Richard Oldcorn discusses the use of the optimisation strategy, which is somewhat neglected by financial planners.
The other day a client asked me how much he should claim as a concessional contribution from the $50,000 he had contributed last financial year as a non-concessional contribution.
He wanted to pay the least total tax in terms of his Pay As You Go (PAYG) and the tax on the concessional contribution.
The only way I could see to do the calculation was to use an optimisation technique — a powerful and useful tool that doesn’t get much press.
Optimisation is about allocating resources to produce a result that cannot be bettered. In financial planning terms, this usually means paying the least tax and getting the most government benefits over the term of the plan. Perhaps it’s easier to look at a simple case.
Jack earns $60,000 and his wife Jill earns $40,000; they have won $1 million on Who Wants To Be A Millionaire?; and they both have cash management accounts (CMAs) — one in Jack’s name and the other in Jill’s.
So how should the $1 million be allocated between their two CMAs so in 10 years they have paid the minimum possible tax and the $1 million has grown the maximum possible amount?
The $1 million could be split between their accounts at least a million different ways. But which ratio is the best?
One way of finding out is simply trying different combinations. But if each solution requires different amounts to be inputted into a financial planning program, this process could take a very long time.
However, computers are perfectly happy mindlessly crunching millions of calculations, which is exactly what optimisation programs do.
With the first approach, the planner has to feed different allocations repeatedly into the computer, and then compare each result with the previous one.
With optimisation, the answer required is inputted (in this case the most money after tax in 10 years), and the computer simply works out the allocation between Jack and Jill to produce the optimised answer.
Since Jack already earns more than Jill, it will be tax inefficient to put all the money in his account. Putting all the money with Jill will be better initially, but fairly quickly she will end up paying more tax than Jack.
A 50:50 split might appear to be sensible, and a more thoughtful planner might suggest $400,000 to Jack and $600,000 to Jill so as to compensate for their respective incomes. But you should always be suspicious of all those zeroes!
In fact, the optimised solution over 10 years, at an interest rate of 4.75 per cent, requires that $669,110 is placed in Jill’s account, and $330,890 in Jack’s. This is impossible to calculate without optimisation software.
Returning to the initial tax query, the client was a 73-year-old, single, self-employed male. His financial details are outlined below.
FY 2008-09
- self-employed income — $63,441;
- bank interest — $2,747;
- UK pension — $8,819;
- German pension — $335;
- total income — $75,342.
Deductions
- depreciation $708;
- work related tax deductible expenses — $22,060;
- medical expenses — $3,441;
- non-concessional super contribution (2008-09) — $50,000.
He wanted to know:
- How much of the $50,000 should be concessional?
- How much PAYG (including Medicare) is paid?
- How much tax on the super is paid?
- The amount of any co-contribution.
As an experiment, I sent this information to two accountants, a planner using Midwinter software, Coin, IRESS (using VisiPlan and X-Plan) and the technical head of one of the major fund managers.
The range of answers was very surprising, with none of them producing an optimal solution.
I’d be interested to know if anyone could improve on $3,230 as the total tax to be paid.
So where else could optimisation be beneficial? Any time assets could be allocated between two or more tax entities.
It’s also useful when allocating money to an individual or their super. Or between a husband and his wife, or between the husband’s super and his wife’s super, or between the couple (non super) and their individual super accounts — to name but a few.
How could you tell whether any plan has been optimised? If any number in the plan has several zeroes after it, you might reasonably assume that it is not the result of optimisation, and it is also reasonable to assume that the planner would not be able to say with any conviction on what basis the number was chosen. Which seems a shame.
Richard Oldcorn is a Sydney financial planner with an abiding interest in optimisation.
