To what extent should the principal of diversification apply to legislative risk, especially in regard to superannuation?
As a hypothetical case, would it change the advice planners give if it was known that the rules on allocated pensions were to be changed so that commutations were taxed as income; and all rebates applying to their income were removed?
In 1982 the maximum taxes on superannuation were nil on contributions, nil on earnings and marginal tax rates applied to five per cent of the end benefit.
Today, superannuation is taxed 30 per cent on contributions, 15 per cent on earnings and 48.5 per cent on end benefits.
The net effect of these changes has been substantial. Under the current rules, individuals in surcharge/excess benefit territory, whose employers contribute an additional $10,000 a year for 20 years, will receive a net tax lump sum of $154,434 (at eight per cent growth before earnings tax).
Under the rules which applied in 1982, the same contributions would have resulted in a net $494,229. This is a reduction in the end benefit of 69 per cent, if the money is fully cashed out.
The demonstrated trend to increase tax is likely to continue. The ageing population will be the great demographic event of the next half-century.
The number of people retiring will greatly exceed the number of people entering the workforce. There will be too few workers and too many government benefit recipients. It is self-evident that the taxation base must be broadened. GST is one step to address this, by making retirees pay some tax. How might this affect superannuation?
Super is compulsory and recipients of benefits are being encouraged/coerced into income streams.
Today these income streams offer attractive tax rebates. One possible method of drawing the growing number of retirees back into the tax net would be to remove or reduce these tax benefits.
This might be accompanied by a punitive tax on commutations to prevent a tax-driven exodus. Government has constantly encouraged income streams as a way of ensuring self-sufficiency in retirement, and is unlikely to allow a massive and lowly taxed exodus from these.
There is a precedent for reducing the tax benefits of retirement income streams with the reduction in the tax-free amount that took effect on the start of the financial year in 1994.
There is also precedent for an erosion of commutation conditions. In 1995, the Tax Office stated its intention (ultimately not implemented) to treat all commutations, up to the maximum annual pension amount, as income rather than an eligible termination payment (ETP).
In 1994, the Senate Select Committee on Superannuation’s paper explored a range of “taxation alternatives for commutations”, including a sliding scale of tax, taxing gains as income, limiting the value or number of commutations, or creating a non-commutable category of allocated pension.
These certainly establish a willingness to erode commutation conditions.
The Government’s preference for non-commutable products is clearly highlighted by the fact that these products qualify for a higher pension reasonable benefit limit (RBL).
An alternative area of possible tax encroachment is the current tax-free status of earnings within pension-paying funds.
What form the tax encroachment might take is guesswork but, in Canberra, the question has been asked: “If superannuation is compulsory, why does it need any tax benefits?”
No comfort should be taken in a hope that changes would always exempt pre-existing assets to avoid the suggestion of retrospectivity. The October 1995 announcement that commutations would be partly taxed as income was to apply on existing assets.
The imposition of a 15 per cent tax on earnings in accumulation mode applied to all in-place benefits, not merely new contributions.
Last year there was an attempt to impose a capital gains tax on the movement from accumulation mode to pension-paying mode, which applied to existing assets, not merely future assets.
It is simply na•ve, and ignores precedent, to believe that government will not do what is necessary to protect its revenue based on a commitment to avoiding changing the rules that applied when an investment was first acquired.
If there is a material prospect of the benefits of superannuation being eroded, should this not raise questions about the wisdom of investors having the bulk of their net worth within the superannuation environment? Should advisers diversify outside superannuation to gain protection against the risk of legislative change on the same grounds as one might diversify outside property or the stockmarket to protect against the risks inherent in them?
I would argue for the principle of ensuring adequate funds are kept outside the superannuation system to meet any anticipated needs for free capital, as a bare minimum. As the first portion of post 1983 benefits can be withdrawn tax-free after 55, there may be no initial tax hurdle for this.
Yet many planners encourage clients to have close to 100 per cent of their investment assets in superannuation, i.e. their whole net worth, subject to future legislative changes.
I certainly am not arguing against super having a significant place in most portfolios, but simply that there are risks if that place is excessive. Surely it is appropriate to highlight to clients that their benefits might not be able to be so freely accessed or lightly taxed in the future, i.e. that their future flexibility might be reduced.
This gives a disclosure of risk which is fair to clients and is sound liability management for advisers.
One of the truisms of financial planning is that tax considerations should not dominate portfolio construction. Unfortunately this principle is sometimes forgotten in an exclusive focussing on the deferral of ETP tax.
Are there risks to the tax status of retirement income streams? The ageing population will have to pay more tax to help the country balance its books. Where will it come from?
Rob Keavney is managing director of Investor Security Group (ISG).
