(03) 9020 2905PORTFOLIO POINT: Super fund members and trustees will face a barrage of offers to help rebuild their battered super balances. Some will be product based, others strategy based. Here’s one strategy worth considering.
There’s more than one way to skin a cat. And as super fund members and trustees prepare for a long slog trying to rebuild lost value from the last 17 months, be ready for a rise in “gearing opportunities” to earn back those losses.
There are plenty of obvious, well-publicised opportunities. For a start, there are the new super gearing rules and the “new” spin on the traditional self-funding instalment warrants that are now being released to the market. The banks themselves have begun to market their own straight lending products that fit under the new September 2007 changes and the costs there are plummeting.
The limelight on super borrowing in the last 18 months has shone almost solely on the instalment trust gearing rules. As markets have crashed, it’s been a darn good thing for most investors that there hasn’t been much in the way of “product” to entice them. Almost all gearing strategies would have caused a faster destruction of net assets since November 2007.
Some of these opportunities will be product based – wrapped investments created by fund managers who will earn their return if they create simple and affordable options that wouldn’t necessarily be available to smaller SMSFs.
(On that point, be ready for more frequent super gearing conversations with advisers. The major fund managers are providing financial advisers with plenty of numbers and research on how to help clients recover some of their losses of the last 18 months, or take advantage of beaten up markets, by taking advantage of the various gearing strategies available inside super.)
But many will be strategy based, where it will be more dependent on getting the right advice. Today, we’ll go through one. And you might find that more and more financial advisers (and accountants, if they’re approaching the subject very, very carefully) are willing to talk to their clients about this.
The strategy involves a straight borrowing in your own personal name to make a contribution to your super fund.
In this scenario, the individual member borrows the money from a bank at a commercial rate and contributes it to the super fund. (We’ll come back to the issue of whether the contribution is a concessional or non-concessional contribution later.)
This would be a non-tax deductable loan. While borrowing to invest in income-producing assets will create a tax deduction, borrowing money to plonk it in your super fund will not. Super is not considered an investment, but a tax structure.
And as so much of this type of strategy comes from tax effectiveness, it is also pertinent to point out that this strategy works best for those who have tax-free incomes from their super funds (over 60 and in pension phase).
If there’s no tax deduction, why would you consider it? It’s might be worth considering, given the confluence of:
- Low interest rates
- Low asset values and the potential for growth.
- Historically high dividend yields.
- Potentially good ongoing income returns from the bond market.
The detail
Let’s take the example of using $100,000 as a loan and investment.
Depending on what the banks do with yesterday’s cut in official interest rates, most people with a home loan can get access to finance for around 5% to 5.3%, at the moment. We’ll assume 5.5%, so the cost of the interest on that $100,000 would be $5500 a year.
The grossed up (for dividend imputation) return on the ASX is currently around 6%, so would earn investors a return of 6%. And investors in pension phase need to take a minimum of 4% of their pension fund each year (ignoring the temporary halving of this requirement announced by the Federal Government recently).
As no tax is paid by those taking a tax-free pension, the income earned at the moment from a straight dividend return from the ASX 100 could make the investment marginally positively geared. Choosing higher yielding stocks has the potential to turn this into an income winner from day one.
But the real benefit from this strategy, of course, is the tax-free capital gains for people who are in pension phase. If the portfolio does rise, then the gains can be retained tax free.
A compound rise of 8% a year for three years would see the $100,000 become nearly $126,000. If in pension phase, that would be tax free. And don’t forget the income from an ASX 100 investment would most likely be covering the interest, or probably very nearly doing so if we get further dividend reductions.
This sort of strategy was looked at by thousands of fund members (both SMSF trustees and managed fund members) in the lead up to the end of the 2006-07 financial year. That was the period when Australians had the opportunity to dump $1 million each into their super funds and there was plenty of people wondering if this strategy made sense.
I don’t know how many people borrowed money for this type of strategy at the time, but there was plenty of interest. At the time, it seemed a very risky proposition. Interest rates were high (and were headed higher). The stock market was even higher. Commercial property was at its zenith and the residential property bubble wasn’t far off popping either. You would have had to have earned about 8% from the investments inside super just to cover the interest outside and there weren’t too many offering that as an income return. (And that’s ignoring the market crumble that has occurred since.) Considerably higher risks than now.
This potential this time around is based on a very different starting point. While no guarantee of success, the signs are certainly more encouraging for a 3-5 year time frame.
How the contributions enter the fund
How does the money go into super?
If the money goes in as a non-concessional contribution (that is, it is after-tax money being contributed), then the whole $100,000 could be put to work. Anyone can put in up to $150,000 a year or $450,000 to cover three years worth of contributions under this strategy.
When it comes to concessional limits, there is a temporary $100,000 a year limit for those aged over 50. This money faces contributions tax of 15% on the way into the fund, because it hasn’t been taxed before. For someone who is self-employed, this becomes a tax deduction, potentially reducing tax to be paid elsewhere by up to 46.5%. In this scenario, if you borrow $100,000 to go into super, $85,000 goes into the fund. But the member would save up to $46,500 on tax, which, if paid of the loan, would reduce the loan to $53,500. If the discipline is followed, then the loan repayments are only being made on $53,500.
Inherent dangers
Obviously, this is a gearing strategy, so if the value of your investments falls, you are going to lose more money.
Dividends could fall. But it would be wise to investigate some other diversification options, including even fixed interest investments (some big name companies are going to be raising money through bonds with attractive coupons being paid. One of the more recent ones, Tabcorp, is offering a return above 7%).
The loan would probably be full recourse. If the superannuation investments turn sour, you will still be responsible for repaying the debt.
We have entered a period of fear where those who take a medium to long-term view of markets will probably be well rewarded. If you are considering gearing strategies inside super, make sure you seek advice.
Bruce Brammall is the principal financial adviser with Castellan Financial Consulting and author of Debt Man Walking.