Self-managed super fund (SMSF) members could be forced to take on more risk, should the Australian Labor Party (ALP) be successful with its plan to scrap cash refunds from franking credits.
At the moment, some individuals and superannuation funds receive a cash refund from the ATO if their imputation credits exceeded the tax they owe. The ALP has said it will do away with this concession if it wins the next federal election.
Should this proposal receive a green light, some SMSF trustees are concerned they could be forced into higher-risk asset classes as they seek to make up the resulting loss of income.
A million funds affected
The SMSF Association estimates Labor’s franking credit plan, which impacts about one million people, could create a $5,000 fall in income for an SMSF retiree earning $50,000 a year. The association says the ALP’s proposal would affect about 200,000 SMSFs immediately and the balance would be affected over time, as they move into retirement phase.
Liam Shorte, a director of Verante Financial Planning, who also runs his own SMSF, says most investors have built their portfolio on the basis franking credits are factored into annual income.
“We deliberately bought Australian shares with high franking credits to help sustain returns,” he explains.
By Shorte’s estimates, his clients’ revenue may be down by as much as 22 per cent should Labor’s franking credit policy be implemented. To compensate, he is allocating more capital to property syndicates and overseas investments, for instance buying exchange-traded funds that deliver exposure to global assets such as the Vanguard MSCI Index International Shares ETF (VGS).
“But with returns from cash and term deposits so low, some members feel they may be forced to take on more risk to compensate for the returns they may lose from franking credits in the future,” he says.
Impact on retirees
Financial planner and founder of Cooper Wealth Management Felicity Cooper explains the Labor Party’s franking credits plan affects retirees more than pre-retirees.
“Those working and with a tax payable amount for the year will still be able to offset their working income with franking credits,” she says.
Jonathan Philpot, wealth management partner with HLB Mann Judd, says the biggest impact is likely to be on funds with pension balances of under $1.6 million.
“In terms of impact over percentage of earnings, a $5 million fund is less impacted by this change than a $1 million fund. The higher the balance, the less impact this will have,” he says.
Act with caution
Philpot cautions against making any knee-jerk changes to the fund’s strategy. “I warn against jumping too far ahead and not buying any high-yielding Australian shares anymore. Income generation is important in retirement. The bank stocks are the classic example. They are yielding seven per cent at the moment.
“Under the ALP’s plans investors will lose three per cent in franking credits, but the banks’ income return is still high. So Australian shares have an important role to play. But obviously, the return outlook is changed by franking credits not being added on top of them,” he explains.
Pat Garrett, CEO of robo adviser Six Park, agrees self-funded retirees and SMSFs, especially those in pension phase, are the ones most impacted because they may have built their savings strategy around the assumption imputation credits would continue. “And, they’re the ones most likely interested in yield as opposed to capital growth,” he warns.
Since it remains unclear what will transpire and when, Garrett’s advice to trustees potentially affected by Labor’s franking credit plans is to focus on investment fundamentals including diversification, keeping costs low and the total return of the investment portfolio, which includes yield and capital growth.
“If Labor is elected and its franking credit plans go ahead, there are potential problems for people who are overly reliant on a small handful of Australian equities and their franking credits for their investment performance.
“Diversification is paramount in an investment strategy. If imputation credit cash refunds are removed, that’s lost income that cannot be replaced with another investment. People will have to review their overall investment portfolios and assess any franking credit changes on an asset-by-asset basis.”
Garrett says franking credit cash refunds may have driven some investors to focus too much on yield at the expense of diversification. So, reviewing the fund’s strategy in light of Labor’s proposed changes may actually trigger a move towards smarter investment diversification over time.
Consider other asset classes
If this change is implemented, and trustees are required to review the fund’s investment strategy in light of it, it’s worth looking at other assets classes that may not be able to fully replace that yield, but provide reasonable yield plus growth prospects and diversification benefits.
“With people living longer lives, most investment portfolios require a growth component. This may include an allocation to infrastructure, bonds or listed property trusts,” says Garrett.
Consider adding kids to the fund
When the time comes to make changes, SMSFA CEO John Maroney says an option may be to bring children who can make taxable contributions into the fund, so the franking credits can be used to offset the tax liability attached to those contributions.
“Contributions are taxed at 15 per cent and children can contribute up to $25,000 each on a concessional basis. So, if two children become members of a fund and contribute $50,000 in taxable contributions, this creates a tax liability of $7,500 which could be offset by any franking credits,” Maroney says.
This approach may become even more attractive should the federal government’s proposal to lift the total members in a fund from four to six people go ahead.
Make sure an SMSF still makes sense
Lisa Papachristoforos, superannuation manager with tax and accounting firm Hughes O’Dea Corredig says should the ALP’s franking credit changes go ahead, some SMSF members who are already retired may need to accept the money in the SMSF may not be enough to last, meaning the fund may have a shortened life.
“This may mean structural changes to their SMSF, or even winding it up,” she says.
Expect more news about Labor’s proposed changes to superannuation following the federal election, likely to be in May.
- Look into alternate asset classes such as infrastructure, bonds or listed property trusts
- Don’t act in haste: wait until any new policies and legislation is passed
- If franking credit cash refunds are reduced, consider how the fund’s investment strategy may need to change
For more information…
For more information on the ALP’s proposed policy banning cash refunds for excess franking credits, see the following SuperGuide articles:
- Excess franking credits: Shorten shortchanges millions of retirees
- ALP’s franking credits policy targets shareholders with low taxable incomes
- Guest contributor: ALP’s plan to confiscate franking credits hits retirees
- Guest contributor: Franked dividends are not a tax concession
For more information about franked dividends generally, see the following SuperGuide articles:
- Franked dividends and franking credits: How do they work?
- SMSF investment: Lower company tax rate and franked dividends
- SMSF investment: Franked dividends and the 45-day rule
- SMSF investment: Companies that pay fully franked dividends
- Super for beginners, part 17: Four must-knows about super’s tax rules