Investment Returns
Ethical Investing - OR Responsible Investing, ESG factors or Sustainable Investing
Helping our clients to understand that their investments are doing good is important to us at Moneyworks. Research shows that investing ethically can increase returns.
We are using the terminology ‘Ethical Investing’ as a catch-all phrase for ‘investing to do good – and avoiding the bad and nasties’.
Other words used to describe this type of investing are ‘Responsible’, ‘Sustainable’, ‘Green’, ‘ESG’ as compared to ‘ethical’ investing, with some organisations having concerns about the implications of the word ‘ethical’.[1] While we understand these concerns (one persons ‘ethics’ may be different to another persons ‘ethics’), we consider that the ‘ethical investing’ terminology sums up the goals of doing good and avoiding the bad.
However, as the world evolves and the understanding of what is ‘good’ and what is ‘bad’ changes, the acceptable types of investment and approaches to investments will continually change.
Ethical Investing is a new approach to investing and provides a stark contrast to the Milton Friedman doctrine that has reigned since the early 1970’s that ‘the purpose of a corporation is to make profits for the shareholders’. This approach gained popularity and has seen swings away from organisations caring about all stakeholders (eg employees, community, environment) to focusing in the power of the dollar and profit.
We have been monitoring our investment managers since 2018 to ensure that they incorporate ethical investment concerns in their approaches to investment, but since mid 2020 we have undertaken a major project to upskill ourselves, integrate independent research into our client reporting and carry out extensive deep dive analysis into our existing fund managers, and new fund managers to understand their approach to ethical investing.
Over the last two years, money has flowed into ‘ethically’ branded investment solutions around the world, but we are aware that there is a lot of room for green-washing (or brown-washing, or other ‘washing’), so wanted to make sure that we did this work properly. ‘Washing’ means that an organisation claims to be doing something, but when a deep analysis is carried out, it is found that the claim is just a label, and that the actual situation under the hood does not match the claim.
There have been a large number of instances of ‘washing’ (we have outlined a few later in this information), and we wanted to make sure that if we were holding ourselves out to provide an ethical investment solution, that our offering was truly true to label.
[1] ESG is Environmental, Social and Governance concerns.
Investment returns and interest rates do matter
To achieve your retirement savings goals, and to get through retirement, you need to understand how investment returns actually work.
When you see a return quoted in the media or on an investment statement, that number is usually the gross return. It is the return before tax, before fees, and before inflation.
That is not the number that funds your retirement.
There are three deductions that matter:
Tax – You do not keep the full return. Your tax rate determines how much of the return remains after tax.
Fees – Investment management and platform costs reduce the return further.
Inflation – Even if your account balance rises, inflation reduces what that money can buy in the future.
What ultimately matters for retirement planning is the return left after all three. This is often called a real return, because it reflects the increase in your actual spending power.
How to read the return numbers in this document
When we refer to a return of 2.00% to 2.50%, we are not saying your portfolio only earns 2.00% to 2.50%.
We are referring to the return left over after:
• tax
• investment fees
• inflation
This is called a real return. It measures the increase in your actual spending power.
Headline return – tax – fees – inflation = real return
For example, if inflation is 3% and your tax rate is between 17.5% and 39%, achieving a real return of 2.00% to 2.50% typically requires a headline investment return of roughly 6% to 10% per year before tax and inflation.
We model using the lower, real return because that is what determines whether your money will last in retirement.
When we prepare retirement projections, we deliberately use real returns. We do not model using headline numbers.
For most of our clients, the long-term planning assumption is between 2.00% and 2.50% per year after tax, fees and inflation. In very conservative scenarios, we may model 1.00%.
It is important to be clear: these figures are not the total investment return.
To achieve a 2.00% to 2.50% real return, the underlying portfolio typically needs to earn something in the region of 6% to 10% per year before tax and inflation, depending on your tax rate and the inflation environment. The higher your tax rate, the higher the required headline return to achieve the same real outcome.
We use the real figure because that is what determines whether your money will last.
Why small differences matter
The next step is to understand how much difference even 1% per year can make over time.
The table below shows what happens if you invest $50,000 for 30 years at different real return assumptions.
Planning assumption: return after tax, fees and inflation | Amount you will have in 30 years, if you invest $50,000 |
|---|---|
0.00% pa | $50,000 |
1.00% pa | $67,392 |
2.00% pa | $90,568 |
3.00% pa | $121,636 |
4.00% pa | $162,170 |
Assumptions: $50,000 invested for 30 years with these after tax, fees and inflation returns, compounding.
An extra 1% per year may not sound significant, but over long periods it meaningfully changes the outcome.
The link between return and risk
The final step is understanding the relationship between return and risk.
If you invest in a term deposit earning 3.50% and your tax rate is 33%, your after tax return is 2.35%. If inflation is 3%, your real return is close to zero or negative. Your capital may look stable, but its spending power is not growing.
To achieve a 2.00% to 2.50% real return, you generally need a diversified portfolio with exposure to growth assets. That involves short-term volatility. Markets will not deliver a straight line.
On the other hand, targeting a 4.00% real return would require a significantly higher underlying return before tax and inflation. That implies a higher level of risk than most retirees are comfortable taking.
For balanced investors, a long-term planning assumption of around 2.00% to 2.50% after tax, fees and inflation is both realistic and prudent. It recognises that what matters is not the headline return, but the growth in your purchasing power over time.
Moneyworks NZ Ltd
P: 0800 225 621
E: contact@moneyworks.co.nz
7c Hall Street, Cambridge 3434
Licensed Financial Advice Provider - FSP 15281
Regulatory Information: Moneyworks is a Licensed Financial Advice Provider (FSP15281), and AML Reporting Entity and is supervised by the Financial Markets Authority.