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The surprising tax implications for funds driven by the Early Access to Superannuation scheme

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Posted In: tax and quantitative
Published: 12/08/2020

The Australian Government has extended the Early Access to Superannuation scheme until the end of the year and forecasts suggest Australians will use it to withdraw up to $42bn from their retirement savings. Elly Grace – Client Relationship Manager and Tax SME – outlines some of the investment tax implications that could arise and solutions to manage these outcomes.

Over the past five years, tax-aware investing has – pleasingly for members – gained traction in Australia’s superannuation investment industry.

This has been largely driven by the 2018 Productivity Commission findings noting some funds have made use of after-tax management solutions, as well as APRA’s new dashboard reporting which seeks to compare like options against an after-tax benchmark. The interest shown by investors during the last election campaign regarding potential changes to Australia’s generous imputation regime has also kept after-tax investing firmly in the spotlight.

Whilst there is certainly an appreciation within the investment community that tax is an outflow that impacts member returns, what many may not have explored is how these tax outcomes can be optimised. And it is precisely this – the “where and how do we start?” aspect of tax-aware investing – which may be the reason why it remains a relatively underappreciated strategy within the APRA-regulated superannuation sector.  Yet now, more than ever, is the perfect environment to embark on this journey and for the results of this strategy to shine.

Why tax matters even more right now

Managing investment tax outflows is particularly crucial during periods of high trading activity such as those experienced over the past six months. Market fluctuations which have resulted from unprecedented member switching and significant withdrawals under the Early Access to Superannuation scheme, which to date more than 2.6 million Australians have applied for.
Whilst the industry has done a remarkable job in rising to this liquidity challenge, as funds reflect on the operational consequences of their efforts, the tax implications are certainly worth consideration. This includes analysis of the capital gains tax impacts of increased portfolio turnover, as well as the higher levels of lost franking credits which transpired, both of which directly impact the returns credited to members that remain in the system.

As funds look further into the future, a factor also worthy of consideration is that Australian corporates are likely to derive reduced profits, and as a result will pay out fewer franking credits. With these tax benefits becoming scarcer and even more prized, now is the time for funds to work closely with their investment managers and provide them with the tools and incentives to ensure they do not inadvertently lose these tax benefits which can significantly add to member returns.

The benefit of starting now

The Productivity Commission report noted that tax-aware investing could increase returns by up to 5.4% over a member’s working life.
In times of volatile and low returns it is even more important to ensure members are not being negatively impacted by the tax consequences that can arise when assets are sold. As such, there is no better time than now to commence an after-tax investing strategy. A strategy that will show your commitment to striving for the best outcomes for accumulation members that have been fortunate enough to remain in the system, as well as ensuring your pension members don’t lose their entitlement to tax-free Australian income.

There are a number of ways a tax-aware investing strategy can be implemented. By far the simplest, least intrusive and quickest to implement from an investment operations perspective is through:

  1. The use of tax data which is queried on a pre-trade basis as part of a trading decision; and
  2. The implementation of after-tax benchmarks and analytics to measure and remunerate investment manager performance.

Optimising on a pre-trade basis

Investment managers can implement technology that queries their proposed trades from a ‘tax outcomes’ perspective across a fund’s entire book. This arms them with all the information they need to execute a tax-aware investing strategy. Such tools enable them to:

  • Assess whether they should hold onto a parcel of assets for a longer period of time in order to secure a discount capital gain (taxable at 10% rather than 15%); and
  • Ensure they understand any potential franking credit benefits they may be giving up as a result of trading Australian Equities that distributed a franked dividend within the 45 days prior.

Managers can use this information at the point of portfolio construction or trading to help to secure the most optimal tax position on their trades. But it is your fund as the taxpayer that must drive this focus for your members by requiring managers to use these solutions.

Automated pre-trade tax solutions and calculation engines have developed considerably since their introduction over 10 years ago and are now part of the daily investment process of many managers. They also improve operational efficiency, replacing cumbersome spreadsheets that were previously required to be updated daily from custodian data to be of value.

From the fund perspective, pre-trade tax solutions provide your internal teams and trustees with valuable insight into your managers’ thinking around the tax consequences of their trading activities. Also they create a clear audit trail and proof that tax is being considered as part of the investment process, in line with the SIS requirements.

Giving managers the technology to manage tax outcomes has the added benefit of enabling you to set up after-tax benchmarks, measuring manager’s after-tax performance to see the real value they are adding to member returns by adopting this strategy.

Benchmarking and measuring after-tax performance

If your fund wants to ensure your managers’ interests are truly in line with your members, domestic and global after-tax benchmarks can be extremely valuable. Well understood by the regulator, after-tax benchmarks are used by APRA in their product dashboard, so it makes sense for funds to move to use the same comparative tools.

There are various versions of an after-tax benchmark, ranging from:

  • A grossed up franking credit benchmark which captures the tax impact of franking credits;
  • Fully replicating, pre liquidated benchmarks that also capture realised tax consequences; and
  • Fully replicating, post liquidated benchmarks that capture both the realised and unrealised tax outcomes.

Implementing after-tax benchmarks is a great step towards focusing on the uplift that can be obtained from tax-aware decision making.

Following this up with after-tax analytics and performance reporting on a specific portfolio or mandate can then further help highlight to managers exactly where and why tax leakage occurred.

Driving positive performance

The Early Access to Superannuation scheme will continue to create market volatility for some time, and even after it ends, many funds are anticipating further economic challenges including lower investment returns and fewer franked dividend payments. Now therefore is a perfect time to consider where you are at in your after-tax journey and review the tools and strategies available.

We encourage you to lead the pack by showing your understanding of this complex area, appreciating the value of the tax concessions afforded to our world-leading and envied superannuation industry, and doing all that you can to maximise the returns credited to your members now, and in the future.

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