How to invest for a living?
Before you go “all-in” on a portfolio full of the highest franked dividend payers on the ASX, read below to consider being diversified from a political and taxation standpoint. Likewise maybe be wary of going “all-in” to other investments based solely on current taxation incentives in place.
When I come across articles about how Australian investors need more diversification it often does not refer to potentially changing tax laws. There is a bit of overlap with these themes but there are different issues to consider.
Normally the focus is on the lack of international exposure to great foreign companies, or lack of exposure to smaller stocks. The over exposure to the banking sector and risks to a falling property market are also emphasized.
Can you still retire on fully franked dividends in Australia?
The recent news of Labor’s plans to reduce the benefits of franking is a reminder that we should not lose sight of diversification in the context of political decisions. I believe that too many investors like to view certain strategies as all or nothing viewpoints. A good example is the classic Property versus Shares click bait style article. Read the comments section and you will generally find people responding that they strongly prefer one or the other. Another example is when investors struggle with the decision to sell. Or deciding whether to invest a large lump sum in the market today or in the future. Many prefer to make an all or nothing decision, so they can then sit back and cheer for the outcome they hope. Often the prudent decision is perhaps to sell half a holding in a stock if the weight gets quite large. If deciding to invest a very large lump sum in the market, then better to dollar cost average to some extent.
Some of this mentality extends to investor’s preference for a certain strategy that ties in with their beliefs about taxation advantages. For that reason, I don’t think my blog will ever get much of an audience. People prefer to read about one person with one clear method of wealth creation and simple rules to follow. You will find many blogs about the multiple property investor, the dividend only investor, or lately the guy who sold everything and invested in Bitcoin!. Think of the click bait from news.com.au you see in the finance section.
The debate over all the potential tax changes coming into the next election makes me potentially want to avoid strong biases to any given strategy. I find it all very difficult to predict. It feels like politicians prefer to change tax laws more than their underwear. I won’t make this post a political debate but wanted to point out that the potential changes to franking I read about today did surprise me. It looks as though many retirees that may be on modest budgets can be affected quite a lot.
I find many investors use an all or nothing approach to wealth creation. We have the camp who loves negative gearing into property. This can extend to enjoying the 50% discount on CGT for assets held above a year. We have those who like placing as much as possible within their super fund to enjoy the better tax treatment. Then of course those who love generating all their retirement income via full franked dividends, and perhaps enjoying some of the associate refunds. Some believe stretch yourself as much as possible on your principal place of residence as it is CGT free. Others believe they have the skills to trade stocks for a living.
If you go all or nothing down one of these tracks hopefully your predictive powers of politicians are strong. I don’t know how the taxation policies are going to come out after the next election. Even the election itself is difficult to predict!
I can tell you though some of the various issues that I have read that may be subject to change. Along with franking as I have just mentioned, CGT is also being looked at for changes. Will the 12-month discount be scrapped or reduced? What is going to happen to negative gearing? Is borrowing within your SMSF likely to stick around? What will the company tax rate be? What will the personal tax rate be? Will the primary residence always keep its preferential tax treatment to the same extent? Will land tax partially get phased in so that stamp duty can be reduced? What will happen with family trusts? Will the GST be increased down the track?
I would offer someone very good odds to predict all the outcomes above for over the next decade.
How to achieve political diversification?
Well to answer this first I will examine things I would possibly be very reluctant to dive into!
For example:
Not having all my wealth (leveraged further with negative gearing) in investment properties. (as we know from the regular click bait articles many still do).
Not looking to put every extra dollar toward my super if I was many years away from retirement.
Not planning to generate all my retirement spending income via fully franked dividends.
Not looking to accumulate all my wealth via my principal place of residence.
Now the next few comments are not applicable to myself but worth thinking about for very wealthy investors. Over time to address the budget the easy political move is often to take a slice off a certain area and specify balances that are deemed very wealthy. We have seen this with certain amounts of super fund balances, and salary levels relating to contributions.
On the property side of things often countries like to clamp down on investors owning perhaps their second or third investment property. In Australia we are starting to see a debate around those that live in an expensive PPOR but with very limited cash flow. The PPOR does not restrict the pension entitlement yet but perhaps eventually a certain price level of the PPOR will be deemed as very wealthy. Maybe one day there will be extra costs for property investors with a certain number or wealth tied up in their property investing strategy.
How to beat Labor’s franking proposal?
If you are in the fortunate category of being very wealthy, it seems logical to potentially consider to spread out strategies and avoid being hit by any crackdown that becomes the flavour of the day for politicians. This way maybe you can keep a bit under these levels that are deemed as very wealthy and easy targets. Strangely though today’s news about franking changes seem to be a grab from the middle class rather than the top end. Just highlights the unpredictability!
In terms of stock selection maybe don’t have an extreme bias on dividends versus capital growth one way or the other. Can we honestly say what will happen with franking and CGT in a few years?
As I write about LICs on this blog a lot I guess I shall provide with a few comments on this aspect. I certainly don’t advise knee jerk reactions to news flow like we have just seen. But if you haven’t given much thought at all to the above it may be timely to have a good think about all the issues.
Are you overexposed to the likes of AFIC, ARGO, WAM funds?
Let’s say all your wealth is in the LICs that are very popular with investors seeking the current high fully franked dividends. If so, then this whole topic might be worth more thought. Such a portfolio could be well diversified across large/mid/small cap and various sectors, even international, but could become less attractive to future investors pending certain potential legislation changes.
The LIC sector has had a good few years now and the taxation landscape and ability for LICs to smooth out fully franked dividends have played a role.
Maybe the best coping mechanism to all of this is the following? When you think you have uncovered a tax strategy to enjoy, perhaps just expect the government to close it one day.
EDIT March 17th
Warning these additional comments as an edit are long and more a blog post within a blog post!
Interesting if others here have a view on this story. Relates a bit to what I wrote about in the post.
The couple in the article emphasise the diversification they are undertaking via various different property types. It’s not my personal idea about what diversification means.
They are still keeping a significant amount of debt. Arguably a little exposed if politicians focus more on those using property to grow their wealth.
Now despite the heavy transaction costs with selling a lot of these properties, they could become debt free and lock in plenty of wealth. Maybe not as much as may seem at first glance. The values may be optimistic, CGT and selling costs to pay. Still a few million in net wealth at their age would sound great to most.
If they can structure it with maybe a million in super, same with one property they like as a main residence, then a couple of million in a balanced portfolio outside of super.. Future governments may not consider them wealthy targets. The super balance isn’t extreme, likewise the value of their residence or property exposure. They also wouldn’t be overly relying on franking or the generous tax treatment in super.
Could things really go pear shaped from there?
But this suggestion doesn’t give them the chance of getting as rich from then on compared with the leveraged exposure they have right now.
It also won’t get them articles on news.com.au
But what if property markets fell by 20%? Ok many feel this is impossible I get that. But if it did happen the alternative strategy I wrote about above wouldn’t cause them worry. Their current strategy would! Or if rental vacancies increased.
They can also then worry less about the government cracking down on those with huge amounts of property exposure.
Back to the saying I have used before. We are all geniuses in a bull market. If they value their freedom and flexibility now, perhaps some humility with their investment prowess can increase the chances of them hanging on to all the wealth.
Not a criticism because with investing the facts are they are far more successful than me. Just a discussion of how I look at things compared with others.
The residence they purchased is probably way more than using one million as I suggested. That may be what they need to be happy in life, therefore my plan may not be ideal.
once again it’s probably those caught in the middle, ie self funded retirees not much above the pension limit and relying on those refund cheques, who might be squeezed the hardest. Will really encourage anyone in that bracket to shed assets and take the pension, even more so than happens currently.
That said i do agree there’s a lot of wealthy people who don’t need this refund cheque and have structured their affairs to maximise it. This should be addressed if we don’t want the country to go broke (or start reducing age pensions, Medicare, etc), would be good if it can be managed fairly though and without those “middle people” being left worst off, as usual
I didn’t decide to write today yet about what I actually thought about Labor’s idea. I’m not a great fan of it though. But I think Adrian you have summed up well with a succinct response. I agree with your sentiments there.
I know I said that I prefer not to bet on what the politicians will do in the future, but I read an article today that led me to think this is where we may be heading in the very long term. That is, a progressive tax scale within super. Here is the article.
https://www.fool.com.au/2018/03/16/why-shorten-is-wrong-and-right-on-dividends/
I also added lengthy comments to my original blog post above. It was based on a news article today about a couple choosing to bet heavily on a particular path to wealth creation. So far they have been fantastically successful, but am curious what others think..
Good post Steve and I agree people need to consider regulatory risk and diversify or have a back up plan. A lot of retirees (including early retirees) are using the franking refund cheque as part of their strategy and concentrating a portfolio in high income ETFs or LICs. And their are many high wealth (PPOR) low cash flow people who would be exposed if the Gov one day included the PPOR in means testing for the pension and other benefits. Regarding tax on multiple investment properties, land tax in many states is getting very large and serving this function already I think.
Yes there are so many areas vulnerable you need plan B and maybe plan C.
When I briefly mentioned more land tax versus stamp duty I had in mind the high costs of moving and the need for a more flexible economy. People are not staying in their job as long now. Yet if another job presents itself in a different location the moving costs can prevent people taking it up.
Land tax and implications for investment properties you are correct. Yet if I am not mistaken you can spread a number of investment properties across the states and get around this? I seemed to recall many property enthusiasts advocating this.
It’s funny you mention the PPOR. I read a forum last night and a few concluded it was no point trying to build up a couple of hundred thousand dollar share portfolio because of potential franking changes. You may as well put it all in the PPOR and get the full pension!
Hi Steve.
Good post. A reminder not to pin ones future on a single strategy (or “structure”)
Fortunately we have enough invested in own names that means the proposed change will have minimal impact on us. Hence we’re likely to continue investing mostly in LICs. But those with smaller franked share portfolios in own names will be hit hardest.
I would however modify our SMSF portfolio. Easy to do in pension mode as no CGT applies. The proposed change in some ways is probably a good thing in encouraging greater diversification away from large holdings of fully franked Australian Shares typical of SMSFs.
Funny in that with our FGG holding recent reporting suggests the dividend from it will be lower longer term than what many might have hoped which disapppinted me a little. I spoke to the analyst at Wilson’s about this awhile back. He stated that they were looking at strategies to improve the dividend but it would be noticeably lower than FGX which of course makes sense. But Labor’s proposed change was a reminder for me to have diversity in the portfolio including the likes of FGG which are more growth than income focused.
I think these changes could be a problem for the LIC sector (especially the active “trading” LICs) if it get legislated. Based on past experience as when LICs temporarily lost the CGT discount (lobbying resulted in Costello reinstating it) there could be a sharp drop in LIC values to a enough of a discount that compensates for the lost benefit. Welcome back the good old days when quality LICs often traded at a decent discount. Good for new investors but not so good for existing ones especially those subject to CGT if wanting to make changes.
Trust investing structures such as ETFs, LITs, unit trusts and AReits etc would likely become more popular given they are not subject to corporate tax. And unlike “trading” LICs the CGT discount is available to the investor.
As seen in the AFR Geoff Wilson is concerned about the impact on LICs especially WAMs LICs given most of the Income is from Capital Gains. The change would impact them noticeably as they already don’t get the LIC CGT Discount and short term CG from trading activity would be subject to full corporate tax rate. SMSFs especially in pension mode would lose the franking credits associated with Corporate Tax paid on CG. Active ETFs, LITs, Property / Unit Trusts would however be able to pass on all CG to the SMSF which would be tax free or 15% in Accumulation. Hence LICs would be at a structural disadvantage so expect them to head south likely into discount territory to compensate for this.
From a rather stressed Geoff W:
“Veteran fund manager Geoff Wilson has blasted Labor for “moving the goal posts” on retirees and warned that investors might pile into property, which would put more pressure on housing affordability.
You’ve got an 80-year-old in retirement who survives on the cash flow that they get from their superannuation and then all of a sudden, if Labor gets to government, that income will drop,” Mr Wilson said after Labor announced a plan to scrap refundable franking credits.
“These people don’t have the potential to earn any more income. They are relying on the system and Labor wants to change the system so they will be worse off.”
Mr Wilson said self-funded retirees would chase higher yields by switching to assets for which corporate tax rates are inconsequential, such as real estate investment trusts and real property.
“It will drive people into structures that don’t pay corporate tax,” he said. “A real estate investment trust is a classic example, but also real property.”
Read more: Investors ‘flabbergasted’ by Labor plan to scrap refundable franking credits”
Happy Investing
Thanks Nodrog I agree on all points. I really don’t know much about the odds of all this getting through. But IF these plans did eventuate there are some significant implications for the popularity of certain investments.
Understandably WAM is a little annoyed! I think it is another thing to worry about for those trying to justify the large premium. Usually when I hear investors doing so it is because of the high fully franked yield. I am guessing their shareholder base has a large component of retirees on modest incomes that may get hurt most if these changes eventuates. Will they continue to hold if their franking refunds are cut and there is the opportunity to exit at a large premium to NTA?
Regarding FGG I was also a little disappointed at lack of explanation about potential future dividends. To be honest I was hoping you could look into it and better understand it for me! 🙂 It doesn’t change my view on it though I am fine to keep holding. Previously I had thought a good dividend might build up for 18/19 and investors may re rate it a little. Maybe the news over franking may result in more investors thinking about the global LICs anyway, who knows.
In regard to FGG historically a very low dividend doesn’t bode well for LICs including International. I don’t think this will change even if Labor policy becomes a reality. Chris McKays LIC has been an exception due to extraordinary performance for a time. I’m not sure how FGG will go if they can’t increase the dividend (and performance) to a modest level.
I find it annoying that Wilson keeps rabbiting on about the mildly lower volatility of FGG / FGX vs the index which they continue to underperform. I think it was Dominic McCormick (or a prominent hedge fund Mgr) who stated that LICs are a bad structure for Absolute Return Mgrs. Of course FGX/G hold a sizable component of absolute return Mgrs. The problem is the LIC Mgr could be doing their job in managing volatility in a scary market but investor sentiment could negate this through an increasing NTA discount. Hence I place limited value in the lower volatility of FGX/G being there when one really needs it! I think FGG will need to lift performance and it’s dividend or it’s future may not be so bright. Time will tell.
When I spoke to Wilson’s guy quite some time ago about FGG the board were looking at ways to increase the Dividend. Having some overseas domiciled funds didn’t help. They were considering trading units in the funds held to try to generate capital gains. However the latest report suggests that they probably can’t find a suitable strategy given the fund mgrs “donate” their services hence why they now keep emphasising that returns will be mostly in the form of capital gains.
It would be interesting to hear your thoughts.
Cheers
There are two areas I consider here. First the NTA discount / premium. That is where I agree that the potential is probably not as great if they don’t manage to get their dividend higher.
Then the issue you mention if they outperform in a bear market would the discount widen? With this issue I just see that as my own investment call to take responsibility for. In this case I have acquired with a discount of more than 5%. My thinking is they wouldn’t widen to more than 10% and that their relative performance would start to look quite strong. Who knows maybe they can trade at NTA or better in such an environment.
The other part of the equation is NTA growth. On this front maybe I give them a little bit more credit than perhaps you are thinking right now. I know they have struggled to outperform their benchmark at least since I have been holding for about the last 6 months or so. I give them a pass mark though considering their cash levels and absolute and market neutral strategies within. I always expect them to struggle matching bull market returns so feel they have gone ok in the last 6 months.
I also am a bit frustrated reading the little games when reporting. Eg highlighting the top level numbers before any fees or donations, volatility numbers. But lately I have been thinking about this a bit differently. I have seen it result in less of a discount to NTA. Hence my post not long ago about the marketing aspects of LICs. Just as long as I am personally aware of the little games.
Your last paragraph is quite interesting and could be the key point. It depends on the managers they have whether they are fine with FGG doing more switching in and out. Some of them are very large so I don’t think would care if they funded a redemption, little work needed on their behalf. If it wasn’t all of the holding in the manager, it still gets to say they are supporting the cause as much as they can which is the truth. Just may mean insignificant transaction costs from any minor rebalancing.
Different for ones that are much smaller possibly. Maybe the hints will be in the monthly NTAs if they speak about taking profits from a fund manager allocation?
On an upbeat note just read the FGG Feb NTA report after my reply. This was very good, FGX also outperformed a little.
Hi Nodrog, I’m guessing geoff only has a few 10’s of millions in his smsf so he should be relatively impartial on this matter !?!?! 😉
I’m a happy holder of fgx FGG and wmi so not cause to snipe at Geoff but for the country’s sake someone needs to think about the long term and for all stakeholders including the young and future generations.
Crying foul over moving the goal posts is well and good if you don’t care too much about what happens in 20 years time. But for those who are going to be around a bit longer it might because of concern when the goal posts get moved for us, ie no age pension, no Medicare, etc. because the country was fiscally irresponsible for 50 years and creditors take control.
Sorry Steve if I keep steering towards the political, it’s hard not to on this topic 🙂
Thank you Gentlemen.
Yes marketing is very important in the LIC environment. So in all fairness to Wilson he has worked tirelessly to raise the profile of the entire LIC sector.
Don’t get me wrong I have a sizable holding in FGX/G. Given our average purchase price for FGG is just over $1.06 I’m quite happy so far.
Trying to get my head around the impact of Labor’s proposed change on the LIC sector is challenging. But as a precautionary measure one thing is for sure avoiding overpaying for a LIC is more important than ever.
Should the worst happen I will be ready with cash in hand particularly outside of Super. The initial resultant NTA discount may way more than compensate for any structural disadvantage. Just like in the good old days.
Cheers
Feel free to comment on the political aspect by all means.
I am not that sure which area of tax reform is the best answer from here so didn’t offer a firm opinion. I see a very messy tax system so don’t know where to start for suggestions to fix it!
I fear any effort by politicians on tax reforms simply create more uncertainty and don’t get us very far.
Think of all the people like us typing away on the internet because of all the uncertainty! A stable tax system (albeit with weaknesses) may have its other benefits.
More on topic, I agree with you regarding the volatility. It’s widely accepted volatility does not equal risk for long term investors so I’m also not focused on it. Nonetheless I like fgx and FGG, and happy to hold both on investment grounds not to mention the good causes they support as icing on the cake. Once again the above post is not intended to take a shot at Geoff, he is a good man and clearer cares about future generations per the name of these two LICs. However I do expect he could have a personal bias on this particular issue…
Volatility. That’s the beauty of mostly investing for income (dividends). I’ve been invested through the 87 Crash and all events since. Focusing on the less volatile income is very liberating. Capital volatility no matter how severe has no impact on me anymore. Franking credits or not it’s all about cash flow for us. Franking is just the icing on the cake. So yes I agree volatility does not equal risk.
I have discussed the latest franking decision and more in a comment on the Forager blog. To recap, the nil tax paying LIC shareholder’s current treatment is the same as that of an equity trust holder ie. both can theoretically get 100% of the the base organisations profits. The proposed changes mean the shareholder will be worse of, due to the 30% company tax. Not saying the proposed change is bad per se, just that they should then change the taxation of trusts as well.
Of course they should look at -ive gearing, cg discounts, tax free over 60s super, deductions v rebates etc. as well. The whole system needs a holistic approach. Ain’t going to happen though. Too many vested interests guarding their own favourite ‘rort’. So we get proposals largely based on the likely affect at the next election.
BTW, I recommend the Forager blog. Haven’t heard of any of the other 38.
Yes it’s not a great system and tends to encourage tax policy changes every few years. Hence my posting about not wanting to bet much on certain tax policies remaining constant.
It’s funny I just went to have a look at the Forager blog which I agree is good, and it’s not responding. Has the comments from Gareth Brown stirred up too much debate and blog traffic today there?
Interesting that the reason Forager choosing to list the Aussie fund as a trust rather than a company appears to have been largely based on the benefit of the cgt discount. If that is retained and franking gets changed they’ll be looking pretty smart. Not so if the reverse happens. The cynic may suggest that it is Forager’s interests to support, or at the least not oppose, Labor’ proposals. Should declare at this point that I hold Forager units.
With regard to your main point, I’ve structured our investments on getting a basic ‘survival’ income even if the world economy tanks. This involved making a number of (hopefully) worst case assumptions. These include franking and the cgt discount being scrapped entirely, pension phase super being taxed at 15% and the low income rebate being retained. This leaves me free to allocate the rest on the basis of what is best at the time without losing any sleep over it.
My cynic radar also got triggered about Forager’s viewpoints on this issue. They would also like to grow their international fund more. I was curious if you had owned the international fund also, assume you were referring to the LIT? I was giving some thought to the international fund. They say they are finding better value in the UK. Relative performance hasn’t set the world on fire but if they improve I wonder if it could get listed one day?
Considering those worst case assumptions you mention seems prudent to me.
I have a smaller holding in the O/S fund via Netwealth. Wouldn’t read too much into that as I set the Netwealth account up to invest in ‘wholesale’ small company managers. They set a 50% limit on these so I needed others to make up the balance. Forager Int was one. I don’t expect it to perform as well as the local fund.
Had another thought on the imputation proposal. All our franking credits are ‘excess’, so it would be quite a hit. However we also have large unrealised capital gains which has made me reluctant to sell some of the now overweight LICs that are also trading at excessive premiums to NTA. Could be the incentive I need to rebalance and tidy up the portfolio on an ongoing basis.
Yeah I made a comment over there too Graeme. Voters care about their self interest and pollies care about getting re-elected, but unfortunately neither of these may be in the country’s long term best interest. Scott Morrison’s super changes got kyboshed and those were probably rather mild compared to this, so I expect it has no chance. Something will have to really snap before there is serious change and a holistic tax system review that is obviously needed. Hopefully our good luck continues, commodities keep running, and nothing snaps for a decade or two yet. Personally I will hold a decent allocation of unhedged global shares as I don’t like to rely entirely on luck though 🙂
Fascinating discussion here folks – loving it.
Legislation will eventually not be able to resist the tax free earnings in Super Pensions too I believe. I expect that to change in my lifetime and especially as the population ages. Lure them in then tax ’em.
I hold a mix of investment bonds (VAS and VGS products via Australian Unity) BKI, IJR and all the Wilson products outside of super and then ARG, AFIC, SOL, MLT, VAS, VGS, VGAD, VGE, IJH, IVV, IAA and IEM inside of super (I do not co contribute to super) – roughly a 50/50 split of Aussie dividend stocks and international growth stocks exposure across the whole portfolio. Maybe I should start flipping the family home every year to get some more diversification – ha ha!
I agree Phil the tax free earnings on super pensions will be too irresistible not to tamper with some more in the future. Your spread out mix of investments at least would have meant you were probably less stressed when reading of Labor’s plans compared to some investors.
I posted this elsewhere. SMSFs lose out:
“Brisbane tax partner Mark Molesworth calculated the after-tax returns on $500,000 invested in Australian shares returning a 4 per cent dividend yield at a 100 per cent franking rate.
The scenario is a simple one, but it demonstrates the varying outcomes of Labor’s plan according to investor type.
For a self-managed super fund in pension mode, the after-tax rate of return on the abovementioned shares would drop from 5.71 per cent at present to 4 per cent. …
But somebody receiving a pension from a fund regulated by the Australian Prudential Regulation Authority – that is, the large industry funds and bank-owned retail funds – would receive an unchanged rate of return of 5.71 per cent.
Mr Molesworth said there was no change for the last investor because pooled super funds had so many members still paying tax that they could make full use of all franking credits.
Read more: Non-SMSFs will do better under Labor’s changes”