A retiree with an SMSF portfolio of $1 million in Australian shares may be worse off by around $20,000 if Labor’s franking credit refund proposal is legislated. What if this loss could be avoided while still investing in franked shares ?
In May 2018, I wrote about how SMSF trustees may use public fund ‘direct investment’ (sometimes called ‘member direct’) options to counter Labor’s proposal. Since then, the concept has gathered momentum with other articles on how public funds expect to treat franking. These include ‘How do direct investment options deal with franking credits?’ by AustralianSuper’s Tom Garcia, and ‘On franking, all public funds are not the same’ by Graham Hand.
The question remains, how does a direct investment option work in practice? There are two ways for retirees facing a loss of franking refunds:
- Close their SMSF and invest exclusively through the direct investment option, or
- Hold some assets via a direct investment option while maintaining the more flexible SMSF.
The second option may be popular as it will allow investors to receive franking credits while preserving the flexibility of an SMSF which can hold a greater variety of assets.
Shifting shares into a direct investment option
The best way to explain the process of shifting investments is by an example.
A $1 million SMSF portfolio holding only fully-franked Australian shares yielding 5% within a pension phase fund currently provides the following return:
- Cash dividend: $50,000
- Refundable franking credit: $21,429 ($50,000 x 3/(10-3))
The loss of the $21,429 refund, or 30% of the investment return, will provide impetus for some trustees to transfer to a large fund that offers a direct investment option. How could you do this?
Individual shareholdings cannot be transferred ‘in specie’ to a public fund so you must first sell your shares. The cash is then rolled over to the new public fund.
The money in the public fund is initially held in cash. You then have the option of transferring most of it (usually up to 80%) to a direct investment option. The remaining 20% is left in the fund’s other investment options, and must include a cash allocation to cover items such as fees, insurance or income payments when in pension mode.
Once money is in the direct investment option, you will be able to select investments from a predetermined list. The options are generally limited to:
- ASX 300 companies
- A selection of listed investment companies or trusts
- A selection of exchange traded funds
- Term deposits
I have had first-hand experience with a direct investment platform and have found it user-friendly and similar to trading via an online broker.
I repeat that a maximum of 80% (this may vary by provider) of the balance can be invested in the direct investment option. The rest must be invested in one of the other options offered by the fund such as a balanced option, cash or term deposits. Some SMSF trustees may consider this a drawback of the member direct strategy.
How much does it cost?
Fees should be a major consideration whenever an investment is contemplated. Given that Tom Garcia from AustralianSuper wrote in Cuffelinks exactly how they expect to treat franking credit refunds under Labor, I have used their fee structure in my example. There are many other public fund options – both retail and industry – which should clarify their treatment of franking.
The fees associated with this strategy will include:
Initial advice fee: There is plenty to consider when contemplating a strategy like this and professional financial advice is a must.
Brokerage to sell your portfolio: It will be necessary to sell your portfolio before it is transferred to the new fund. For example, it would cost $1,200 to sell a $1 million portfolio held via Commsec at their brokerage rate of 0.12%. There will also be a period where investments will be ‘out of the market’ during the transfer process. This process may end up taking a couple of weeks.
Brokerage to buy shares within the new fund: The brokerage rate in direct investment options varies from fund to fund. AustralianSuper’s fee is 0.12% for trades over $50,000.
Fee on the 20% investment not in the direct investment option: This fee will vary depending on the investment option chosen. Index options are the least expensive. For example, AustralianSuper’s balanced index fund has an annual fee of 0.16%, while the general balanced fund costs 0.66%.
If the 20% is held in the cash account in the member direct option, it can earn a higher interest rate (cash plus 0.9%) but it incurs a charge of 0.12% on the cash balance.
Annual administration: All large industry funds charge an administration fee which varies from fund to fund. On a $1 million direct investment in AustralianSuper, the annual administration fee would be $867 (an account keeping fee of $117 and an asset-based administration fee of 0.11% capped at $750).
Total costs for a $1 million portfolio
Assuming an online broker is used, the cost to transfer would be:
- Share sale (0.12%): $1,200
- Share purchase in AustralianSuper: $960 (for 80% of portfolio)
- Total upfront cost: $2,160
On top of the brokerage, there may also be a fee payable to a financial adviser for advice on the transfer.
Assuming the balanced index option is chosen for the 20% not invested in the direct investment option, the fees would be:
- Annual administration fee (pension): $867
- Investment fees (balanced index for 20%): $320
- Investment fees (member direct for 80%): $395
- Total ongoing fees (per annum): $1,582
Fee comparison with SMSFs
According to a June 2018 report from ASIC:
“The average annual cost per fund of running an SMSF in 2015–16, in terms of administration and operating expenses, was $3,595 and, for investment expenses, was $4,173.”
That totals $7,768. Clearly, many trustees manage their fund for significantly less. However, the comparison shows that some trustees would pay lower fees in a direct investment option, on top of benefiting from franking refunds (if legislation changes), instead of using an SMSF.
Is a member direct investing option worth considering?
At this stage, we’re jumping the gun. Labor needs to be elected, and then it must obtain Senate support for its proposal, and already, the cross-benches are indicating a lack of support. It is premature to take action now, although it is worth knowing the alternatives.
The cost-effectiveness of this strategy depends upon a host of tax and investment considerations. Notably, SMSFs are far more flexible in the range of investments allowed in member direct. An SMSF would be required for direct property, many small cap stocks, unlisted bonds and more esoteric holdings such as collectibles.
In the example provided, the benefit from using a member direct investment will be at least $20,000 per year, although most franking credit refunds are smaller than this. Such a benefit will be attractive to a retiree who is willing to compromise in terms of how they invest and what they invest in.
(Graham Hand has commented on this article here).
Professional advice is required before contemplating this strategy. This article only scratches the surface of the issues that need to be considered.
Matthew Collins is a Director of Keystone Advice Pty Ltd and specialises in providing superannuation tax, estate tax and structural advice to high net wealth individuals and their families. This article is general information and does not consider the circumstances of any individual investor. It is based on a current understanding of related legislation which may change in future.