Where small deposits become massive money
One day, a long, long time ago, a mancreated a law. The outcome of that was the single greatest investment schemeAustralia has ever known. Take a ride on the slowest and most boring tourthrough the investment markets you’re ever likely to take. This is the onereally rich people have been taking for years and keeping quiet about it.Today, it’s your turn. Today, we look at superannuation.
What is the history of superannuation?
A long time ago, Australia had a huge runon inflation. In 1983 the Labor Government signed the Prices and IncomesAccord. This was a large scale deal between the government and the unions(unions used to be a real big thing) that looked to put a cap on the highinflation rate. In the ten years prior to December, 1983, the inflation rate inAustralia averaged 11.2% p.a. To put that in some sort of perspective justthink about this. The price of goods and services was doubling every 6 years,just due to inflation. These are the very same markets that your parents andgrandparents tell you about when they brag about housing. Thing is grandad; ifhousing didn’t double in this decade, it bloody well went backwards in real(inflation adjusted) terms! Basically, this is a detour to reinforce two facts.First, your parents and grandparents don’t understand inflation and secondly,of course prices double every 7 years if inflation is over 10% a year. If theydisagree, I plead with you, get them to contact me directly.
So, with the inflation genie being pushedback into the bottle, the next ten years saw inflation fall to an average of5.7% per year. The outcome of the Prices and Incomes Accord was the creation ofa retirement savings account for workers. Up to this point in history savingfor retirement had happened in a number of ways, none of which was systematicor widespread. The first was for workers to put aside a little money each weekand invest it for their retirement. Unfortunately, just like today, peopledon’t start to think about retirement until they are about ten years away from it.Not exactly a load of time to get that compounding machine cranking out thedollars for you, is it? Another way retirement was covered was through employerprovided, defined benefit schemes. These programs are like rolled gold to themillennials who will never know what they are like. Basically, the businesswould guarantee a certain agreed upon % of your final wage, for life, once youretired. This was beyond great for the employee but left business balancesheets completely loaded up with assets they needed to keep in order to pay forthe (every growing) number of employees that retired onto pensions. It isn’thard to see why businesses were keen to shift the risk of retirement back ontothe workers. The last way of sorting out retirement was to do exactly nothing.Don’t save, don’t invest, and be unlucky enough to never work for a pensionproviding company. When retirement comes you just go onto the aged carepension. Terrible plan with a really poor outcome but it certainly happened.
The next round of legislation forsuperannuation came in 1992 from the Paul Keating led Labor government. Yousee, some really clever boffin had poked her head up inside the halls ofgovernment finance and told the big boss upstairs; “Paulo, mate, the populationis getting hell old. I’m not sure we are going to have enough tax income to payout all of these pensions. You might want to look into that.” Well, look intohe did. After picking himself up off the floor a decision was made to turn theretirement savings schemes, kicked off under the Prices and Income Accord, intoa nationwide deal.
The entire superannuation system was builtup on a three pillar approach. The first was the compulsory payments that youremployer has to make into your superannuation account. The second is that employeeswill add extra to these accounts and the last was a government pension safetynet that is means-tested. Beginning in 1992 the Superannuation Guarantee (thisis what the government called the employer contribution that forms ‘pillar 1’of their plan) was set at 3% of your income. This rate then increased by 1% peryear (with a gap in 1997, 1999, and 2001) until it reached 9% in 2002. Morethan a decade later, in 2013, a brave Labor government would look to increasethis to 12% in increments over time. Of course, there was a massive fight andwe only ever got to 9.5% before it was all put off into the distant future.Nice one guys.
So, yeah, I negative gear because I hatetax. Does super have tax?
Oh man, you invest in things for tax reasons?!You are going to love superannuation. The money that your employer puts intoyour superannuation account (the Superannuation Guarantee (SG) we were speakingof earlier) is taxed on the way in at 15%. The government set up these low taxrates (otherwise known as concessional tax rates) as a way of luring in moneyand making it more appealing. It’s the carrot and stick story all over again.The stick is you can’t get to your money until you retire or turn one billion.The carrot is, low taxes. Another carrot, at least for me because I like shinythings, is that the money is locked away. So really, I see it as two carrotsand no stick. But I’m not all right in the head either… Anyway, theseconcessional tax rates apply to the employer SG payments and any pre-taxpayments you put in.
Let’s have a look at an example and we’llmake it all about you. So, you’re a pretty smart and hard worker. I wish I hadyour work ethic, not to mention your intellect. Now because of your superiorbrain power and all round gumption, you are earning $200k a year and arecomfortably in the highest tax bracket. So, on your 200k income your employeris sending 9.5% of this amount to your super account. That’s $19k per yeargiven over to the very clever people at your superannuation fund. Yoursuperannuation is going to send 15% of this, up front, to the ATO in order tocover the taxes and you are left with $16,150. Your superannuation experts willnow take that money (most likely in the default, balanced fund) and invest it foryou. Your rent, coupon payments (fancy way of saying bond interest), cashinterest and dividends will all be collected and taxed at a rate of 15% insideyour super. Your fund manager does all of this work so you don’t really need toworry about it. If your fund manager wants to sell something then they have topay capital gains tax, just like in the real world. The capital gains tax rateis 15%, unless… you’ve held that asset for longer than 12 months. In that case,you get a one third discount (way stingier than the 50% discount in the ‘real’world) so you only pay 10% capital gains tax.
By now you are probably noticing that thereisn’t a lot of tax being paid here. For all of you anti-tax fiends out therethis is probably looking pretty good, and it should. There is one last taxrelated thing you should know. Once you hit retirement age (currently 55) andpull the pin on work, your superannuation account becomes tax-free. Now wewon’t get into the finer details but, because you are really smart, you areobviously going to have a decent sized superannuation balance. The first $1.6mis tax free and will be paid out to you in retirement. Everything over that$1.6m figure will remain the same as things were before you retired. Earningsstill taxed at 15%, still growing away. Every time your ‘tax-free’ account getsbelow $1.6m you just top it up with your ‘taxed’ fund. But just let this sinkin. You have a $1.6m balance generating you an income and on that, you don’tpay any taxes whatsoever. This is how you retire to relative comfort.
What happens if they change the rules?
This is probably the single biggest issuewith superannuation. In the fancy circles (that you hang out in) they call it‘legislative risk’; which is basically saying the government could change therules whenever they like. Given that Australia had $2.7 trillion (4th largestin the world) in superannuation funds at the end of June 2018 (and we just hada 10% growth year…) the potential honey pot that governments could sink theirteeth into is huge. In the last ten years we’ve seen proposed increases to theSG payment to 12% put off and off and off. At this rate, when we finally get tothe 2021 start of the increases, the Liberal government will again push theseout. The bigger fear, rightly, relates to the tax treatments withinsuperannuation. You already saw in the last federal election that Laborproposed a rolling back of the franking credits system. This would have been ahit to retirees with superannuation balances, without a doubt. So maybe, evenfor me, there is a stick within a stick to the superannuation system. The governmentgives you the tax relief but you need to be able to trust them not to changethe rules in the next 30 years. For some, that is simply a bridge too far.
Do rich people use this?
Oh God, yes! A general rule in life (thatyou might want to follow) goes something like this; if you want to be rich, dowhat rich people do. So in that vein I’ll tell you about this clever retiredaccountant, Steve Elliot. See, Mr. Elliot knew superannuation was a great ideaand he went hard into it. Then he retired in a really comfortable position,living on Sydney’s northern beaches. Of course, eventually he got reallyrestless and started to scratch out some numbers and beating on his trustycalculator again. Ah, it was just like old times. The figures he came up withwere both shocking and led to one of the bigger overhauls of superannuation inrecent memory.
So what did Mr. Elliot do? He just sat downand tried to work out how much money a really wealthy family could get into thesuperannuation system and hence into a low-tax environment. He assumed that thepre-tax limit into superannuation was $25k, the post-tax limit was $100k (wehaven’t spoken about this but there is a $100k limit on after-tax payments intoyour superannuation), the person began work at 18 and retired at 61. The longterm earnings rate (minus inflation) was that of the Australian Super balancedfund. How much did this person end up with in super upon retirement? A verycool $25m thank you very much. If it were in the bank earning 2% interest thatis still a $500k income stream, with not a single tax dollar paid. Just shortof $10k a week. Minimum. So, yeah, rich people use super because they know howto make money, hold on to money, grow money, and how to not pay taxes.
The outcome of all this, by the fireplace,work from retired Mr. Elliot was a change to the caps and rules aroundsuperannuation to close some of these obvious gaps. Today, if you earn morethan $250k a year (including superannuation) you will be hit with an additional15% tax (to bring it up to 30%) on all of your additional contributions. Thenthere is the $1.6m pension fund account we spoke of earlier. That was set up tostop the (simply huge) tax free payments being doled out. So now, they can onlyget to $1.6m at a time. To be honest that has barely slowed them down, butstill, the government tried.
What are some of the rules I should beaware of?
We’ve already covered off on a bunch ofthese but they bare repeating. Don’t put in more than the $25k pre-tax cap.Yes, this includes the SG your employer pays. Don’t put in more than the $100kpost-tax cap per year. Well played to you if you can. Going over these limitswill lead to a slap from the ATO. At best, they will make you take the extramoney back. At worst, you’ll get hit with a tax bill, plus penalties. Don’targue. They know where you live. So, I want to buy property with my super… Godhelp you. Well, if you really do want to do this incredibly stupid thing thenthere are some details you’ll want to know. First off, you’ll need aself-managed superannuation fund. I’ll walk through some of the issues withthese in the next section. First, I’ll walk you through a short history of theAustralian property bubble. Sorry, my mistake, I meant the completely fairlypriced Australian property market that has been manipulated as a politicalfootball for two generations. Yeah, nailed it. So, back when Johnny Howard wasrunning the show he came up with this wicked good idea. So, property is amazingand only goes up, right? Right Johnny. And borrowing to invest turbo chargesyour returns, right? Right again Johnny. This was pretty much the thoughtprocess that went on in the Liberal party when they opened the floodgates ofcredit lending to superannuation accounts. The only catch, and the outcome ishilarious, probably saved a lot of households cracking and scrambling theirretirement nest eggs.
So now you can borrow to invest in stuffwithin your superannuation fund. Sounds great, right? Well yeah, except for theone line they put in the legislation about loan recourse. You see, within asuperannuation account, banks are only ever allowed to lend out on thecondition of ‘limited recourse’. That means that if the loan goes bad they areonly able to claw back the property the loan was made on and assets within thesuperannuation account. This saved a lot of people having debt collectorskneecap them from their retirement fund gambles. Sorry, I know property isnever a gamble. Especially not when using leverage. My bad. So, if the bank wearsthe risk of not being able to chase you to gets its money back, like ourcurrent system of full-recourse loans, then wouldn’t it be interesting to knowhow much a bank would really lend you? The answer is about 30% of the purchaseprice. See, the banks only ever take the risk of giving you 80, 90, 100% of thepurchase price because they will hunt you to the end of the world to get theirmoney back, plus interest. If they can’t do that then they get realconservative, real fast. Tells you something about how risky housing really is,doesn’t it?
Now you’ve got yourself a property insideyour super. Good thing is, it’s probably cash flow positive because, you know,you had to put down a 70% deposit, plus transactions costs like stamp duty. Nowthe real fun begins. You can rent it out but it has to be at an ‘arm’s length’to you. That is, you can’t live in it, and honestly neither can your crackheaduncle. You’ll need to find an agent, at a minimum to find a tenant, or get somerandom off the streets in. As far as the ATO is concerned it has to earn ‘themarket rate’ of rent, so you can’t do a mates’ rates deal either. Oh, andselling a house is a pain in the arse when you are already one billion yearsold and trying to spend your retirement money. Long story short, don’t.
I’ve heard about these self-managed superthings. Should I get one?
Self-managed superannuation funds. Ah, mynemesis, I see you have returned. You want to know how I know these things area bad idea? Every time some guy with a gold tooth tries to sell something at aseminar, it’s usually the worst idea in the world. For a period of about 15years, the hottest thing in Australia was the self-managed superannuation fund.Now if you need more reasons that my ‘guy with the golden tooth’ indicator justread on.
Firstly, a self-managed superannuation fund(SMSF) is a pain in the arse. You need to submit the tax statements, do ayearly tax audit and pick your own investments. Now I know you are very smartbut let me save you the time. You aren’t that good. So, to save you the effortof doing the taxes and mandatory audit, you’ll hire an accountant. Accountantslove SMSFs. With the advent of the ATO eTax thingy, their basic business modelof $99 for 10 minutes’ work, once a year, has been shredded. Enter the SMSF.Don’t expect to get away from a year’s worth of accounting services with a billunder $4k. This is ding number one to a SMSF.
Secondly, how good an investor are you,really? I mean, really? So now you’ve got one of two options. Go through doornumber one and you get a fund manager, broker, real estate guru (gold tooth guysbrother by the way) to pick your investments for you. They won’t come cheapeither. Decide against that (gold tooth guy creeps me out too) and you walkthrough door number 2. You are now sitting upon your pile of patientlyaccumulated capital like the master of the universe you truly always thoughtyou were. Now you’ll go out and invest the shit out of this cash. “I’ll have$500k of Slater and Gordon shares!” you’ll scream out in April, 2015. And then…it’s all gone. To be clear, I’m calling a 99.8% loss of capital and no dividendbasically a total loss of capital. Trust me, if really, really smart fundmanagers can’t beat the index even half the time over a ten year period,neither can you. I know its mean. I’m sorry. I guess I just want you to berich, not poor and bitter.
Let’s take a different approach and look atsome of those really smart people you should be giving your money to. First ofall, I don’t care ultimately who you go with but I can tell you I’m with
Australian Super and I’m in their balancedfund. I think it’s great. Industry funds get a bad rap from their for-profitbrothers like AMP, CBA, BT Financial, Macquarie and all the rest. To be fair,I’d be pretty annoyed if I were competing against an investment firm that wasowned by the members who put money in and didn’t have to turn a profit. Incontrast, CBA shareholders would not be impressed with this system. Mostly, youneed to keep an eye on the fees you are paying. Try and make sure you don’t goover 1% p.a. as an investment fee. For example, CBA will charge you, on theirmost basic account, a 0.75% p.a. investment fee, and a 0.15% fee every time youbuy or sell (hint; adding money to your account would be classed as a ‘buy’), a$5.88 per month account fee, and an additional 0.12% p.a. ‘because, f* you’fee. The latest research shows that Self-managed super funds don’t normallyeven make financial sense (from a fees point of view) until the balance is over$600k and much more likely, over $1m. If you are seriously considering a SMSF pleaselook closely at an industry fund.
When I’m old and rich, I’m still going tothink you’re a dickhead
I get this a lot. Mostly after I’ve toldpeople they aren’t that smart but there is still a way they could be rich. Sogo ahead, hate me if that’s what helps you; just make sure you follow theadvice. Right now I am going to take you through from now (you’re 35, right?)to your retirement. As we established earlier, you earn $200k a year (well doneby the way) and you have $19k going towards super. That turns into $16,150after taxes. You now have two choices. Choice one sees you do nothing else butkeep working. Choice two has you increasing your pre-tax contributions to superup to the $25k limit. In both situations you retire at 65, start with a currentbalance of zero, and you are invested in the Australian Super Balanced fund.Started in 1985, the balanced fund has returned 9.65% per annum. This return isafter investment fees and taxes are paid. Now I know you are so sneaky smartyou’ll want to know what the inflation rate has been since then too, right?Nice one. Inflation has averaged 3.3% p.a. over that time giving our Balancedfund a real (or inflation adjusted) return of 6.35% p.a. So, although pastreturns are no guarantee of future results (except in property, am I right?!),they are a decent guide when the data covers 35 years of returns. With thosereturns being the future assumed average, when you retire, still angry with me,at 65, you’ll have $1.3m if you go with choice one. If you up yourcontributions, choice two will give you $1.78m. These figures are in today’sdollars. If you only do one thing that rich people do, please let it be this.Put money into your superannuation account. It is the best tax perk stilllegally available and the most effective way to compound your wealth intoretirement. Thirty years from now, sitting on your beachside balcony, you canopen your yearly account summary, lean over to your children and impart thewisdom; “Welcome to the greatest show on Earth”.
