Franking credit refunds enhancing risk

Franking credit refunds discourage diversification in SMSF investment strategies, putting retirement savings at risk, according to a Labor MP.

The only fully refundable imputation system in the world encourages investors to be overweight Australian shares, meaning they have not adequately spread their risk.

When quizzed about their approach to the diversification of their retirement savings, one retiree I spoke with said: “Oh yes, I’m diversified. I’ve got all four of the big banks and some of the regional banks too in my SMSF!”

That is, their franking refund-fuelled SMSF investment strategy is focused purely on one asset class, within one sector of that market and in an extremely concentrated portfolio of less than 10 holdings.

It’s the result of a tax payer-backed refund incentive that ultimately distorts investment decisions and sees the vast majority of Australians underwrite a risky strategy of a mostly wealthy minority.

Too many Australians are putting their retirement nest eggs in the franking refund basket.

This is why we’ve seen the initial cost to the taxpayer of refunding dividend imputation credits blow out from an initial $500 million a year during the early 2000s to nearly $6 billion today.

As the Grattan Institute has highlighted, while the wealth of older generations has jumped in line with asset prices, the share of senior Australians who pay income tax has nearly halved – from 27 per cent to 16 per cent – in the past two decades.

Many more Australians, particularly in an environment of historically low interest rates, are clearly making investment decisions solely on the incentives of franking credit cash refunds.

It’s little wonder the franking refunds strategy – one among many other approaches to generating either income and/or capital gains – has become such a crowded trade in the SMSF space.

But shouldn’t investors make economic decisions because of economic fundamentals, not because of favourable tax treatment?

That was the clear lesson for the taxpayer and investors stung by the collapse of agribusiness Managed Investment Schemes, backed by generous tax breaks.

The franking refunds-focused strategy often limits the investor’s ‘universe’ set to high-yielding, domestically facing businesses, including banks, telecommunication providers and retailers, many of which are facing challenging headwinds.

Mark Draper of GEM Capital Financial Advice also argues the incentives provided by franking refunds mean investors deny themselves the opportunity to invest in some of Australia’s best companies that derive income from offshore.

Andrew Ainsworth and Graham Partington of the University of Sydney and the Centre for International Finance and Regulation’s Geoff Warren have said “the degree of home bias among Australian investors does not seem untoward, except perhaps in the SMSF sector”.

The SMSF Association’s own report has warned about a lack of diversification among many SMSFs.

“Many investment specialists recognise that even a portfolio containing 30 stocks may not provide sufficient diversification, and there is strong consensus that managed funds help form the building blocks of a diversified portfolio,” it says.

Further analysis by Credit Suisse Private Bank found a diversified portfolio of bonds, Australian and international equities, hedge funds and commodities outperformed an ASX 200-only portfolio over a 10-year period.

And in the case of SMSFs taxed at 15 per cent and with franking credits included in net returns, the annual return is only about 0.56 per cent above a balanced portfolio despite volatility more than 2.5 times higher.

That is, a lot more volatility and potential risk for only a slightly higher return – it’s a gamble that’s underwritten by the taxpayer.

Australian investors’ reliance on franking refunds is also a handbrake on Australian companies and our listed equity markets.

The vast majority of countries don’t have any dividend imputation, let alone refundability, and their stock markets do just fine.

Of course, the Australian stock market more than doubled between 1987 and 2000 when cash refunds weren’t part of the dividend imputation system.

And as economist Stephen Koukoulas pointed out during his recent evidence to the House of Representatives Standing Committee on Economics inquiry into Labor’s policy, the over-reliance on franking credit refunds is one reason why the Australian stock market is still 15 per cent below the 2007 peak, while the United States, German and Canadian stock markets are substantially higher.

When the United Kingdom unwound refundability, it resulted in little impact on the price of UK equities.

Leverage is also a concern in the SMSF sector, with the ATO joining other regulators by sounding the alarm for the borrowing arrangements that have hit $42 billion in loans.

The surge in property speculation by leveraged SMSFs combined with falling house prices presents another potential risk to the sector.

Should retirees really be punting their life savings on just a handful of stocks and/or a single property?

Of course not.

The problem of a tax system encouraging more risky investment strategies is that more Australians could lose their savings and end up on the age pension.

The Liberal Party has continued to recklessly ignore the financial stability risks associated with Australia having the second-highest household debt in the OECD for years now.

That’s why Labor has proposed banning limited recourse borrowing arrangements if it wins office.

Only Labor wants to move the Australian tax system away from one that distorts investment to one that encourages diversification and which will ultimately benefit savers.


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