Robbing Granny in the name of Paul

When I was first asked to comment about the ALP’s proposed scrapping of franking credit refunds my response was I was “flabbergasted”. “Flabbergasted” that the party whose Treasurer Paul Keating created franking credits would cut those benefits accruing to retired workers, “flabbergasted” that the Leader of ALP Opposition who earns over $375,000 a year would begrudge retirees receiving around $5000 a year on average, “flabbergasted” that the ALP would be offering tax relief to low- and middle-income Australians whilst pulling benefits from the lowest earning individuals who don’t even earn enough to pay tax, and finally “flabbergasted” that it is claimed that “this change only affects a very small number of shareholders”.

Having had time to reflect on this change, read through the fine print and discuss it with a number of people within the industry – and I thank those clients for their thoughts – my views have changed somewhat, but not necessarily in a positive sense.

“ Firstly, this change only affects a very small number of shareholders who currently have no tax liability and use their imputation credits to receive a cash refund.”

“1.17 million individuals, and superannuation funds”

Bill Shorten speech to Chifley Research Centre as quoted by SMH “Labor to target rich retirees in budget fix” 13 March 2018.

Discriminatory policy

We think this is a very discriminatory policy. Whilst we are happy that charities and not-for-profits are exempted from the changes, we are not so happy that the likely worst affected are the very lowest income earners with small holdings of Australian shares.

It is also discriminatory between different types of superannuation funds. Members of mature superannuation funds are discriminated against versus members of less mature funds. The most mature of funds are Self-Managed Superannuation Funds (SMSFs) whose members are all retired, and they would receive no franking credit refunds. The least mature or growing funds are funds largely dominated by younger accumulation phase members with a relatively small proportion number of pension members.  These growing funds will be paying significant net tax to the government since the vast bulk of their fund members are in accumulation phase, paying 15% tax on fund earnings together with contributions tax.  It is our understanding that pension phase investors in these least mature funds would still be receiving the full value of franking credit refunds under this proposal.  The growing fund won’t be getting a refund of tax from the government, but within the fund pension members effectively get a full refund via offsetting (reducing) some of the net tax payable at the overall fund level. A $1m pension phase member of a growing fund would receive full value for franking credits, but the same $1m pension phase investor would not if they were to establish an SMSF. This proposal is clearly discriminatory, and if implemented would favour growing funds such as many industry funds, over SMSFs.

But we don’t believe this discrimination is restricted to SMSFs. Any superannuation fund dominated by pension phase investors will likely stand to lose the value of some or all of franking credits. Mature and often closed defined benefit funds would fit into this category.   Some of these funds may be fine in financial years with good investment earnings, but may lose some franking credits in years with low or negative investment earnings where tax payable on accumulation phase earnings and contributions are less than the value of franking credits.  We know of a few funds that are government or industry based which may likely be immediately impacted should these changes be implemented.

Industry ticking time bomb

We believe this change may ultimately impact a much greater number of Australians at some stage in their life than the current 1.17 million individuals targeted by this change. Whilst the proposed changes will primarily currently impact mature pension phase SMSFs and low income investors, we believe as the superannuation industry matures as a whole, as more and more members of pooled superannuation funds migrate to pension status, the loss of franking will likely start to impact a growing number of government, retail and industry funds. And these changes would then impact the returns and fund balances of pension phase members of those funds be they rich or poor.

Approximate $5000 a year impact

We estimate that denying the refund of franking credits will reduce the returns for pension phase SMSF by approximately 0.5% pa, meaning a retired couple with a $1m superannuation balance would be $5000 worse off each year, or a retired couple or individual with a $500,000 superannuation balance would lose $2,500. Now this might not sound a lot, but $50-$100 per week makes quite a difference for a retiree. It might mean being able to eat out once a week, take an annual domestic holiday, afford the expensive running costs of air conditioning or cover the cost of a cataract operation.

“$50-$100 per week makes quite a difference for a retiree.”

Our estimate of the impact of scrapping imputation credits is based on our submission to the Tax Discussion Paper entitled “Foreigners set to gain at the expense of Australian retirees?” (April 2015).  We based our estimate of the impact of imputation assuming an average SMSF exposure to Australian shares, and the franking credit yield of the S&P/ASX200 Index.  Investors with higher allocations to Australian shares, or allocations to higher yielding Australian shares could earn even higher levels of franking credits and would thus stand to lose more.

Impacts the lowest earning individuals who don’t even earn enough to pay tax  

Treasury’s analysis of ATO data indicates that 610,000 Australians in the lowest tax bracket (earning less than $18,200) would be impacted by this proposal, with a further 360,000 individuals impacted in the $18,201 to $37,000 tax bracket. Given this, I should not have been surprised that someone like my mother, who recently passed away, would have been significantly negatively impacted by this change. My parents worked hard all their working life, judiciously investing savings into the share market, managing to save enough to largely self-fund their retirement. They retired prior to the implementation of compulsory superannuation, so their share investments were held outside superannuation. My mother lived off the earnings from those shares, but she rarely earned enough to actually pay income tax, but I can assure you that she dearly valued the franking credit refunds which boosted her modest retirement income.  When she was well they enabled her to take the odd holiday, and when she wasn’t so well, they helped pay the medical expenses.

Closing the gate after half the horse has bolted?

In introducing the proposals, Bill Shorten used an example of an extreme franking credit refund of $2.5m to a single SMSF in the 2014-15 financial year. This example is now well out of date and passed it’s used by date.  The current government has introduced a $1.6m per person cap on pension phase superannuation which we estimate halves the problem. Perhaps a better way to eliminate the few extremely large franking credit refunds would be to either limit the total amount people can invest into super (not just the amount in pension phase) or limit the maximum franking credit refund per person. Let’s not make just about everyone’s retirement tougher because a few individuals have managed to take full advantage of the system.

Other Impacts

There are other impacts likely to arise from this change should it ever come to pass. Whilst members of defined benefit superannuation funds may not be directly impacted, the organizations’ that underwrite those benefits may need to increase their funding if the expected pension phase investment return assumptions are reduced.  Banks and insurance companies may need to reconsider their capital positions in light of the potential impact of these changes on income securities.

Pension fund trustees may need to alter asset allocations.  Some might argue that reducing exposure to the very concentrated Australian share market might be a good thing, but it will very much depend on where the money goes to. As well as Australian shares, SMSFs have a strong preference for Australian property, and we are not so sure allocating more money to a fairly expensive domestic property market is necessarily a good thing. Increasing exposure to global shares makes more sense, particularly since SMSF seem under-allocated to global shares compared with industry and retail fund allocations.

We also believe that any changes will likely impact the financial advice that investors receive, particularly investors in mature SMSFs.

Value of financial advice

Tax changes provide financial advisors and tax professionals the opportunity to add value for their clients. Pension phase SMSFs might likely restructure in a number of ways. They could move their pension assets into growing industry or retail funds to continue to receive the effective value of franking. Or they could look to “grow” their own SMSF, by adding say their children who are in accumulation phase as members, but there are constraints to this within the current SMSF rules.

Sadly, the 610,000 lowest income earners who would be affected by this change are probably least able to seek advice and least able to restructure their assets.

Don’t act too soon

We also discourage people from acting too soon on this proposal. It is the policy of the opposition. Not only do they have to win the next election, they would need to win over sufficient cross bench senators to make this change to the law. And even were it likely to happen, companies may act to flush out franking credits prior to any change coming into effect – buybacks and special dividends may come with a flurry in that case.

Conclusion

Overall, we don’t see this as good policy.  It’s discriminatory. Whilst positioned as a “taking from the rich to give to the poor” policy, it’s actually 610,000 of the lowest earning individuals who will likely feel the most relative pain. It also discriminates between different types of superannuation funds, impacting the returns and fund balances of pension phase members of SMSFs, but not the returns and fund balances of pension phase members of growing funds such as many industry super funds. We also think that as the superannuation industry matures, and many more members of funds retire, these changes will likely impact members of many of the more mature government, industry, and retail super funds, not just SMSF members. If passed, this policy may become a ticking time bomb for many, many Australians.

Franking credits provide a very valuable increment to the income of all defined contribution retirees be they rich or less well off, as well as to very low income investors outside the super system, and surely we all hope to retire comfortably one day.

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