Opinion: Why higher dividend yields are making funds more attractive

By Managing Director of Brook Asset Management Mark Brighouse At Brook we are seeing more and more enquiries from investors, and their advisers, who recognise that the rapid decline in interest rates has significantly altered the trade-off between "risk-free" investments and "growth" investments. At the same time that interest rates have been dropping, share prices have also fallen, leading to a rise in current and prospective dividend yields on shares. While the cuts to dividend payouts have been well-flagged, the decline in share prices has outpaced these cuts in dividends leading to a sharemarket that yields much more than short term interest rates. After adjusting for investment companies, the New Zealand market is on a gross dividend yield close to 8%pa. A six month bank deposit could earn between 2.5%pa and 4%pa depending on the amount (check here for up-to-date rates). Such a large gap between equity yields and bank deposit rates is rare, but the Reserve Bank of New Zealand recently signalled that it is a situation that may remain for some time.

While investors have to weigh up the risk associated with investing in shares and be mindful that the global economic downturn is far from over, one part of the decision is clear. Under the tax regime for Portfolio Investment Entities (PIEs) the benefits of receiving this income via a PIE fund are likely to be significant for many people. For example, a taxpayer with an income of $50,000 would pay a marginal tax rate of 33% on gross dividends from shares held directly. This income tax would take 2.64% from the 8% dividend yield. But if the same investor used a PIE fund they could be on a lower 19.5% PIE tax rate and the tax could amount to 1.56%pa. The investor could be more than 1%pa better off holding shares via a PIE. Imputation credits don't alter the equation. Both individuals and PIE funds can use imputation credits against their tax to pay, but the PIE fund can get a refund of any surplus imputation credits in certain circumstances whereas the individual must carry them forward. Now consider the extreme example of a person on an income of $50,000 pa moving from a bank deposit in their own name to shares held in a PIE fund. This investor would find that the after tax income on their investment increases from 2.68% pa to 6.44% through a combination of higher gross yields and the benefits of a PIE structure. Of course investors have to understand that shares and bank deposits have significantly different risk profiles. But with some sound advice and a long term time horizon, they may find that this is a rare opportunity. ___________ * Mark Brighouse is the Managing Director of Brook Asset Management Limited. For more information go to www.brook.co.nz.