Think outside the superannuation square
The introduction of compulsory superannuation many years ago changed the face of retirement income saving in Australia. It also resulted in the creation of a specialist advice industry overnight.
However, for too many investors it has created an overwhelming reliance on superannuation as the core (and sometimes only) retirement funding strategy, a mind-set many financial advisers find hard to break through. Australian investors need to remove their superannuation goggles.
Although none would dispute the importance of diversification, if left to the client, the result would be that all too often investment portfolios are not adequately diversified.
Most investors understand that diversification can reduce the risk of reliance upon the performance of one single asset class, or one single security, or even a single fund manager investment philosophy.
But they fail to see that diversification of strategies can also guard against regulatory and legislative risk.
It is a common refrain among Australians that it is not possible to retire until the stipulated preservation age. That is not quite true.
The fact is that it is possible to retire whenever a person feels financially secure enough to do so. It is just not possible to access the superannuation savings to assist in retirement finances, until the individual has reached the preservation age.
There is no denying the tax effectiveness of superannuation, but it should not be relied upon as the sole retirement funding source.
The younger your clients are, the more this holds true. Chances are that those in their 40s now are likely to find that the rules and regulation around superannuation savings are very different when they reach their preservation age.
It may be that the payments that are currently tax-free will have lost this status, or that withdrawals will need to be partly or totally annuitised in the form of a mandated income stream.
Perhaps not.
The point is that there is no certainty, and it is important not to rely on only one funding strategy when it comes to future financial well-being.
Putting eggs in multiple baskets
Fortunately, the idea of using supplementary or complementary strategies, rather than a solely superannuation-based approach to retirement, is one that is gaining support.
One strategy that is growing in popularity for those investors who have accumulated wealth outside superannuation, but are caught well short of their preservation age, involves using an investment bond to secure a transition-to- retirement (TTR) type income stream.
"Although none would dispute the importance of diversification, if left to the client, the result would be that all too often investment portfolios are not adequately diversified."
The tax advantages of a traditional TTR strategy are generally well known, but are only really of maximum benefit and flexibility to those investors who have reached their respective preservation age.
Consequently, there are an increasing number of investors that find themselves in a position where a TTR type strategy would be particularly advantageous, but due to their age, have been excluded from participating.
However, there is a structure that works conceptually like superannuation, but is free from the usual contribution and accessibility restrictions imposed upon superannuation.
It is a little known fact that it is possible to commence a tax-effective regular payment plan from an investment bond immediately upon setting it up. Yet the myth that investment bonds must be held for 10 years before becoming tax effective somehow persists.
Before its 10-year anniversary, each payment received from an investment bond is assessable to the investor, but more importantly, each payment is proportionately made up of earnings (which are tax assessable), and capital (which are non-taxable).
The tax assessable portion also qualifies the investor for a 30 per cent tax credit. In most cases only a small portion of the withdrawal is assessable for tax.
There is no mandated minimum or maximum payments, as there are with account-based pension type income streams, and the income can even be switched off entirely if desired by the investor.
Investment bonds can, therefore, provide a very flexible and tax effective transition-to-retirement strategy.
FOR example
Take the case of Duncan. He is aged 46 and has been working in the mining industry for the past 12 years, on a fly-in-fly-out (FIFO) basis.
He has had the foresight to accumulate significant wealth during that period, but hasn't sought financial advice, and he holds $750,000 in a number of term deposits.
The downside of FIFO work is that he has missed spending time with his young family. He has now taken a consulting role which sees him working three days a week in order to regain some work/life balance, but his income has now dropped by $48,000 net annually.
As a 46 year old, Duncan has not yet met his superannuation preservation age, so therefore cannot access any of his superannuation monies to affect a top up of his income.
However, if Duncan was to invest the $750,000 he presently holds in a number of term deposits into an investment bond, he could commence an income stream of $4000 per month, bringing his net income back to the required level.
A key benefit of this strategy is that over the first 12 months, only a small portion (approximately $2286) of the $48,000 received is assessable for tax; the majority of the balance ($45,714) received as income is non-assessable for tax purposes.
Additionally, Duncan would also receive an investment bond tax credit of 30 per cent on the taxable portion (providing in this case, a $686 tax offset).
This strategy may offer other advantages as well. It may result in a much lower adjusted taxable income, therefore minimising the effect of relevant levies such as Medicare levy and the deficit levy, while potentially improving the retention or outright eligibility of other peripheral benefits such as Family Tax Benefit Parts A and B, health insurance rebates, and the like, for which eligibility is assessed upon taxable income.
Other benefits of this strategy include:
• Eligibility to contribute: There is no work test with an investment bond as exists within superannuation. The investment bond can also be opened in the name of a trust or company.
• Tax efficiency: The earnings within the investment bond are taxed inside the investment bond at a maximum of 30 per cent and do not need to be included in an investor's tax return. Any franking credits earned by the investments can be used by the manager of the investment bond to offset tax paid within the investment bond.
• Simplicity and liquidity: There is no preservation of funds. The investor does not need to include earnings on a tax return unless a withdrawal is made. Funds withdrawn prior to the 10th anniversary will have earnings assessable to the investor but with a 30 per cent tax credit. Funds withdrawn after the 10th anniversary are generally non-assessable in their entirety.
• Choice: There is generally a range of investment options/asset classes to choose from.
• Flexibility: The investor can switch investments within the investment bond without triggering a personal capital gains tax liability.
• Estate planning: Death benefits can be paid to beneficiaries tax free, and, unlike superannuation, irrespective of whether the beneficiaries are dependent or non-dependent. In most cases, the death benefits are not subject to probate and do not form part of the deceased's estate. In the case of the Lifeplan NextGen Investments bond, a Wealth Preserver feature can even be activated to pay a deferred lump sum, an income-stream or a mix of both to any of the beneficiaries. This option may be advantageous with beneficiaries that are spendthrifts, or the financially vulnerable who may potentially be preyed upon.
It is not a set-and-forget process. In effect, the investment bond is phase one of Duncan's retirement. When Duncan reaches preservation age, superannuation becomes phase two.
At this later date, a further strategy may be to withdraw the remaining balance from the investment bond (particularly as it has passed its 10th anniversary and withdrawals are now non-assessable), and top up his own or his spouse's superannuation.
An investment bond is far from a panacea or magic bullet for everyone's investment needs.
Nor does it replace common sense basic financial planning principles.
Used appropriately, it is an investment that can offer significant value for investors who are looking to accumulate wealth outside the superannuation environment and perhaps help guard against superannuation's constant legislative tinkering.
Greg Bird is the national business development manager at Lifeplan Funds Management.
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