Tom and Kate:  A Case Study

Sometimes it is hard to judge whether investing ethically in socially responsible funds is a going to be successful. As it would appear that investment is difficult enough without adding a potentially restrictive screen of ethics.

So this paper is based on an actual scenario, where we are looking back over time and looking at some of the successes and failures and how the Tom & Kate fared.
A good indicator is that the couple are still clients of Ethical Investment Advisers and we have maintained an ongoing professional relationship for over 16 years now. (This is not unusual for our clients.)

The Clients
When we first met the clients they were both doctors, who were married (to each other), he (let’s call him Tom) is mid 50s and she (let’s call her Kate) is late 40s and they have 2 children, one child living at home and under 18, the other child away at university.

Both clients were earning in excess of $150,000 per annum and the paying highest rates of tax, plus Medicare.

Tom & Kate were referred to us by another client Daniel, a General Practitioner, who thought that our company was doing a good job and knew that, like him, the clients wanted to invest in an ethical manner. (Daniel is still a client too!)

Financial Concerns
Their money was not working for them, they had some funds in the bank but the interest only made their tax burden higher. They were looking for ways to save some tax and use their income stream to produce wealth.

Ethical Concerns
They were both concerned about polluting industries, mining, deforestation etc. They wanted to avoid armament, tobacco, gambling and some larger pharmaceutical companies.

Positively they wanted to invest in recycling, alternative energies and some innovative medical companies.

Starting Out
In the early years we started by looking at the income stream and how it could be used to grow wealth. This requires a 5-step process:

1.    Initial consultation and information gathering using a fact finder questionnaire.
2.    Preparation of an ethical investment plan.
3.    Presentation of the plan to the clients for discussion/amendments.
4.    Implementation of the plan.
5.    Optional ongoing management service.

Initial Discussions
It was very important when we first started out that the clients were happy with our service, that they understood the process and that we understood what they were trying to achieve.  By asking about clients’ ethical concerns we get an in depth feel for what the clients are trying to achieve and what motivates them.

Often there is more to it than just making as much as possible and paying as little tax as possible. Ethical investors tend to care about how the money is spent and its impact on society and the environment. But that is not to say that the portfolio should not make money, because contrary to some opinions ethical investment is not charity.
 
Budgeting
They were aware that they had a huge cashflow but never seemed to know where it all went, so part of the investment process was to work out where the money was going and how to better use the cash flow to improve their financial situation.

Investment Property
We recommended that they buy an investment property in an inner Brisbane suburb, close to amenities, transport, universities and schools. The property is a good renter and they were happy to rent to students, who could between them pay a higher rent for a larger house with 4 bedrooms.

(We were happy to give advice on investments like residential property, that were not generating commissions for us, because we were and still are fee based advisers.)

The house has been an extremely good investment over the years and the mortgage is now quite small compared to the value of the property, because when Tom retired they decided to pay the mortgage down, using profits from their personal portfolio.

Buying Shares
They were not interested in using Margin Lending to start a share portfolio, so we recommended that they take a loan with a bank, using equity in their home, to buy some shares. We initially bought a portfolio of larger and smaller shares and as the portfolio grew, they bought more shares. They could use the interest on the loan (less the dividends from the shares) to offset tax.

In the portfolio we bought some of the smaller banks, recycling shares, alternative energy and technology shares, some large and some small innovative medical stocks.

We often bought shares with low income, so that the negative gearing was maximised and most of the profit was from capital gains.

Salary Sacrifice
The other issue we wanted to address was to get them both putting funds into super, which even then was a low tax environment and the salary sacrifice lowered their incomes dramatically. Initially this was all through their employer superannuation, because at that time the legislation wasn’t allowing freedom of choice in super funds.

Kate is still salary sacrificing into her employer super and will continue until she retires.

Self Managed Superannuation
Because it was hard to find ‘ethical super’ we were early adopters of self managed super funds (SMSF). This allowed Tom & Kate to invest the super into investments which were in line with their ethical concerns.

Initially we started moving cash and shares from their personal portfolios, this took time as we wanted to ensure that we minimised capital gains tax in the process.
Although there was not income tax deduction from the contributions, as they were all post tax, it still had several advantages for Kate & Tom.

The interest from the investments were only taxed at 15% in the super and the capital gains were only taxed at 10%. By putting the funds into the super meant that they were able to grow over time and were not subject to the recent caps on contributions.

Losses
We could offset some of the gains with losses on some of the shares. In the medical innovation area some of the early start shares can very volatile and speculative. But if the shares took off they would be very lucrative. We had wins and losses in this area, but as much as possible we would mitigate losses, by selective selling over time.

Some of the medical stocks like CSL gave the portfolio prodigious gains and some of the smaller stocks more than doubled in value and then might go bust.

Speculative Stocks
If a small speculative stock doubled, often we would sell half, so that the original investment was safe and could be put into another stock. A case in point was a stock called Ventracor. The company invented a mechanical heart which was going through all the human trials in USA and Europe. It couldn’t quite get to manufacture before it was sold out to a US company for enough to pay off its staff super entitlements. But we had still made some money on the stock. 

There are probably still people alive today with a Ventracor heart whirring inside them, Tom & Kate were also happy to think they were helping medical innovation.
Kate & Tom are still investing in speculative medical companies and we are still applying the same rules.

Ongoing Advice
It was apparent from the beginning that the super and personal portfolios were works in progress and that meant that there was an ongoing need to meet regularly to discuss changes to the portfolios, changes to the regulations and legislation, share offers, audits etc.

At the beginning we agreed a fee structure and over time we have renegotiated the fees. As the portfolio has grown in size and complexity we have managed to agree a mutually rewarding figure, which is well within the industry norms.

Ethical Example
In the 1996 one of the companies in the portfolio was Woolworths, which were picked up for around $2.90 per share. They were a good company with excellent industrial relations and good customer service. Since then there has been issues around the acquisitiveness of the company and its relationship to smaller towns (like Maleny and Mullumbimby) where it is ruining smaller stores.

But the main reason Kate & Tom pulled out was that Woolworths bought Australian Leisure Holding Ltd, which was a company owning many hotels that were packed with poker machines and housing TABs. As Kate & Tom didn’t want to be investing in gaming, they sold the Woolworths shares for around $16.00 a share in May 2006.
Without our ethical research capability it would have been hard for Kate & Tom to know about the gaming and would possibly have held the stock in contravention of their own ethics.

Estate Planning
Another very important issue was estate planning and how, should they die, or to lose testamentary capacity, would their investments be looked after.
This included looking at their wills, powers of attorney and advanced health directives. We looked at the situation from an investment point of view and put them to contact their solicitor to organise their wills etc.

With large portfolios and complex families (including divorce, remarriage, mixed families etc) it is sometime worth looking at Testamentary Trusts within the will.
We also advised them on Binding Beneficiary Nominations for their super funds, to ensure that the super assets went where they wanted them.

Tom & Kate did not want to set up a family trust, but this can be another way of transferring family assets across generations without incurring capital gains tax. 

Moving to Pension Phase
Tom is currently drawing a pension from the self managed super fund (SMSF) and Kate is drawing a Transition to Retirement Pension (TTR) from the SMSF. This has meant that as they are now both over 60, that they are drawing a tax free income and saving lots of tax.

Now they are in pension phase the SMSF is totally tax free, no income tax, or CGT to pay again. The super is giving them a very good income stream even at the minimum levels the government requires they draw.

Insurance Collapse
One of the issues we helped them with was when the Professional Indemnity Insurers collapsed a few years ago. Many doctors felt exposed as they had no insurance to cover them, should they be sued by disgruntled patients.

We helped Tom & Kate look at options and ways to protect their assets against the possibility of losing everything to an unfavourable court decision.

In the end the government stepped in and the issue was averted, but at the time Kate & Tom had a professional adviser to look at their situation and find solutions to their financial concerns.

Changing Situations
When Kate & Tom first became our clients they were pre-retirees, with very little assets other than their employer super and their home.

Now Tom is a retiree and Kate is reducing her hours and drawing a pension to compensate for the lower income stream. They have an investment property and a large super fund, which will provide them with an excellent income stream for the rest of their lives.

Very soon Kate will retire from work, (with another large employer super, which has been massively bulked out by years of salary sacrifice) and their circumstances will change again and we will be there to assist them through the changes.

Better Returns
Kate & Tom could have been far more aggressive in their investments, but they felt comfortable with the options that they took. This is because everyone has their own set of values and investor profile. Part of the process we go through is looking at individual profiles to see what would be appropriate investments.

Since its conception in 1998 the SMSF has grown to around $1.8 million, this has been due to investment/rollovers over the ensuing 13 years of $980,000 and growth of around $820,000.

Tom & Kate have made huge tax savings over the years, due to negative gearing and salary sacrifice.

The investment property is worth in excess of $800,000 and their personal portfolio was sold down to pay off both the $300,000 mortgage on the property and the $100,000 used to buy the original shares. They also have a mortgage free home that has been completely renovated and they have assisted their children to buy properties.

Market Forces
It is hard to get an absolute return on the fund, because the balance has been constantly changing, with contributions, rollovers and recently pension payments. Based on a 13 year average balance the return has around 6% compound per annum net of all costs. The Global Financial Crisis (GFC) certainly ensured that the average return has dropped since December 2007.

Investment in growth stocks is not linear and there will be periods when returns will be negative. Kate & Tom recognise this and understand there might be periods of time when their portfolio goes backwards, but it is always good to have someone with whom to discuss the situation and look for options.

Appropriate Advice
In this example Tom & Kate did not want to use Margin Loans, Family Trusts, or higher growth asset allocations and conceivably they could have made more money, or saved more tax, by using those strategies.

Sometime we would suggest some companies in which to invest and they would decline, mainly because they were not happy about the ethics of the company, even if it was good for their financial situation.

It is all down to the individual as to what is appropriate and it is our job to listen to what is said and find the appropriate investments for our clients.

A Rewarding Outcome
Kate and Tom believe that our advice has been financially and ethically rewarding for them.  If you are looking to achieve similar results to Kate and Tom, please contact our office. We look forward to helping you as we have helped Kate and Tom.

Disclaimer
The contents of this article are intended as general advice only.  No specific person’s circumstances, financial situation or objectives have been taken into consideration.  You should not act on the information provided without seeking personal advice from an appropriately qualified financial planner.   While the source has been verified as reliable, the actual content has not been checked for accuracy.  Consequently Ethical Investment Advisers does not warrant the accuracy of the information nor accept liability for any errors in the data.