A new value proposition

The new superannuation rules combined with the innovative products that enable access to equity in the family home through reverse mortgages and debt-free equity release (DFERs) provide a range of strategy opportunities for financial planners.

Specifically, they encourage those seeking to move from offering clients a transactional competency based on technical and rollover issues to an ongoing service offering that covers both traditional investments and the family home.

The new value proposition focuses squarely on assisting clients in prioritising their goals and cash flow management in the broad context of all of their assets.

In essence, the two primary investments for most Australians will be their family home and their super.

They can be viewed as two empty buckets given preferred tax status by the Government to be filled during a family’s working life, and emptied during retirement. Because the traditional rules and order of filling and emptying are inconsistent with maximising family wealth, planners will have a critical role to play in reassuring and validating decisions.

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The ‘two bucket’ approach to financial planning has specific application to middle Australia, where the drivers of increasing longevity, continuing aspirational spending, insufficient savings and unsustainable social security entitlements combine to make accessing the equity in the family home inevitable.

To illuminate the issues and opportunities, we have looked at two relatively affluent Australian families where the new rules, specifically through super, encourage regulatory arbitrage.

First we meet the Optimists, who seem to have a risk tolerant approach to the management of their financial affairs, and their near neighbours, the Pessimists, who appear to be risk averse.

A positive and proactive approach

The Optimists are a 50-year-old couple who own their own home, have money in super, money outside super and generate a reliable, above average and appropriately insured income in excess of their living costs.

The Optimists’ plan is to move to a more expensive home, borrowing ‘interest only’ for 20 to 50 per cent its value. They are confident that the value of a new home in their preferred suburb is likely to grow at an above average and robust rate in the medium to longer term.

The Optimists’ plan is to maximise their super by salary sacrificing the maximum amount they can into their own super each year.

In doing so, they reduce the tax paid on earned income to the contribution tax rate of 15 per cent, compared to their higher personal marginal tax rate. They intend to supplement their living expenses by accessing their non-super assets as they need to.

The Optimists’ family plan will see their balance sheet, at the time of their retirement at age 60, largely consist of a diversified portfolio of growth and defensive assets within a self-managed super fund, a family home and borrowings secured against the home.

Their super assets will have grown in a tax-sheltered environment, which will probably have had an ongoing tax rate of plus or minus 5 per cent per annum.

In the de-accumulation stage, the assets in the funds will not incur any tax liability on realisation, and imputation credits will be paid back into the fund, resulting in a negative tax rate, which will offset the costs of running the fund.

The payments out of the fund, both regular and irregular, will be tax free. Their home, they hope, will have grown substantially in value and, of course, will be tax free on sale and exempt from the assets test if social security entitlements are available.

Overall, the arbitrage of tax rates on earned income and the maintenance of solid gearing on the home should result in both a more diversified portfolio and a substantially greater net-worth than otherwise would have been achieved.

In addition to having enjoyed living in the superior home for 10 years, at age 60 they will be able to, among other strategies:

~ continue the loan and make repayments through tax-free withdrawals from their super;

~ refinance the loan through a reverse mortgage and make no further payments;

~ pay out the loan, at least in part, through a debt- free equity release;

~ pay out the loan through a tax-free lump sum drawdown from superannuation; or

~ sell the home (realising the capital growth tax free) and move to a lower cost one.

In addition, from age 60, the Optimists will be able to offer tax shelter to their children, who will be able to invest part of their discretionary savings through the family super fund via undeducted contributions.

A negative and cynical view

The Pessimists live in a similar house to the one currently owned by their neighbours, the Optimists.

Although their family circumstances are very similar, their attitude and behaviour suggest they are risk intolerant. They seem to be comfortable living within the financial outcomes that are consistent with managing their financial affairs in line with their risk aversion.

The Pessimists believe that the Budget’s super changes are unsustainable and will be a burden on their children and their children’s children.

They are deeply suspicious of the policy intent. They fear that once money is locked away into super, the rules will change to their detriment.

They choose to retain a conservative and diversified approach to their family balance sheet.

They intend to remain in their current home, which has no borrowings, contribute the minimum amount into their super obliged by law via an industry super fund and add any new savings to their non-super investments.

Above all, they have no intention of seeking the advice of a financial planner, because they believe all planners’ advice is directed towards products where they receive commissions.

Beyond age 60, they plan to stay in their family home and spend all of their super and no-super assets very slowly. They have no notion of either regular drawdowns of money through a reverse mortgage to supplement their super and social security or the use of a DFER to diversify their investment risk.

The Optimists and the Pessimists provide a unique challenge for both the general and financial planning communities.

While in each case their initial circumstances are identical, the implemented plans are significantly different. So what could go wrong in each case and what are the consequences for financial planning?

The new super rules could change

Of course they could, but let’s work out what might happen that would have a retrospective impact.

Clearly, changing the contributions amounts or tax will have no effect because it is prospective. What is possible includes:

~ changing the earnings tax;

~ increasing the tax in the accumulation stage;

~ creating a tax in the drawdown stage;

~ changing the exit taxes;

~ imposing tax on all or some withdrawals;

~ changing the exit rules;

~ increasing the amount that must be drawn down regularly; or

~ limiting the proportion that can be taken as a lump sum.

When we look at the possible options open to a government, either the Coalition or Labor, it is difficult to imagine the backbench living with the responses from the rump of the baby boomers, who will be screaming ‘it’s not fair’.

As a consequence, any future changes are likely to be incremental and minimally retrospective.

The equity and property markets could turn — and so could the clients

Financial planners cannot guarantee how the markets will behave; they can only guarantee to use a robust process to protect the client from the disappointments that often accompany unreasonable expectations.

This includes using a logical form of diversification and educating clients of the vicissitudes of investment markets.

Lindy has reverted to her single name since her divorce from Michael Optimist. She is now known as Lindy Litigate.

Michael had been the ‘patriarch’ of the Optimist family. He was strong willed and dominated conversations, particularly those held with professional advisers.

Michael asserted that ‘they’ were risk tolerant and their financial planner simply accepted his assertion.

The markets also reverted to longer-term trend lines. While their home’s value had not dropped, it had not increased either. As far as their superannuation was concerned, it was some 30 per cent off the original illustrated value at age 60.

In summary, their future lifestyle was going to be somewhat more humble than either had suspected when they put the original plan in place. And, of course, there were now two households to support.

True to her name, Lindy was now suing her planner

The expert witness her planner called went looking in the files to find a robust financial planning process that had generated a properly informed commitment to defend the case.

At the heart of such a defence is the principle of a properly informed client commitment to the financial plan and the risks it entails.

A critical component of such a process is proof that trade-off decisions relating to the allocation of scarce client resources were appropriately illuminated and accepted.

The expert witness knew that effective trade-off decisions could only be made when the elements of the trade-off have been separated, and can be clearly understood and compared.

A key trade-off decision is between comfort with financial risk and the financial risk required to achieve goals.

Analysis of the Optimists’ goals, needs and priorities in light of their current and anticipated financial resources and the financial environment should have demonstrated that their goals could only be satisfied from their resources at the level of risk that Michael said he was happy to take. But, of course, there was no meaningful assessment of either Michael’s or Lindy’s financial risk tolerance. The planner had simply taken Michael’s ‘instructions’. There had been no collaborative decision. In essence, the planner was doing what he thought was right for his clients.

Informed consent and collaborative planning

In collaborative planning, decision-making is shared between the client/s and planner.

In essence, the plan is the personal contract between the client and the planner designed to meet the client’s needs. Any product recommendation is the outcome of the ‘know your client’ process.

The planner needs to collect sufficient information to be able to prove that the product and service being recommended meets the individual needs of the client and his or her family.

The client brings their goals, aspirations and commitment to not only prioritise any lifestyle trade-offs, but any gap between the financial risk needed to achieve their goals and the financial risk they would otherwise prefer to accept.

They must agree to ‘live’ the plan, the product decisions and any behavioural changes needed.

The planner brings their knowledge of financial products, markets, regulation and, of course, other clients in similar circumstances.

The outcome is what is commonly known as the ‘properly informed commitment’ of the client. In the end there is a shared responsibility.

Proof of a rigorous planning process

In order to justify decisions made and the contract agreed upon, the planner must demonstrate the rigour of the planning process adopted. A robust financial planning methodology needs to prove five things:

1. that you know the client, their current circumstances, their financial and psychological needs and their expectations;

2. that you explored the alternative products and strategies available to the client;

3. that you know the products and services in the strategies explored and selected;

4. that you explained the risks in the strategy, services and product/s selected; and

5. that you received your clients properly informed commitment to accepting the risks in the plan and to its implementation.

The better strategy

The family home is now an intrinsic part of the planning process.

In both the accumulation phase and the spending phase there is reason to explore the options, rewards and risks.

In both phases, the intrinsically better strategy is the non intuitive. In accumulation, it is not in paying down the mortgage, but in taking on a higher exposure to both property and interest rate risk. It is in maximising super across the whole family. In retirement, it is not in spending all other assets and leaving the home as a last resort, it is in either borrowing against the home or selling part and even re-investing sale proceeds as a form of diversification. Is it possible that these will become the default options going forward?

This clearly requires a solid methodology for arriving at the plan, as the better strategy may prove to be unsuccessful for a particularly litigious client and their family.

Obviously, the two dominant approaches currently entertained by licensees and their agents, financial planners, portfolio picker questionnaires and ‘I know what is best for you, trust me’ are neither adequate nor defensible. To gain the client’s ‘properly informed commitment’ is the challenge. It demands three things: transparency; financial literacy; and negotiation skills.

The development of a consistent process has two ancillary benefits; an inherently compliant approach to planning and the consistency that goes to the heart of running a scaleable business.

Final questions

So how should we deal with the Pessimists? Can we allow their inherent mistrust of the super system to stymie their ability to improve their net wealth at retirement?

How do we deal with the Optimists? Strategy selection has just become much simpler, what role do financial planners have in this new super system where the default options will be explained to everyone via the media?

What are the new rules for portfolio construction in both accumulation and drawdown when the family home is part of the asset mix?

The final challenge is to answer the question: would you be confident in receiving advice on such issues from an individual who would receive a financial advantage from making the recommendation?

Paul Resnik is principal of Paul Resnik Consulting Group . E-mail your thoughts to him at [email protected].