Thirty-two per cent. It’s a number to gladden the heart of anyone who hates paying tax – which, let’s face it, is all of us.
For it is the proportion of Australian equities that a superannuation fund needs to hold in its portfolio if the fund is to pay zero income tax.
There is outrage from the super industry lobby every time the government hints at raising taxes on the $1.4 trillion that is Australia’s collective retirement nest-egg.
It’s sometimes taken for granted that super funds already benefit from some generous tax breaks.
Former treasurer Peter Costello’s gift of tax-free pensions is the most obvious, but 1987’s bequest of dividend imputation by the Bob Hawke government isn’t bad either.
Dividend imputation was designed to make sure shareholders didn’t pay income tax on dividends received from post-tax profits. A “franking credit” is the means by which a shareholder receives back the tax already paid by the company, so they can pay tax on it at their own rate.
A company pays tax at 30 per cent and a superannuation fund at 15 per cent – so the fund gets a cash rebate.
The magic number
Having built a career on such calculations, former Colonial First State boss Chris Cuffe recently worked out that a super fund need hold only 32 per cent of its portfolio in Australian equities to cancel out all its income tax liability – so long as those shares are paying fully franked dividends sourced from post-tax profits.
Dividends paid from pretax profits or other sources are “unfranked” and no use as a tax offset.
Cuffe assumes a franked dividend yield of 6 per cent on the Australian shares portfolio, and a yield on the rest of the portfolio of 4 per cent – about what term deposits are paying at the moment. His calculation also ignores the impact of any realised capital gains and expenses from running the portfolio, so the number is a bit rubbery. But his point stands – franking credits are a privilege and super funds should use them to the fullest.
Focus on pretax returns
More’s the pity that many are not, thanks to a funds management structure still focused on pretax returns. Too many fund managers are running portfolios in a way that plays down the value of franking credits, or worse still forfeits the right to receive credits altogether; ignores the concession on capital gains tax received when a share is held longer than 12 months; and shuns off-market buybacks when these can deliver powerful post-tax outcomes for clients, even if they appear to hurt pretax performance.
The soaring ASX 200 is finally moving superannuation funds back into “capital gain” territory, with many having used up the losses carried forward from the global financial crisis. But few of the funds’ Australian equity managers are equipped for this transition.
Therefore they will not properly adapt to a new environment where holding stocks for less than 12 months, and thus losing the concession which halves capital gains tax liability, becomes more heavily penalised as capital gains tax can no longer be offset, says the director of after-tax strategies at Russell Consulting, Raewyn Williams.
“I find many funds managers are good at giving you the responses that make you think they’ve got post-tax considerations covered, but then you ask what tax profile they’re managing to and they won’t be able to tell you,” Williams says.
“You need to understand the different tax situations of your investors – franking credits are a bit of a wash to retail investors on the top marginal income tax rates, but they’re very valuable to pension funds or charities which don’t pay tax. Franking credits become a genuine yield play for those large investors.”
Need for data
One hurdle to better post-tax management is that the tax data that would help managers optimise real returns for super funds is sitting out of reach within the super funds’ custodian. This data would, for instance, help managers ensure they were selling the right parcel of a particular stock so as not to breach the minimum 45-day holding period to be eligible for franking credits, or the minimum 12-month holding period to halve capital gains tax liability.
“Very few managers have built the pathway which would allow them to get that data in real time to their front office systems,” Williams says.
“It really makes a mockery of any attempt to consider the capital gains tax implications of trading.”
Another big hurdle, observes the head of investor solutions at Warakirri Asset Management, Andrew Nolan, is that most Australian equity managers are still measured using traditional pretax benchmarks.
“That doesn’t provide the right incentives. I think the knowledge base on improving after-tax performance is better than a couple of years ago, but if you don’t measure it, you don’t know.”
Warakirri compiles after-tax benchmarks and surveys the “real” performance of products offered by some 35 managers. However those willing to submit to the post-tax test represent nowhere near the entire universe of Australian equity managers: the “long only” category of the widely used Mercer investment performance survey (which only ranks pretax performance, by the way) contains just 67 managers.
The difference between pretax and post-tax performance might not be huge in a particular year, but when it’s compounded over a 30- to 40-year superannuation accumulation horizon, it becomes very meaningful, Russell’s Williams says.
Since dividend imputation was introduced in 1987, the franking yield has been about 1.3 per cent every year on top of the performance of the ASX 200, according to Williams.
For super funds paying a 15 per cent tax rate, the rebate on franking credits amounts to an annual post-tax performance boost of half that, or 0.65 per cent, because their tax rate is half that of the corporate tax rate (as we said, franking credits were designed to help shareholders avoid paying tax again on dividends paid from a company’s post-tax profits).
Charitable trusts or funds paying a pension don’t pay tax and therefore receive the full 1.3 per cent annual benefit of the franking credits.
“That’s 1.3 per cent return a year not being measured or targeted in a pretax approach,” Williams says.
Full entitlement for CGT
It also pays to qualify for your full entitlement of capital gains tax concessions by ensuring shares are held for at least one year. The value of the concessions – depending on the size of a portfolio’s gains, its level of turnover and overall market volatility – can range between 0.2 and 0.5 per cent a year for super fund investors, Williams says. (This concession is irrelevant to charities and pensions, which pay no income tax.)
Funds managers are expected to pay more attention as their biggest clients, the super funds, gear up for the start of reforms to their governing legislation from July 1. The reforms include a requirement that trustees of super funds take after-tax outcomes into account, including the payment of performance fees to funds managers based only on their post-tax returns “where possible”.
Warakirri’s Nolan has noticed some changes in the behaviour of funds managers “at the margin”, he says.
Managers running Australian equities for pension funds are permitting more portfolio turnover if it’s deemed advantageous, he says, given that any loss of capital gains tax concessions for holding stocks less than 12 months is irrelevant to these non tax-paying funds.
The legislative requirement to consider post-tax returns is “more of a stick than it should be”, Russell’s Williams says. It’s only galvanising super funds now because they have been too slow to move previously.
But she says the best funds will leap on the changes as an investment opportunity, benchmarking managers and changing mandates to try to grab as much of the post-tax return advantage as they can.
Russell runs its own after-tax survey of Australian share managers. In the September quarter of 2012 alone it found real returns for the 18 products surveyed exceeded pretax reported returns by an average 1.01 per cent for accumulation-phase super funds and 2.06 per cent for pension funds.