Costly dividends

SMSF trustees tend to have a bit of affection forAustralia’s banks and broader financial stocks. Big yielding companies that have long and distinguished histories of paying.

They are certainly not asset classes that have starred in the last 12 months. In fact, their performance has been appalling. But the evidence suggests that the percentage of SMSFs holding, or overweight, banks hasn’t dwindled too much. Why? Exactly because those dividends continue to be paid, no matter what the share price falls to.

The worst news from the most recent bank profit reporting season was from the ANZ, which held its first-half dividend steady. Even with the sub-prime crisis, the remainder of the banks raised their fully-franked dividends.

Not only is it unlikely that too many SMSF trustees have lightened up on banks, but it is quite possible that they have been topping up, based on the even thicker yields that some of these companies have been trading on now that their share prices have tumbled.

The great thing about a dividend is that you’ve got it. Once it’s been paid, it can’t be taken away. But share price growth can be lost in an instant.

The downside of a dividend is that it will be taxed as income. Within super, for funds that are in accumulation phase, the tax is 15%. If you own $1000 of Commonwealth Bank stock, you’d have received dividends of (approximately) $63.10 this financial year (as at the close on Tuesday). Grossed up to take account of franking credits, that is $90.14. A super fund in accumulation would have to pay approximately $13.52 in tax in total on that $90.14. (Although franking credits mean that the fund will get a net tax refund.)

However, if CBA’s share price were to appreciate (for example, from $40 to $50), the super fund would have no tax to pay (unless it sold its shares).

As we know, when it comes to taxation, there is a bias inAustraliain favour of capital gains over income. Capital gains made over a period of longer than 12 months are paid at half the rate (outside super) or at two-thirds the rate, or 10%, inside super. Income (dividends, rent, interest, distributions, etc) is fully taxed at the taxpayer’s marginal tax rate.

So, what are the benefits for a super fund if its investment strategy is built around chasing capital growth, rather than income, from its Australian ASX-listed portfolio? What if you reweighted a portion of your portfolio more towards the kind of stocks that offer more of their return from capital gains, rather than dividends?

To show how this might work, we’ll have a look at three portfolios. All three portfolios, over a 10-year time frame, will achieve total shareholder returns (TSR) of 10%. TSR for the growth portfolio will be 8% growth and 2% income, the neutral portfolio will be 5% for both capital growth and dividends, while the income portfolio will be 8% dividends and 2% capital growth.

What happens over a 10-year period? For the purpose of the model, we have assumed that all income is being taxed at 15%. We’ll also assume that nothing has been sold during the period to trigger capital gains tax for any of the portfolios.

Essentially, the benefits accrue because the growth portfolio is only taxed on 2% of its total returns, while the income portfolio is seeing 8% (of its total 10% return) taxed.

There are a couple of things to note. Firstly, the growth portfolio has outperformed by 20 percentage points over the 10 years. After the 10 years, the growth fund is 8.6% higher than the income-based fund, based purely on paying less income tax along the way.

The growth fund has essentially been able to delay paying tax on a greater portion of its gains until it sells assets and is due to pay capital gains tax. Except that once a fund is flicked into pension phase, it no longer has to pay tax on capital gains. In this way, it is possible that tax can be delayed until tax no longer applies.

The fact is, also, that growth companies tend to be riskier investments. Their lack of a dividend is one reason that their share price is likely to be more volatile than other stocks. Because of the higher risk, it is also likely that TSR for growth companies, over the long term, should be higher than for income-based investments. But for the purposes of this example, we’ve kept TSR the same.

This is not to suggest that everyone rush to sell their banks and load up on the likes of BHP, Rio Tinto, CSL and Cochlear. But it hopefully shows the point that there is a potential cost to taking the dividends. And over a longer period that can prove to be significant.

The majority ofAustralia’s top 100 stocks would naturally fit into the “neutral” or “growth” portfolios above. This has become even more pronounced in recent times as the resources sector has been holding the market up while industrials have stayed near their lows for the year.

Age is one thing that should be taken into account. It is a well-spouted and sensible principle that the longer a member has to retirement, the more aggressive should be their investment strategy. But this is usually talking about a weighting towards growth asset classes (shares and property in general) over income assets (cash and fixed interest).

However, the same can be applied to asset classes, if they are broken down. The longer the time frame you’ve got until you’ll need your super, the higher the proportion of Australian equities you should have devoted to growth shares, rather than income shares.

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Those with DIY super funds have, usually, no one to blame but themselves when it comes to poor returns. If you were in charge of the investment strategy for your super fund and your super fund had an awful year, then you can be castigated by not inviting yourself to your own end of financial year knees-up – no champagne for you. You can’t “spin” the message to yourself (although you could refuse to look at the results I guess).

Members of managed fund super (industry, corporate or retail funds) don’t have that control. Their futures are in the hands of their board of trustees and the investment managers those trustees have hired to play the guessing game for them.

It’s been a poor year for everyone – except those who have been fully invested in cash for the whole financial year. June 30 is likely to show negative returns virtually across the board. Big fund trustees are unlikely to be looking forward to explaining falling superannuation balances to members.

Thankfully for the fund managers, they have the Australian Institute of Superannuation Trustees to help them with the “spin” when it comes to selling the unpalatable message to a potentially hostile membership. AIST is holding two seminars (inSydneyandMelbourne) this month, called “Communicating negative returns to members”.

Clearly, fund managers need a refresher course on putting a good light on rubbish results. It’s been a while since any of them had to “sell” negative returns to the membership base. Even more interesting is the list of speakers – two of the three speakers down to talk are industry fund marketing managers.

“Many members will be concerned, and some upset and angry. How we communicate volatile financial markets and the complex nature of long term investments is vitally important,” the invitation on the website says. “Funds have a lot to lose if they get it wrong.”

So, those of you with managed super, get ready for an onslaught of spin that could rival aShaneWarnecomeback. Information on how great your super fund is, a focus on “three, five and seven year returns”, and the benefits of taking a “long-term view” on your super investments.

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Finally, this is my last SuperSecrets column (for a while, at least). Superannuation editorTrishPowerreturns from her sabbatical next week and Eureka Report’s superannuation column will switch from Fridays to Wednesdays from now on. I hope to return later in the year to fill in forTrishagain. But until then, I’d like to thank Eureka Report’s readers for their generous encouragement over the five months that I’ve been keepingTrish’s chair warm.

Bruce Brammall is a senior financial adviser with Stantins Financial Services (hyperlink, please).