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Labor’s franking policy is a ticking bomb for all super funds

The Australian Labor Party (ALP) proposal to limit cash refunds of franking credits will clearly impact many pension phase SMSFs, but we believe it also has the potential to impact many other superannuation funds.

In this paper, we build a model of the key variables which determine whether a superannuation fund is likely to lose refunds of net franking credits under the ALP proposal. Our model is consistent with and helps explain an article in The Australian which reported that $309 million in franking credit refunds were paid to over 2000 APRA-regulated superannuation funds, including 50 (out of a total of 240) large APRA funds, in 2015-16, impacting 2.6 million member accounts.

The ALP proposal

On 13 March 2018, the ALP announced a proposal to abolish the net refunding of franking credits to Australian investors other than for charities and endowments. The initial proposal was expected to impact 1.17 million individuals and superannuation funds and generate $59 billion in government savings over 10 years.

On 26 March, the ALP revised their proposal in the light of significant public criticism. Direct investments by welfare pensioners (part and full aged, disability and other Centrelink pensions) were also excluded, ensuring 306,000 pensioners will continue to receive cash refunds. SMSFs are also exempt if they had at least one welfare pensioner before 28 March 2018. Our understanding is this exemption does not apply to other superannuation funds.

Which super funds are affected?

Note that franking credits themselves are not abolished. Australian investors can continue to use franking credits to offset income tax payable and for a superannuation fund, contributions tax payable.

The ALP believes the main superannuation funds impacted by this proposal will be pension phase SMSFs. However, ATO taxation data (as quoted in The Australian) and analysis of APRA statistics show that many APRA-regulated funds will likely also be affected. This implies the impact may be far broader than initially predicted.

Analysis of key drivers (to losing franking credit refunds) and their potential magnitude.

Franking credits will be lost if total tax payable by a superannuation fund is less than franking credits received. Tax payable is a function of tax on investment earnings on the accumulation portion of a fund, as well as contributions tax payable on normal contributions. The percentage of pension phase assets, the level of taxable earnings and the level of contributions will vary from fund to fund and may vary from year to year.

For example, taxable investment earnings will be largely determined by the state of investment markets. The level of franking credits can also vary between funds and over time. We base our estimate of the typical impact of imputation assuming an average SMSF exposure to Australian shares based on March 2018 ATO statistics of 31%, and the franking credit yield of the S&P/ASX200 Index which has averaged approximately 1.5% pa over the 10 years to December 2017.

Investors with higher allocations to Australian shares, or allocations to higher-yielding Australian shares could earn even higher levels of franking credits. They stand to lose more if franking credit refunds are denied. In our analysis we double the level of franking credits in our high-franking scenario.

Loss of refunds depends on pension v accumulation and franking levels 

We then varied the proportion of a superannuation fund devoted to pension and accumulation as well as the levels of franking credits, contributions tax and taxable income [1].

Figure 1 illustrates the outcome of our sensitivity analysis varying the proportion of pension assets and the level of franking credits.

Clearly funds with 100% pension assets will lose all their franking credits. We estimate that for a typical level of franking credits, funds with 70% or less in pension assets should not expect to lose franking credits. For funds with double the typical level of franking credits, this number drops to 50%.

If accumulation phase (or 15% taxed) members aren’t paying contributions and therefore aren’t paying contributions tax, funds are more likely to lose franking credits. Funds with higher levels of taxable income would be less likely to lose franking credits. Higher levels of taxable income are usually associated with strong markets or the realisation of capital gains.

The number of funds impacted will vary from year to year in response to the level of investment returns. When investment returns are very low or negative, tax on investment earnings will also be low, increasing the chance that the value of franking credits received by a fund exceeds tax payable.

Accordingly, when investment returns are low, a higher percentage of superannuation funds may miss out on some or all of their franking credits, exacerbating the low investment returns.

The winners and the losers

We find that the loss of franking credits is likely to be positively related to:

1) The percentage of assets in pension, with maximum loss at 100% pension assets, but losses starting to occur from 50% to 70% pension assets

2) The level of franking credits generated by the underlying assets (the more franking credits generated the more likely you are to lose some).

The loss will be negatively related to:

3) The level of taxable income generated from the underlying assets (with losses in franking credits more likely in periods of weak investment markets meaning investors may receive a double hit to returns)

4) The level of contributions and contributions tax payable by accumulation members (the less contributions tax payable the more likely a fund loses franking credits).

Our model explains why The Australian reported that 50 large APRA-regulated superannuation funds (out of 240) received net refunds of franking credits in the 2015/16 tax year.

Mature funds may suffer most from loss of refund

Our scenario analysis finds that any relatively mature superannuation fund, where maturity is defined by the percentage of member balances in pension mode, may be in a net franking credit refund position.

While many SMSF members have been vocal critics of this proposal, we believe members of other superannuation funds probably don’t even know they receive franking credit refunds (they are not reported on investment summaries) and probably won’t know whether they might miss out on franking credits should this proposal be enacted.

Finally, we believe that as the superannuation industry matures as a whole, as more members migrate to pension status, the loss of franking credit refunds will impact a growing number of people, be they members of government, industry, retail or SMSFs.

As such we believe this proposal may represent a ticking time bomb for the whole superannuation industry.

This article was authored by Dr Don Hamson. Dr Don Hamson is Managing Director at Plato Investment Management Limited. This article is for general information only and does not take account of any person’s financial circumstances.

1. We vary pension proportions in rests of 10% from 0% to 100%. For franking credits we used a normal level of franking credits as discussed above and then we doubled the level of franking credits to reflect a higher exposure to Australian shares and/or a higher franking yield from the Australian portfolios. We use two levels of contributions – none (reflecting for instance pension phase SMSF with greater than $1.6 million balances per member) and 7% of the accumulation balance which attract contributions tax of 15%. Similarly, we varied the taxable income level which can be caused by (for instance) realisation of capital gains. Full details of our assumptions are available on request.

Active Investment Success Relies on Finding a Top Personal “Trainer” to do the Heavy Lifting

A mate recently cancelled his gym membership at a popular city health club, citing lack of motivation, high monthly fees and a general malaise about “just not getting results’’.

Out of interest, I asked him what his training regime looked like.

A brisk walk on the treadmill, he confessed, followed by a quick sauna and an obligatory large iced-coffee (with cream and ice-cream) in the club lounge afterwards.

Those stubborn kilos are still hanging on for dear life.

Comparisons can be drawn between my friend’s story and the heated – often hysterical – active versus passive investment debate dominating financial news headlines in recent months.

Proponents of active investment, quite rightly, argue for its superior ability to outperform the market over the long-term, with astute investor-led analysis and individual market research informing which stocks to include in any given portfolio. But active management is far more than just stock picking and here lies the often unseen value. Active management utilises all the tools available to achieve a tailored outcome for investors; asset allocation that considers the return you need at the risk you can live with, dynamic management to help avoid downside risk and ‘smooth’ the ride, precise factor exposures and even tax strategy – there is no one right way to invest for everyone. Each investor has a unique set of goals, real-world constraints and risk preferences.

This is contrary to passive investing, which follows the index, relies on trends and is often based on exchange-traded funds.

The Australian market is dominated by two sectors – banks and resources. And the top 20 Australian-listed companies account for 47% ($804 billion) of ASX200, leaving the remaining 180 stocks to make-up the remaining $900 billion.

The inherent risk with a passive Australian shares strategy tracking the S&P/ASX 200 Index is that it will overweight companies that have gone up in price and, therefore, have greater representation in the Index. So, when they fall, the portfolio hangs on for the ride from the peak to the trough – with painful consequences for total returns.

The bottom line is – markets are cyclical, what is winning today could lose tomorrow.

A philosophy that rewards past performance at the expense of future prediction isn’t an intelligent, strategic approach to creating wealth.

Also, it’s important to understand the distinction between cost and value. There is no disputing that passive strategies typically have lower fees and have done a good job of beating ‘average active managers’ (their term not ours). The key word here is average – an average manager will probably deliver average results. Our advice is to only use an excellent active manager – one who has the runs on the board, with a disciplined and robust process that is bigger than any key individual and will endure beyond the current group of people.

Find an active manager who reports their fees. Transparency is king when it comes to trust and building strong long-term relationships.

Warren Buffett once put it simply.

I just advise looking at as many things as possible and you will find some bargains. And when you find them you have to act, Buffet said.

The world isn’t going to tell you about great deals, you have to find them yourself and that takes a fair amount of time.”

The prevailing truth is that price doesn’t dictate a great company. Good investors must do proper due diligence in determining whether, firstly, they’ve found a great company and, secondly, if it’s a great company at a great price i.e. it can be a great company but the price might already reflect that in which case it is not a bargain.

There are no shortcuts. This takes thousands of hours of quantitative research, face-to-face meetings, stress testing analogies and scrutinising their balance sheets, and ongoing monitoring.

That’s the beauty of astute, wise and experienced (‘above average’) managers, they invest their time, energy, experience and the muscle to do the heavy lifting for their clients and the results speak for themselves.

Here at FinSec building sustained long-term wealth for people is at the core of ‘why we do what we do’. And, although no investment manager can ever promise they will always beat the market (if they do, run in the opposite direction) long-term wealth is only achieved with a smart, strategic and transparent investment policy and an in-house investment committee accountable to it.

It’s an approach any ‘above average’ manager should be able to prove and is best illustrated by an example of our own performance plotted below.  (Blue line is the index compared with FinSec’s performance represented by the red balls).

 


* FinSec Partners performance compared with index June 2010 – July 2017

Which brings me back to my mate.

Him not shedding his winter weight, of course, wasn’t the gym’s fault.

He just didn’t have the right training schedule and he could have done with the disciplined, rigorous support of a qualified and experienced personal trainer who knew how to get the best out of him to enable him to achieve his goals.

Powerful data reveals strong link between our nation’s happiness and financial planning

People happiest with their lot in life are most likely to have a financial plan, according to the FPA Live the Dream report. The national research of working-age Australians also includes insights into the regrets, dreams, and attitudes to matters of money and life across generations, genders and geographies.

Almost one in four Australians (23%) surveyed believe they are living the dream. These enviably content people who dream big and are prepared to act of their plans are nearly three times more likely to seek the advice of a financial planner (24%) than those who describe themselves as not yet living the dream (9%).

Not everyone is content, however. The research also shows 80 per cent of working-age Australians are stressed about money and finances, with 1 in 4 indicating acute stress levels. Gen X and Gen Y are the most stressed about money and finance, and are the generation most likely to struggle with planning. Half of Gen Y (53%) finds planning their life hard. Two in five Gen X Australians feel the same way (44%), while Baby Boomers are the most likely to find planning easy to do (25%).

Read the full report here.

Changes to the Assets Test for Age Pensions came into effect on January 1 – Ensure Centrelink have your correct numbers

 

Last years Federal Budget included a number of significant changes to means testing for the Centrelink age pension, these changes came into effect 1 January 2017.

Over the last couple of months Centrelink began communicating with those that will be affected. As a consequence of this communication we have had a number of clients report that their asset numbers seem to be inflated, which if left uncorrected will result in a lower pension entitlement under the new rules.

Should this occur, it is best to assume:

  • that you will receive less in pension benefits until the true value of your asset pool is established
  • that a refund will not be provided.

What you need to do

You must ensure Centrelink has the correct information with regard to your current asset portfolio.

If you have a My Gov account you can check the asset values Centrelink currently hold against your records by visiting https://www.humanservices.gov.au/customer/services/centrelink/age-pension

Alternatively if you are at all concerned about how the changes to the age pension will affect you, please contact a Finsec Partners adviser to discuss in more detail.
Information regarding the new legislation is summarised below.

Who is affected by the changes to the assets test for Age Pensions?

Australians over the age of 65, currently receiving a part or full age pension, will incur a $3 reduction per fortnight (currently $1.50 per fortnight) to their pension for every $1000 in assets owned above the ‘assets test free’ threshold.
The new thresholds are dependent on whether you are single or a couple and rent or own your own home. The below table outlines the new asset threshold limits (the number at which the pension starts reducing) for each scenario.

What assets are included in the threshold?

The market value of most assets are considered when calculating your age pension. This includes but is not limited to:

  • Property (excluding your home)
  • Motor vehicles, boats and caravans
  • Financial investments
  • Superannuation if you’re over age pension age
  • Business assets
  • Household contents and personal effects

Please note: there are different rules for contributions paid to live in a retirement village. Some farm related assets, funeral plans and carer payments may also be exempt.