Prize fight: gearing versus super

Andrew Lowe

The Government’s proposed simplification of superannuation measures stand to increase the attractiveness of superannuation as a structure for accumulating assets for retirement relative to other structures.

It is clear that when comparing investments held in a client’s individual name versus those held in super, that at marginal tax rates of 16.5 per cent and above, the superannuation structure holds the upper hand.

However, some clients saving for retirement are prepared to leverage their investments via a gearing strategy for the purpose of accelerating their savings. This is generally easier to achieve via non-superannuation-held assets. Borrowing introduces the potential for higher returns but brings with it a higher degree of volatility.

So, while acknowledging that we are not comparing like with like, how does superannuation (non-leveraged) stack up against a geared non-superannuation investment?

The analysis

The results of a comparison between two significantly different alternatives are highly dependent upon both the variables chosen and the output measured.

In this analysis, we have sought to ensure that the net annual costs of investment are equalised and have the results measured by the sum of the net accumulated benefits.

This analysis, therefore, ignores the increased potential investment risk and volatility borne by the geared investor.

Analysis assumptions:

Geared investments

~ Client is on the 41.5 per cent marginal tax rate.

~ Client borrows $100,000 on an interest-only basis at a 7.5 per cent per annum interest rate.

~ Interest expense is tax deductible.

~ $100,000 (100 per cent loan to value ratio [LVR]) is invested into an Australian share portfolio returning 3 per cent per annum income (25 per cent franked) and 6 per cent per annum capital growth (unless otherwise stated).

~ Investments are held for at least 12 months before disposal (50 per cent capital gains tax (CGT) discount applies).

~ All taxes are considered.

Superannuation investment

The after-tax annual cost of the geared investment alternative is grossed up (at the 41.5 per cent marginal tax rate) and contributed to superannuation on a pre-tax basis (via either salary sacrifice contributions or deductible personal superannuation contributions).

In scenario one for example, the year one contribution to superannuation is $4,179 and decreases to $1,889 by year 10.

Fifteen per cent contributions tax applies to taxable contributions.

A superannuation fund invests into an Australian share portfolio returning 3 per cent per annum income (25 per cent franked) and 6 per cent per annum capital growth (unless otherwise stated).

Investments are held for at least 12 months before disposal (one-third CGT discount applies).

Benefits are received tax-free at retirement after age 60.

The results

The results of this modelling are shown in graphs 1, 2 and 3. The graphs reveal the net value of investments after all taxes over holding periods of one to 10 years.

Scenario one

Over the 10-year investment period under the stated assumptions, we see the geared investment produce a significantly (34.6 per cent) higher net benefit than the superannuation investments.

In this analysis, the longer the period of investment, the greater the advantage to the geared investments.

In summary, in an environment where a client can borrow at (a tax-deductible) 7.5 per cent per annum to invest in assets producing 9 per cent per annum, having more capital exposed to these returns makes some sense.

While the gearing alternative is attractive, the net return of the superannuation investments has increased because of the abolition of tax on end benefits — the Government’s changes to superannuation have closed the gap in this comparison (see graph 1 in Money Management Magazine May 3, 2007 page 22 ).

Scenario two

In this scenario all variables are maintained, but the investment return in year five is minus 10 per cent for both the geared and superannuation investments.

The net benefit of each alternative is reduced relative to scenario one, not surprisingly, but the interesting result is the change in the superior strategy.

Over the 10-year investment period under the stated assumptions, we see the superannuation investments produce a 23.9 per cent higher net benefit than the geared investments.

This result demonstrates the volatility of the geared investments and the impact of negative returns on gearing as a wealth accumulation strategy.

This result is also influenced by an additional factor; a lower account balance in the years following the negative return produces less investment income and increases the net cost of the investment in these years. This means that a larger amount is invested in pre-tax dollars into superannuation in these years (see graph 2 Money Management Magazine May 3, 2007 page 23).

Scenario three

In this scenario all variables are maintained, but the investment return in year one is minus 10 per cent for both the geared and superannuation investments. This exaggerates the effects shown in scenario two, with a larger amount invested in pre-tax dollars into superannuation in every year than in scenario one.

Over the 10-year investment period under the stated assumptions, we see the superannuation investment produce a 46.5 per cent higher net benefit than the geared investments (see graph 3 Money Management Magazine May 3, 2007 page 23).

Alternatives

A less aggressive gearing strategy (with a LVR of less than 100 per cent or an instalment gearing strategy, for example) will moderate the returns of the geared investments.

While such an alternative would have reduced the risk of the geared investments, it would have taken away some of the upside from this strategy.

With the advent of widely held geared share funds in recent years, the leveraging-up of superannuation assets has become possible.

Many superannuation platforms make such options (such as the OptiMix Geared Australian Share investment option available via ING OneAnswer Personal Super) readily available.

Such an option, when used in this comparison, would bring the results of the two alternatives closer together.

Attractive options

The Government’s changes to superannuation have generally increased its attractiveness as a structure for accumulating wealth.

This has made the comparison of gearing and superannuation closer than ever.

Gearing retains its ability to magnify investment returns and, accordingly, will remain attractive to investors looking for this result and who are prepared to take on the increase in volatility that accompanies this upside.

Superannuation, on the other hand, is an increasingly attractive structure for wealth accumulation, particularly in uncertain investment markets.

Andrew Lowe is manager of technical services at ING Australia .