger than you think.

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