How to strike the right balance between caution and growth with a low-risk flexible investment portfolio

Question: With inflation now at about 3%, the SA Reserve Bank cut rates by 0.25 basis points. That’s great for borrowers, but I’m a 68-year-old pensioner living off the interest from a 32-day call account. I know it’s not ideal – no growth and I’m just spending the interest. I have R5-million. Can I do better without taking big risks?

Answer: A call account is safe, but three things will hurt you over time:

• Your income will reduce as rates fall. Since last year, you will have experienced five interest rate cuts and, as a result, your income will have reduced;
• Inflation will hurt your buying power over time. If you are living off the interest from the investment, the capital amount you invested will buy you a lot less in the future than it does now; and
• Bank deposits are not the most tax-efficient investments. You are taxed on all the interest (after your initial interest exclusion) the bank deposits generate, regardless of whether you are drawing it all as an income.

A solution I like to use as an alternative to bank deposits is a low-risk flexible investment portfolio. This is aimed at helping your money grow at an inflation-beating rate, keeping the tax you pay at a minimum and protecting your savings from too much risk.

There are two elements to this portfolio:

1. An income fund: These are invested in low-risk structures such as money market funds and bonds, and typically target a return of CPI +2%. As the interest element of these investments will be taxable, we do not put everything into this portfolio. This is where the second part of the portfolio is used.
2. A low-risk hedge fund: A low-risk hedge fund realises most of its return in the form of capital gains rather than interest. As a result, you will end up paying a lot less tax on your income. You need to ensure that you are in a low-risk hedge fund, so ask your financial adviser to confirm the value at risk (VAR). If the VAR is 5%, it means there is a 99% chance that you will not lose more than 5% of your investment in a month.

Do not be alarmed when you see the management fees on the hedge funds. They are a lot higher than normal investments. Rather look at what the returns have been in the past. These returns are the returns after the investment management fees have been deducted.

Let’s compare the after-tax returns on your bank deposit with the flexible investment portfolio. I have assumed that you are paying tax at a rate of 30% and that the bank call account is giving you a return of 8.5% on your R5-million investment. 

Flexible investment

For the flexible investment, I used the five-year average returns on a typical income fund and a low-risk hedge fund. This gave a return of 10.59% over the past five years. I had 15% of the capital in the income fund and 85% in the hedge fund. As only 40% of your capital gain is taxed and your marginal tax rate is 30%, your effective tax rate for the capital gain is 12% (which is 40% of 30%).

The flexible portfolio provides a much better after-tax return, but remember that it is riskier than a bank deposit. It has a volatility of 2.4%, which is still lower than a typical cautious portfolio.

As you can see, a bit of planning can put you in a better position. Again, before you take any action, do speak to your financial adviser, who can help you strike the right mix in your portfolio. DM

Kenny Meiring is an independent financial adviser. Contact him on 082 856 0348 or at financialwellnesscoach.co.za. Send your questions to kenny.meiring@sfpwealth.co.za

This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R35.