Summary of key findings:

• The proposed changes to franking credit rules, if legislated, will have a minimal influence on Australian share market volatility.
• Investor impacts will vary, with Self Managed Super Fund (SMSF) investors in the tax-free retirement phase the most impacted. The loss of value will be most pronounced for those individuals not paying tax, and who are ineligible to receive the Age Pension.
• Superannuation investors holding diversified portfolios in accumulation phase will be little affected.
• If the proposed changes are passed, impacted clients can review investment strategies, improve portfolio diversification and focus on the total return of their portfolios, rather than relying solely on Australian share income returns to meet goals in the future.

Background

The changes to franking credits proposed by the Labor government have escalated as a prime cause for concern among Australian investors. This update addresses the likelihood of the changes coming into effect, and if passed, the implications for Australian savers and retirees, both in terms of impacts to market volatility, as well as portfolio strategy.

At this point, a few days out from a federal election, there is no guarantee that Labor will win government, though current polls indicate a likely victory which elevates the franking credit discussion to something more than just an academic exercise.

Should Labor win government, the Bill would also need to be passed into law. While a minority Senate may present some challenges, the clear policy stance presented by the Labor Party would create a reasonably strong mandate for the Senate to enact the changes into law.

1. Labor’s current proposal

The Labor Party is proposing to roll back the treatment of franking credits to the rule that was in place prior to July 1 2000, making franking credits non-refundable. This would mean that investors on a low tax rate, or non-tax payers, may lose part or all of the franking credits. To protect low income earners, an exemption for individuals eligible for certain government support programs such as the Age Pension, Newstart and others has been proposed. Other exemptions apply, such as for SMSF’s where at least one member was a recipient of a government pension or allowance at 28 March 2019.

In order for individuals to continue to benefit from the full value of the franking credits received, the level of taxable income would need to equal or exceed the value of franking credits. Any excess franking, which would currently result in a refund from the Australian Tax Office, would be foregone.

2. The impacts of the change are not borne equally

Franking credits are intended to have the effect of removing double taxation on company earnings. At present franking credits are earned when an Australian company generates earnings from its Australian operations and has paid tax on those earnings. For ease of explanation in this update we have assumed that the Australian company tax rate is 30%. For investors with an income tax liability that exceeds the value of the franking credits received, there will be no lost benefit. For investors with a tax liability that is less than the value of franking credits held, a portion of the benefit will be foregone.

The loss of value will be most pronounced for those individuals not paying tax, and who are ineligible to receive the Age Pension.

An interpretation of lost benefit cannot be derived by simply comparing an individual’s marginal tax rate with the company tax rate. For example, it would be false to assume that in all cases an individual with superannuation in the accumulation phase, during which time a tax rate of 15% applies, would lose half of the benefit. There are scenarios where this might be the case, however, the franking credits offset the individual’s income tax liability regardless of whether the tax liability is the result of income and capital gains generated from holdings in Australian shares or other parts of the portfolio.

Consider the following example: An individual holds an accumulation phase superannuation account invested across a mix of Australian shares, global shares and bonds. If we assume a 70% allocation to shares and a 30% allocation to bonds, and within the allocation to shares we assume 50% is held in Australian shares and 50% in global shares. Within the Australian shares allocation not all locally domiciled companies generate earnings from Australian operations, and not all earnings have had tax paid. The “franking level” of dividends paid by listed Australian companies is approximately 70%.

Taking the income yield from shares and bonds for the 2018 financial year would result in a yield of 2.5% on bonds, 4.3% on Australian shares (pre-franking) and 2.7% on global shares. The portfolio yield is 3.2%, which creates a tax liability of 0.48%. The value of the franking credits at the portfolio level equate to 0.45% resulting in a tax liability of just 0.03% of the value of the portfolio. Therefore, for superannuation investors in the accumulation phase, who are holding a well-diversified portfolio, there is little to worry about. The assumption that half the current value of franking credits could be lost, is ill-considered.

However, for self-funded retirees paying zero tax, the impact of the changes is more pronounced, with the value of the franking credits foregone, resulting in a loss of approximately 0.45% of portfolio value annually under the scenario of an investor with 70% growth assets and 50% Australian equity home bias. The impact would be even higher in the case of a less diversified portfolio with a higher exposure to Australian equities. For a retiree holding their entire portfolio in fully franked financials stocks, the impact, based on a pre-tax yield of 5.6% and a franking level of 100%, could be as much as 2.4% in lost franking credits. This extreme example also serves to highlight another important point, regarding the unintended risks stemming from highly concentrated portfolio positions.

Labor’s proposal also creates a potential inequity in the impact of the change between pensions taken from SMSF’s versus from large pooled funds. This stems from the ability of larger funds to still give their (tax-exempt) pensioners the benefit of franking credit refunds via their unit price returns because tax is levied at the total fund level, not the particular product or member level. The extent of this disparity remains to be seen and may be subject to each fund’s pricing policy and the makeup of their member base between accumulation and post-retirement members.

3. Addressing concerns for Fintech clients

The proposed changes have generated some common questions from our clients which are worth addressing. For example:

• Should Fintech’s Investment Management Committee substitute Australian shares for other high yielding assets to make up for the loss of franking credits?
• Will the change to franking credit rules result in heightened share market volatility?

a. Substituting Australian shares for other high yielding assets

The question of what can be done to “make up” the loss of yield from a change to the franking credit rules raises a broader question about the investment strategy being pursued and the goal that the strategy has been designed to support. Often, this question is attached to an income-oriented investment approach, whereby an investor seeks to meet their spending requirements from the natural yield of an Australian equity portfolio.

This behavioural tendency is understandable considering many investors spend their working lives trying to achieve a “savings target” that will support their goals in retirement. As a result, once retired, investors are often psychologically averse to spending from the portfolio in an amount that would make their balance drop. Understandably, the result is that many retirees are drawn toward an income-focused approach without realising the possible negative implications.

An excessive emphasis on yield can result in unintended risks. This could result from substituting investment grade bonds for high yield credit, or, sacrificing broad diversification for allocations to single countries, sectors or even stocks in a desire to chase yield.

A further consequence is that an income-oriented approach pays too little attention to the capital base, which can result in the portfolio being eroded by inflation and failing to last the duration, or that a retiree underspends from their portfolio and lives an unnecessarily frugal retirement.

Instead of constructing the portfolio to only align income yield with spending requirements, a total return approach aligns the portfolio’s asset allocation with the investor’s Investment Risk Profile and spending goals. This is the approach recommends to keep clients portfolio well diversified across asset classes and focused on the overall, or total, return. Where the need for additional income occurs over and above the yield generated by this broadly diversified portfolio, the investor spends the amount made from the overall portfolio, or the total return, rather than switching around holdings to generate additional yield.

b. Implications for share market volatility

A further concern voiced by investors is whether the change to franking credit rules could contribute to share market volatility as investors re-price the value of Australian equities under a new set of rules.

While impossible to reliably quantify, the changes to franking credit rules are likely to have a modest impact on share market volatility. Removing the franking credit refund will have a minimal impact on most investors. The key impact will be on zero tax paying investors who are not subject to the exemption. Larger superannuation funds will continue to receive a portion of the franking credit refund, which will vary depending on the level of tax paid relative to the value of the fund’s franking credits. Generally speaking, funds with concentrated exposures to Australian shares will have more franking credits in proportion to their overall tax liability and will be at greater risk of losing a portion of the benefit. This will likely lead to some re-weighting to other asset classes to balance out the level of franking with the tax liabilities of the fund.

As is often the case though, equity valuations, macroeconomic and geopolitical events both locally and globally are likely to have an outsized impact on share-market volatility compared to the changes to franking credit rules.

4. What will Fintech do?

The low likelihood of a serious market correction as a direct result of what is still just a proposal, means that Fintech sees no need to rush a decision to change portfolio settings and incur unnecessary transaction costs.

If Labor win the election and the changes are legislated, revisiting goals and personal circumstances to judge the effect of the change is a critical first step. It is important that Fintech clients understand, and not overstate, the potential impact. For clients invested in Fintech’s well-diversified portfolios in the accumulation phase, or for savings outside the superannuation system, it is likely that the overall impact on your investment strategy will be negligible.

For self-funded retirees paying zero tax, the implications for portfolio positioning will depend on the starting point. For client’s holding portfolios with concentrated exposures to Australian equities, the opportunity exists to review their goals and improve the mix of diversification.

By focusing on the entire return earned by the portfolio, rather than just the income yield, a total return approach maintains your portfolio’s diversification and allows for better alignment with investment goals. It also provides more control over the size and frequency of withdrawals.

To discuss any of the above further in relation to your specific circumstances, contact Grant Chapman on telephone (07) 3252 7665.