The following article was generously contributed by a regular reader and commenter. I hope you enjoy reading West Wind’s journey as much as I did. He raises some interesting questions those considering retirement should consider.

Before starting, let me make it clear that I am not an Accountant or a Financial Adviser. This is just a tale of how one individual managed the transition from everyday share punter to contented self-funded retiree. For more intricate detail, seek professional advice.

Having started investing in shares during my student days, my early experience was listening to tips and reading newspaper articles and occasionally accepting broker advice. This was OK whilst the market was bubbling along with an upwards trend. The common call was “speculate to accumulate”. There was never any thought of dividends. In the 70s this seemed to work. There was profit taking for a car and later a house deposit (pre capital gains tax!).

Later came marriage and kids and associated responsibilities. A couple of significant dips in the market saw some of the exuberance go out of the investment behaviour. I became a bit more interested in what the companies did and who ran the company. I also started reading investment newsletters (Huntley, Intelligent Investor, Marcus Padley). Further on there were some short courses in understanding financial statements. So in my 30s and 40s there was a shift to doing my own research. The emphasis was still on capital gains, as I tried to select companies that were either just emerging as profit producers or were companies that had done something wrong and were fighting their way back. The indicator of success was when they started to pay a dividend, and the price rose – but then they were sold to move on to the next prospect. Capital gains tax was an issue that had to be kept an eye on, as I was inclined to fully reinvest all the profits then be scrambling to pay the taxman when the end of the financial year rolled around.

This process worked pretty well. Instead of having a large number of companies and frequent trades, I limited myself to 3-4 at a time and usually held them for 2-3 years. Stock picking is a great leveller. You have some successes but you also have your losses. Typically out of say 3 selections, I would get one where you might lose 50%, one that earns 50%, but also one that is a 5-10 bagger. If one of my selections started to develop as predicted, I would buy more. I always had a figure in mind of what I thought it was worth. This would change as more information became available, so my valuations might have increased 3 or 4 times during the holding period.

But I am getting away from the topic. When I reached my 50s, I was coming to the conclusion that I would like to manage my own super in retirement. I thus started a Self Managed Superannuation Fund. I also had an employer/industrial super fund running in parallel, to which I contributed all my working life. Upon retirement this was transferred into the SMSF

I also had to think about what will I live off and how much will it be. Questions arose like how much capital will I have, will I draw down the capital, or will I preserve it and live off the dividends. If you choose the former, there is always the risk that you will outlive your savings. If you choose the latter, you need to structure your investments appropriately.

On this basis, I now had to transfer my private investments into the SMSF. This brings on a whole new bout of managing capital gains taxes. One of the very few advantages of the GFC was that share prices were depressed and capital gains were substantially reduced. Mr Costello also provided a window of opportunity for transferring substantial amounts into Super Funds. Hopefully the GFC is behind us, but the Federal Government is now tightening the ability to transfer funds into Superannuation. Both these factors reinforce the need to have a strategy to transfer personal assets from outside the Superannuation environment, into Superannuation. In terms of minimising capital gains, you need time. In fact you also need good accounting advice, because by the time you pay capital gains tax and Superannuation contributions tax, it may not be worth the exercise of transferring the funds into super. You need to sort this out well before retiring.

You also need to consider wether you have the right investments in your portfolio. If you choose as I did to preserve capital and live on dividends, you need to develop a dividend stream that will provide you with your needs. If you don’t, you will find that upon retirement, your regular salary has ceased but you have a less than desirable income stream. Hence, in the process of transferring assets you might also consider changing the type of investments

So, presuming you can get all your realigned investment assets into the super area, once you elect to move from the accumulation phase to the pension phase, the benefits are substantial. These include no income tax, no capital gains tax, and full reimbursement of dividend franking credits.

Initially on starting to develop my portfolio within the SMSF, I stuck with the conventional wisdom. This is my family’s life savings, my wife and I have to live off the income and it should be invested in blue chip, dividend paying shares. This included the banks, infrastructure trusts and large insurance companies. However, with the GFC, not only share values, but dividends also took a hit. I had to decide to accept a 20-40% decrease in dividends or try to do something about it. So I decided to move away from the original SMSF philosophy of diversification and revert back to the selective stock picking. That is, I have picked up on Dean’s theme, “concentrate to accumulate”. I now look for businesses that I think are in a growth area, have low debt, are well managed and are paying, or within 12 months of paying, a franked dividend. Ideally the dividend should be greater than 5%.The investment horizon is nominally 2-3 years – unless they severely disappoint. If they continue to grow they may be held longer. Instead of holding 20 stocks, I am down to 14 and still looking to reduce.

I sometimes ask myself, have I raised the risk profile? I probably have, in that the shares we now hold tend to be smaller companies and they will be harder to sell in a falling market. However, the shares have been bought for the longer term and pay a better dividend. Provided the dividend stream works essentially to plan, I feel the risk-reward relationship is acceptable.

How has the SMSF performed? After losing 44% of capital value in 2008, we gained 98% in 2009 so we are 9% above where we were at the end of 2007. However, the more important issue is dividends. In terms of the dividend stream, it averages about 6% of the market value, which is more like 8.5% when we get the franking credit cheque from the taxman. In terms of annual performance (I add the dividends, franking credits and capital returns each reporting period to keep it simple) it grew 16% in 2008 and 28% in 2009.

So the conclusion I make is if in your SMSF you wisely (and can) choose to not live off your capital, start thinking about dividends, and what makes a good dividend paying company. Start to include these companies in your portfolio as you approach retirement so you can start this enjoyable part of your life without a discontinuity of cash flow – and if you feel a bit depressed about approaching retirement, don’t be, because you are not really retiring, you will just have more time to think about your investing!

Related posts:

1. Is Retirement Running Away From You?
2. Some good numbers
3. Investing and the Government
4. Delving into my Super
5. SMSF’s the Largest and Best