|
Pump Up Your Super
The growing band
of self-managed super funds can now accelerate earnings by utilising the
previously banned practice of gearing. John Wasiliev tells how.
Superannuation
has been revolutionised by a radical development, approved by the government
only a matter of weeks ago, that allows do-it-yourself super funds to borrow
money to invest in assets such as shares, property and art.
Such a strategy was previously prohibited and DIY super funds are likely to
make the most of the new rules. It's a development that commercial super
funds are almost certain to explore as they look for ways for investors to
build wealth at a faster pace than otherwise possible.
The decision allows DIY funds to use an instalment payment strategy to
overcome a prohibition on super funds of any type, borrowing money to
leverage investments. The investments can be in real estate, listed shares,
publicly available managed funds, paintings or sculptures - or even more
exotic assets such as collections of rare coins or stamps.
It is a
development that some in the industry are hailing as an exciting advance and
already super experts are putting much energy into creating strategies to
exploit the new rules.
It is an
opportunity for those who know what they are doing to take advantage of the
attractions of borrowing to invest. These attractions include the ability
to gain the benefits, principally the capital growth benefits, of owning
investment assets before they have been fully paid for.
Another
attraction is letting the assets, through rental income or dividends, pay
off the loan and then - thanks also to capital growth - end up owning a
valuable investment.
But others in the
industry are encouraging investors to approach this new entitlement with
caution, given the extra risks that can be involved. Such risks include a
topical one: the prospect of higher interest rates creating payment
pressures for a poorly planned investment.
A more specific
risk is ensuring that any strategy is implemented according to the new
rules. "There are some worrying stories already about funds looking to gear
without being aware of restrictions like only being able to invest in assets
or implement strategies that would normally be allowed," says Graeme Colley,
chairman of SMSF Professionals Association of Australia (SPAA).
A superannuation
fund can own collectibles but there are strict rules associated with it.
For instance,
only certain assets can be bought by a DIY fund from its members, namely
shares listed on a stockmarket, a business property or investments in
publicly managed funds.
"We are hearing
about people wanting to put antique cars and stamp or coin collections they
own into a geared super arrangement, and using borrowed funds to buy more of
these assets.” Colley says.
A super fund can
own collectibles, but there are strict rules associated with this ownership
- such assets cannot be bought from a member.
“Anyone who tries
this will run into serious compliance problems," Colley says.
“People must be
careful not to gear for the sake of gearing," says lawyer Peter Bobbin of
Sydney's The Argyle Partnership who has developed what he describes as a
superannuation acquisition instalment trust. It comes with instructions that
allows a fund to implement a borrowing strategy themselves. This $3500
service is an alternative to packaged strategies being offered by a number
of commercial organisations, including Sydney-based Calliva SuperAccess,
Quantum Warrants and Perth-based DIY Super Warrants.
The packages,
which are mostly aimed at property investments, include all the necessary
documentation plus a loan facility that satisfies the required super rules
and regulations. They come with a range of fees, of which the major one is
an application fee of between 5 per cent and 5.5 per cent of the value of
the investment. There are also borrowing fees of up to 2 per cent for the
interest-only loans.
Many more of
these arrangements, both DIY and complete versions, are expected to be
offered in the months ahead by large and small financial organisations that
are known to be working on possible strategies.
But Bobbin says
the fact that gearing and super is certain to develop a higher profile in
the foreseeable future does not remove the need for the strategies to be
kept in perspective. He recently gave some advice that he considers crucial
to a client who wanted to implement a gearing strategy.
"He decided he
wanted his super fund to borrow and asked what he needed to do to get
started," Bobbin says. "I asked him 'what for?' and he didn't have an
investment in mind."
Bobbin advised
him not to get too excited, and to work out an investment plan first, and
make sure the strategy and the investment were right.
Also worth noting
is that people who get overexcited about new strategies often become the
most vulnerable to fly-by-night operators, who are bound to be attracted to
ideas such as this one.
But Craig Day, a
senior technical manager specialising in DIY super at Colonial First State,
says that with all the potential risks in mind, the scope for a fund to
introduce a borrowing strategy does have the capability to change the way
many people plan their retirement savings. The extra attraction of super is
that, when the fund begins paying a benefit to its members, there won't be
any tax on the investment profits or on the super income for those that are
over 60, Day says.
Super is now
regarded by most as a savings arrangement where contributions are steadily
invested over time in a concessionally taxed environment. It has the
potential to become a tax-free pension income or a lump sum when the savings
are converted to benefits by a retiree over the age of 60.
Until now,
gearing has been a strategy available only outside super. "This is a
fundamental change," Day says.
He sees potential
for the rules to be used by young people to build up their super faster than
they may ordinarily do.
In the past, the
standard advice for those without the level of savings to justify the cost
of a DIY fund was to wait. Given DIY funds have fixed expenses, such as
accountancy and audit fees, it is suggested that anyone with a balance of
less than $250,000 should not set up their own fund. But adding borrowings
to the fund assets will allow people to build up to these critical levels
much faster and start a fund earlier.
"We could see
another boom in self-managed super fund start-up as a result of this," Day
says. |
THE BORROWING
RULES IN BRIEF
-
The borrowing
is applied only to an asset the fund is normally allowed to acquire.
-
The legal title
of the asset is held in trust on behalf of the fund until it is fully paid
for: a fund is not permitted to hold the asset in its own name.
-
The fund has a
beneficial interest in the asset as well as the right to acquire legal
ownership after making the necessary instalment payments.
-
Once the fund
has repaid the loan the legal title of the investment can then be
transferred to the fund to hold directly.
-
The lender is
an individual (including a fund member or someone related to a member) or
a commercial lender.
Most important is
that the rights of the lender against the super fund are limited to the
rights relating to the asset. In other words, if the geared investment goes
pear-shaped for any reason - the main one being that interest is not paid -
the lender can't make a claim against other investments owned by the fund.
This is described as a limited recourse arrangement. The worst a lender
can do is sell the asset to claim any money owed, plus expenses, and then
pay any balance to the fund.
Borrow to invest
in property
CASE 1 INDIVIDUAL
REAL ESTATE INVESTOR
Janet is 50 and
has recently received a divorce settlement of $250,000 in non-super assets
from her ex-spouse. She would like to use the money as a deposit to buy a
residential investment property for $550,000 but wonders whether she would
be better off contributing it to her DIY super fund to take advantage of the
new tax concessions for payouts once she turns 60.
By salary
sacrificing, she could increase her loan repayments and potentially pay down
the loan faster.
Under the new
rules, Janet will not have to choose between a geared strategy outside super
and an ungeared strategy within super.
She can
contribute the money to her DIY fund and, under the new rules, her fund can
borrow to buy the investment property. By doing this, she will get all the
benefits (as well as the risks) of gearing, as well being able to take
advantage of the tax benefits of super.
By gearing within
super, she will have the option of paying down the loan by way of entering
into a salary sacrifice arrangement with her employer.
Given that salary
sacrifice contributions within the new contribution caps are taxed at a
maximum rate of 15 per cent instead of her marginal rate, this would allow
her to pay down the loan with 85c out of every dollar of pre-tax income
instead of 53.5c if she is on the top tax rate.
By salary
sacrificing, she will be able to increase her loan repayments and
potentially pay down the loan faster.
Attractive link
to instalment warrants
The particular
nature of the rules that apply to DIY funds borrowing to invest are crucial,
given the lifting of the prohibition of loans came as a surprise to super
experts.
The changes to
the rules are due to the fact that the government wanted to confirm the use
of instalment warrants by super funds after the Australian Taxation Office
late last year deemed them to be in breach of the previous rules. But
resulting legislation from the government's intervention is much broader.
Indeed, says
Colonial First State senior technical manager Craig Day, it allows a super
fund to borrow money, subject to certain conditions, to buy just about any
kind of asset. The memorandum explaining the new law mentions assets such as
real estate, art work or listed securities.
Although these
are all DIY fund investments, Day thinks there is no reason a borrowing
strategy couldn't be expanded to larger super funds by being added to
managed fund investments on superannuation platforms such as his
organisation's First Choice offerings. What makes the strategy distinctive
is the link to instalment warrants.
Instalment
warrants are an alternative investment in ordinary shares or managed funds.
The best description of a standard instalment warrant is a packaged
investment that combines a share with a tax-deductible loan that allows you
to gain the benefits of owning a second share.
Instalment
warrants were accepted as a DIY fund investment for years because of a
particular quirk in their design. Part of the package is an insurance
feature provided by a protective option that limits any potential loss to
the initial investment. Although there is a loan involved, there is no
obligation on the investor to repay this if it becomes uneconomic to do so.
Day says that
while the expectation was that changes to approve them would allow super
funds to invest in commercial instalment warrants over listed shares, the
new legislation is much broader. It effectively allows a fund to borrow to
buy any assets it can normally invest in, subject to the condition the
arrangement is along similar lines to an instalment warrant with some extra
legal sophistication.
As Argyle
Partnership's Peter Bobbin puts it: "Under the law, a super fund is not
strictly permitted to borrow but the new entitlement relaxes this
prohibition so long as certain conditions are met”
Under the law, a
super fund is not strictly permitted to borrow but the new entitlement
relaxes this.
Fund trustees can
go to the bank and borrow money so long as they follow a certain procedure
which includes not putting any other fund assets at risk and ensuring that
the assets against which money has been borrowed are held on trust in the
fund's name, with the fund having the right to acquire the assets by
repaying the loan through instalment payments.
These conditions
liken the fund's risk to that of an investor who buys stockmarket-listed
shares. With a share investment, no more than what the shares cost can be
lost.
Not that there
isn't a substantial risk, as far as a fund is concerned, if it proves to be
a bad investment. The fund's involvement will still be a major commitment:
somewhere between one-third to one-half the value of the geared investment.
If the investment
is a property worth $500,000, for example, that suggests a commitment by the
fund of between $165,000 and $250,000, which could represent more than 30
per cent of the total current assets of an average $800,000 SMSF. Add to
this the stamp duty and borrowing expenses associated with the strategy to
get the total cost.
John
Wasiliev |
