Large superannuation funds are not the only ones celebrating average double-digit investment returns in 2017. The Australian Taxation Office (ATO) also benefits from the fact superannuation funds must pay a share of their investment earnings to the tax office.
Around the world, other pension funds can focus on pre-tax outcomes, given their tax-exempt status. Not so Australia, so it is strange many Australian funds persist in designing, managing and assessing their portfolio outcomes in pre-tax terms.
Evidence of the value of tax efficiency in equity portfolios in improving after-tax returns to superannuation funds has been mounting (our published research shows roughly 50 to 90 basis points extra are possible per year, pre-fees, on top of equity market returns and manager alpha).
A best-practice fiduciary will recognise the member as an important stakeholder in how the fund discharges its obligations to the ATO. Funds indifferent to the tax impact of their investment strategies, or overly cautious, are creating an ATO win at the expense of their members.
After-tax investing is just ‘fool’s gold’ if the portfolio-level benefits don’t translate to superannuation fund members being better off
One question raised is whether after-tax investing benefits truly flow through to superannuation members’ accounts. A superannuation member does not invest directly into an equity portfolio, but contributes to a superannuation fund that pools the member’s contributions with those of other members to create a fund-level equity portfolio.
Each member’s interest is usually tracked by allocating units in this fund-level portfolio, valued using unit pricing rules. Unit pricing rules require accrued (future) taxes to be deducted from member accounts.
If a tax-efficient portfolio is just deferring taxes, a member must effectively pay them anyway before they can access their retirement savings. After-tax investing is just ‘fool’s gold’ if the portfolio-level benefits don’t translate to superannuation fund members being better off.
To answer this question, we created three hypothetical superannuation members of two funds with equity portfolios. The funds and portfolios were identical except that one was pre-tax focused (tax naïve), while the other was tax efficient.
The portfolios were compared over 40 years, covering members’ accumulation (30 years) and pension (10 years) phases. Importantly, we tracked fund outcomes not only at the portfolio level, but also at the member unit pricing level after accounting for deferred taxes.
By the end of the accumulation phase (just before the first member retired and began drawing a pension), the tax-efficient fund was 4.69 per cent larger than the tax-naive fund. As fund members entered retirement one by one, this difference continued to grow. At its peak, the tax-efficient fund was 7.20 per cent larger than the tax-naïve fund, even after setting aside future taxes accruing to the ATO.
At member level, these differences – solely due to tax efficiency in one superannuation fund’s equity portfolio – equated to around $60,000 to $70,000 extra in each member’s account before retirement. By the end of retirement (as the hypothetical members one by one exited the fund), each member had almost $200,000 more to help with retirement through their investment horizon with the fund.
For those who understand how tax-aware managers approach equity investing, these differences are unsurprising. One reason is that tax efficiency represents a mix of permanent and timing tax benefits; for example, when a manager generates a ‘long’ gain taxed to a superannuation fund at 10 per cent rather than a ‘short’ gain taxed at 15 per cent, the 5 per cent difference does not get clawed back in a deferred tax provision in member-level unit prices.
Australian equity strategies that prevent loss of, or have properties that tilt towards, franking credits also create tax benefits that are permanent, rather than timing, in nature. Another reason members themselves benefit from being tax-efficient inside a superannuation fund equity portfolio is that accrued taxes do not have to be withdrawn from the portfolio until they become due (or current).
Future tax liabilities do immediately reduce the value of a member’s account, but they do not reduce the value of the invested portfolio
Future tax liabilities do immediately reduce the value of a member’s account, but they do not reduce the value of the invested portfolio. This acts like a 0 per cent interest rate loan from the ATO – the portfolio can earn returns on the loan principal while ever the taxes remain deferred rather than due. Those extra compounding returns flow directly through to superannuation fund members.
With these findings, superannuation funds can dismiss concerns that after-tax investing is like fool’s gold. Rather, it is a genuine lever – hardly exploited to date – to be used in portfolios to grow retirement savings for members.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.