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40% taxpayer wants to beat inflation

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A reader wrote to say: "I am a single South African, 5 years off retirement and looking to invest R3.5 million. I would like to get a return which meets or beats inflation after tax (I am paying tax at the highest marginal rate of 40%). I am certain I will not need the money for 5 years. What is the lowest risk option that can meet this expectation?"

17 Nov 2013 The reader will have to take on some risk in order to stand a chance of beating inflation. The answer to his question depends on his particular circumstances, and I try to cover as many of the bases as I can in my answer, so let's look at the options:

Pay off debt

If you still have any debt or mortgage payments, then first use your cash to pay off your debt.

Interest exemption

If you haven't used up your interest exemption, then invest part of it in a 5-year Inflation-Linked Retail Savings Bond (up to an amount which allows you to utilise your allowance). These are guaranteed by the South African government, and provide a return linked to inflation (at the time of writing you could invest at a rate of 1.25% over inflation).

Unfortuanately, retail bonds may well achieve lower returns than inflation on an after tax - e.g. a 7.5% return (the highest rate on fixed rate retail bonds at the time of writing) after tax equates to 4.5% (and implied inflation over the next 5 years is 6.25%).

Retirement contributions

It's easier to beat inflation on a before tax basis - I assume that you are contributing at your maximum into an appropriate retirement fund savings account?

Preference shares

It must be mentioned upfront that preference shares are not without risk - they carry business risks and with it the possibility of capital losses, no protection against inflation rising & the risk of the tax regime changing; but once the above options are exhausted, preference shares are probably the least risky way of achieving after-tax returns in excess of inflation (but rates do sometimes fall below inflation, they are in no way guaranteed of achieving returns over inflation).

You can either invest directly in preference shares via an online trading account, or via a collective investment scheme like the Grindrod Diversified Preference Share Fund, the PSG Preferred Dividend Fund or the Coronation Preference Share Fund or even the Sanlam Alternative Income Fund.

For instance, some of the listed preference shares are:

Be careful of some stocks which have been legally structured as preference shares, but have none of the usual characteristics of preference shares (e.g. RECM & Calibre Preference shares).

Secured investments

Check the secured investment rates with the various insurers (Clientèle Life, Hollard Life, Nedgroup Life, ABSA, Discovery, Momentum, Liberty Life & Old Mutual's Investment Frontiers). Depending on the rates they offer (vs expected inflation), you might want to invest some of your money there. Avoid putting all your eggs in one basket, as even seemingly secure companies might go bankrupt.

Ordinary shares

Shares carry many & large risks of capital loss, but depending on the yields at the time being earned on preference shares, one might want to consider investing a small portion of one's cash in the stock exchange. In particular note the timing risk, that you might enter the market at a time when stocks are at a high.

Some of your future expenses (& inflation) will be related to the oil price - you can hedge out some of this risk by investing in a company like Sasol, which benefits from a rising oil price (but in return for which you take on many other risks - companies can fail completely)). On a personal note, I have been opportunistically investing in Sasol, as a partial hedge against the oil price rising, whenever I have felt that its price is low enough.

It takes some expertise to minimise the chances of getting your fingers burnt, but it's also worth looking at other commodity companies - for example South African has 70% of the world's chrome supply, a key ingredient in stainless steel - by investing in these type of companies at the right time one can gain a degree of protection against commodity prices rising (but runs serious risks if they fall, as well as business risks).

High dividend yield shares

How much dividends shares give is very much up to the board of directors of companies, and even if a share has been paying high dividends it doesn't mean it will continue to do so. So, there is risk involved.

Allan Gray Stable Fund

Another option is to invest in something like the Allan Gray Stable Fund which "aims to provide a high degree of capital stability and to minimise the risk of loss over any two-year period, while producing long-term returns that are superior to bank deposits on an after-tax basis." Note that whilst that's the fund's aims, there are no guarantees and it could easily underperform. There's also a timing risk, so it would reduce risk to invest portions in over a period of time.

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