We know that the majority of dinner and coffee table discussions have been revolving around franking credits lately. There is so much mis-information and misunderstanding for a policy that still requires a change of Government and successful negotiation through the Senate. We have overheard any number of strategies, from moving to a union super fund and hoping they have some franking credits left over, buying property or trying to find something that can yield 10%. Yet the best action for all investors is to simply do nothing.

The proposed policy will apply to anyone not receiving an Age Pension, but primarily to those who have around $900,000 to $1,100,000 in superannuation who receive a tax refund each year. This is due to the fact that these refunds are generally made up of 100% franking credits. For those with balances exceeding $1.6m, the available tax refunds were vastly reduced following the introduction of the pension cap on 1 July 2017.

As a first step, it’s important to stress that there is a low probability that markets or individual shares will fall substantially following a Labor party victory (outside of listed investment companies.

This is due to a number of reasons including:

  • The substantial portion of major Australian shares owned by foreign institutions that already have no use for franking credits. This is evidenced by the fact that most major dividend companies share prices fall only by the amount of the dividend upon announcement, not the amount of the associated franking credits.
  • The majority of Australia’s largest investors, particularly institutions and pension funds will still receive the full benefit of the franking credits as a deduction against their income tax, meaning it is unlikely their portfolios will change. This is due to the fact that a large portion of most union super fund members are in accumulation phase and therefore paying tax. The franking credits received on your pension account are therefore used to reduce the tax payable on these accumulation accounts.
  • The increased involvement of pension funds in what has been the DIY investor dominated preference share sector, with Uni Super’s $200m bid for the latest NAB preference share a perfect example. This shows the value in the fully franked dividends paid by these products and an increasingly large market in the country.
  • It is likely to be the major listed investment companies (LICs), which pay investors consistent fully franked dividends by virtue of paying tax at the company rate that feel the brunt of any volatility as opposed to managed funds, which are structured as unit trusts and simply pass the associated income onto the investor.

There is no doubt the implications for those receiving franking credit refunds will be substantial, yet we believe the legislation is unlikely to be approved in its current form with a cap on refunds the more likely result.

The proposed change and concern around income levels has lead us to important discussions around income needs and the ability to produce the required income in an ultra-low interest rate environment.

Whilst the proposed change will have a substantial impact for some, there is no simple solution to replacing this lost income should the legislation pass. For example, consider the dividend currently offered from Westpac Banking Corporation shares (WBC), which is around 7.2% before franking credits are applied and 10.3% after.

There are very few assets around the world that offer yields of 7.2%, let alone 10.3% without requiring the investor to take on a substantial amount of risk. Potential examples include mezzanine debt, peer to peer personal loans, highly leveraged assets or even Turkish Government bonds (14%). Investments of this risk level are simply not suited those in or saving for their retirement in most cases.

So with an increasing income required to be drawn from superannuation, but lower interest rates, less franking credits and slower economic growth, the question of sustainability has come to a head. Investors can simply not expect to achieve an income of 6, 7 or 9% without either taking an extreme level of risk or giving up either the potential for capital growth, or capital in its own right.

We have always believed that the more appropriate strategy in this environment is for investors to seek total returns, from both growth and income, rather than focusing solely on income. We have already seen the implications of companies paying out the majority of their profits in dividends, becoming akin to a bond or term deposit, whereby their share prices simply stagnate.

At this point it is important for those investing through superannuation to keep in mind that the entire system was set up to ensure that your superannuation balance is withdrawn overtime so that it eventually becomes taxable. It was not intended as an estate planning tool, hence why the minimum pension payments increase regularly as you age from 4% to 5% at 65 and reaching a maximum of 14% in your 90’s. That does mean you should not seek to maximise your balance through sound investing and strategic advice.