The May 2009 budget proposed changes to the treatment of these benefits which is likely to affect both the issuance and immediate implications of employee share schemes in the future.

Currently, as a recipient of shares or options under an employee share scheme , you get the choice on when to pay tax on the benefit you receive. If you do nothing, you will be deemed to defer the tax until a later date (the “cessation time”). Alternatively, you can elect to pay tax on the discounted benefit upfront by making an election in your tax return.

Under the new rules the tax treatment will flow from the structure of the scheme rather than from a choice made by the employee. Based on the terms of most current schemes, many recipients will be required to pay the tax upfront from now on.

While this may seem like bad news, it may not be as bad as you think. In addition, those who received employee shares or options prior to the announcement have a last chance opportunity to exercise their right to make an election that will affect the taxation of these securities.

Employee Share Scheme tax deferral not always a good thing …

The ability to defer tax is an alluring proposition. However, you need to consider the consequences associated with the deferment.

The best way to understand the benefits of an employee share scheme is to consider what you forgo in exchange.

Imagine you are are offered a cash bonus of $100,000. You take the benefit as cash and are left with $53,500 as disposable cash (after PAYG tax). You choose to invest the $53,500 in the shares of your employer.

Now consider an employee share scheme. In this case, instead of the $100,000 bonus, you receive $100,000 worth of your employer’s shares at no cost. Prior to the proposed changes, you could defer the tax on this benefit for up to 10 years and you get almost twice the number of employer shares that you could have voluntarily purchased from the after tax bonus proceeds.

It sounds like a far better proposition, but is it?

Under the employee share scheme you have not eliminated the tax liability, you have simply deferred it. You need to add this liability to the equation.

By accepting the employee share scheme you are effectively investing the deferred tax liability in your employer’s shares. While this may pay off handsomely, many fail to realise that they are contributing some of their own capital to the investment.

Another consideration that is often overlooked is the level of concentration risk you are accumulating in relation to your employer. Becoming increasingly reliant on the prospects of your employer, for both income and investment growth, can be a recipe for disaster.

But, why pay tax upfront when you can defer it?

A consequence of deferring the tax is that any subsequent growth on your investment is taxed at your marginal tax rate. Electing to pay the tax upfront means that future growth can be taxed under the discounted capital gains tax (CGT) regime .

Electing to pay tax upfront can therefore result in lower overall tax.

Generally, as the investment growth rate increases, the benefits of paying tax upfront increase – i.e. the higher the growth rate, the greater the benefit.

If you’re interested in a detailed comparison of deferring tax versus paying tax upfront for both shares and options, please click here.

While on the surface, deferring tax seems like a great option, in some circumstances it may be better to make the election to pay the tax upfront. On this basis, the new rules, which require you to pay tax upfront, may not be as bad as you think.

Immediate opportunities … 2008/09 Employee Share Schemes

Those who received employee shares and/or options during 2008/09 may find that this is their last chance to have a choice over when to pay the tax. If you were fortunate enough to be issued with these securities during the lows of the global financial crisis, you may consider that 2008/09 is a good year to opt for the tax election.

However, there are a number of issues you will need to consider, not least of which is your ability to fund the tax upfront from your own resources. Investing the time in a review of your options may prove to be well worth the effort.

Please be aware that this is a complex area in which you should seek advice from a competent expert.

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Some would want you to believe they can perform the financial equivalent of alchemy. But, realistically, the best a truly competent, professional adviser can offer is to help you develop and effectively use the financial resources or capabilities you already have.

In saying this, we do not want to denigrate the value of good advice. It can be substantial, particularly compared with the damage that can result from poor advice or naïve do-it-yourself wealth management attempts. But the ability to provide that value does depend on having some good raw material to work with.

The inescapable truth is that unless you are born into riches, lucky or successfully take inordinate investment risk (either consciously or unconsciously), you are your primary source of wealth creation.

Your wealth depends on your projected surplus capital …

For most people, the further they are away from planned retirement the more likely it is that their most valuable asset is the ability to generate income from work. Either from their own direct employment or running a business that employs others.

But it is not simply their income that is most important for building wealth. Rather, it is the difference between their after-tax income and the amount they spend. This is free cash flow that can be used to purchase investments or repay borrowings.

An estimate of the lifetime value of free cash flow can be made by summing the best guesses of each year’s free cash flow (in today’s dollars) from now to your proposed retirement age.

We call this amount your “projected surplus capital”. For somebody in their 30’s or 40’s, its value may far exceed existing net investment wealth (i.e. investment and superannuation assets less borrowings).

Consider the simplified, hypothetical example of a recently qualified, 35 year old medical specialist and his family. Currently, their net worth consists entirely of the family residence worth $1.5 million. It is regarded as a lifestyle asset, rather than an investment.

Over the next 25 years to his proposed retirement at age 60, the doctor’s best guesses of the annual averages of the key inputs to the calculation of projected surplus capital are as follows:

1. Gross Practice Fees (p.a.)                        $750,000
2. Practice Expenses                                    ($250,000)
3. Net Practice Income (=(1)-(2))               $500,000
4. Net Tax Payable                                        ($150,000)
5. After Tax Income (=(3)-(4))                      $350,000
6. Spending on Lifestyle                               ($225,000)
7. Free Cash Flow (=(5)-(6)                        $125,000 p.a.

Estimate of Projected Surplus Capital = $125,000 p.a.* 25 years to retirement = $3,125,000.

This projected surplus capital, plus the value of the family residence, is the best guess of the family’s wealth in today’s dollars at the doctor’s age 60. His future wealth depends on him being able to deliver on these free cash flow expectations.

In such circumstances, a good adviser will help ensure, among other things, that:

• the doctor pays no more tax than necessary;

• as capital is realised, it is allocated between lifestyle and investment assets consistent with the family’s objectives;

• an investment strategy is implemented, designed to maximise expected return for risk taken; and

• the family’s desired lifestyle is protected in the event of a major insurable catastrophe.

There also may be valuable advice given about running the business more effectively and / or achieving a better work /life balance. But the focus of the advice is more about managing, protecting and, perhaps, enhancing wealth rather than directly creating it.

Increase projected surplus capital to create wealth …

So if wealth managers and financial planners can’t make you wealthy, what is the “secret” to wealth creation. Please keep it to yourself, but here it is:

“For people in the wealth accumulation stage of their lives, they need to be able to generate free cash flow – essentially, spend less than they earn.”

What an insight! So obvious, a huge percentage of the population misses it entirely.

And, it gets better:

“If you want to increase your wealth, then you need to find ways to increase free cash flow and, thereby, increase projected surplus capital”.

Earth shattering!

But think about it. If our doctor could increase his after-tax income by $25,000 p.a. (i.e. by 7%) and reduce his lifestyle expenditure by $25,000 p.a. (by 11%) free cash flow increases by $50,000 p.a. Projected surplus capital increases by $50,000 p.a. * 25 years = $1,250,000. An effective increase in investment wealth of 40%!

Your investment banker or stock broker will not offer you wealth creation opportunities like that. And with no investment risk and, largely, under the doctor’s control.

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However, with the Australian dollar (AUD) appreciating 36% against the US dollar (USD) and 25% against the Reserve Bank’s trade weighted basket of currencies over the six months to September 2009, we are concerned that some poor decisions are being made in response.

The past six months has seen strong local currency gains in international shares almost completely offset by exchange rate losses when converted to AUD. This has resulted in some investor disenchantment with international shares. The knee jerk reaction has been to either reduce the international share allocation and/or to choose share funds that are protected against exchange rate movements i.e. hedged.

We think a permanent currency hedged exposure to international shares is a better alternative than changing allocations based on what the AUD has done or is expected to do. The latter is not investing – it’s exchange rate speculation.

But for serious long term investors, despite the immediate pain, we encourage you to ignore currency movements and maintain an unhedged allocation to international shares, based on an objective assessment of what is an appropriate long term asset allocation for you. In many cases, a strengthening AUD will imply topping up your international shares’ holding, rather than reducing it, to restore its previously determined weighting.

How do exchange rates affect returns on international shares?

Our view that you should ignore exchange rate movements when investing in international shares is based on the following:

1.    Currencies are not investments. Long term, they have:

• an expected real (after inflation) return of zero; and

• no impact on the expected returns of international shares; and

2.    Protection against currency movements (i.e. hedging) adds to investment costs. While hedging may provide peace of mind, it reduces expected long term after-tax returns.

The first point is a little esoteric, but the following chart supports the argument. It shows the annualised movement in the AUD against the USD (it could have been any currency) for the following rolling periods:

• 12 months;

• 5 years; and

• 20 years

from 30 June 1969 to 30 September 2009.

It shows that over 12 monthly periods (the green line), exchange rate movements are extremely volatile, varying between plus and minus 30% p.a. for the period shown. Such swings can completely swamp local currency returns on international share investments.

For five years periods (the blue line), exchange rate volatility reduces considerably. But it still can massively affect the currency adjusted returns on international investments.

For the five years to July 1986, the AUD fell 12% p.a. against the USD, enhancing the return of US share investments when converted to AUD. Conversely, for the five years to October 2007, the AUD rose 10.7% p.a. against the USD, so that US share investments fared much worse in AUD than in USD terms.

But the key takeaway from the chart is that at 20 years (the red line), volatility largely disappears. For the 20 year periods ending 30 June 1989 to around March 2001, the AUD depreciated at about 2-4% p.a. against the USD. Most recently, no clear direction is evident.

Economists argue that over the long term, exchange rate movements must (largely) reflect actual and expected differences in inflation between countries. The long term AUD/USD exchange rate data shown above provides support for this view.

In the 1970’s and 1980’s, Australia was and was perceived to be a high inflation country, relative to the US, resulting in a depreciating currency. But the past 20-25 years has seen differences in both actual and expected inflation narrow.

If exchange rates did not adjust for inflation differentials between countries, the prices of similar goods and services could vary purely due to inflation differences. But this creates incentives for international trade and exchange rate pressures consistent with restoring relativities. Eventually, either inflation differences will disappear and/or exchange rates must change.

Long term, then, exchange rate movements primarily serve to adjust relative prices between countries. They seem to do a reasonable job despite the fact that, short term, they could do anything. The serious investor understands the role of exchange rates and, accordingly, that currencies are not investments, they do not have expected long term real returns and they have no impact on expected risk adjusted, real returns of international shares.

Hedging your international shares costs real money …

Implied by the above discussion is the view that protecting your international share portfolio against exchange rate movements has no expected long term economic return. But it has certain costs.

At a minimum, there is the management time consumed in implementing the protection. There are also transaction costs in the form of foreign exchange spreads associated with purchasing and regularly rolling over the necessary forward foreign exchange contracts.

And, if your international share portfolio is owned by a tax paying entity, “successful” currency hedging could result in unexpected taxation obligations. When the AUD rises, a profit is made on the foreign exchange protection, equal to the fall in the value of the investment portfolio converted into AUD. This profit is treated as taxable income that cannot be offset by the unrealised loss on the underlying investment.

However, a fully hedged exposure to international shares does provide you with diversification benefits, as discussed in our previous article. If short term exchange rate volatility threatens your resolve to maintain long term investment discipline, perhaps the costs of hedging are worth bearing.

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What you live off when you’re not working …

In our introductory meetings with potential new clients, we want to obtain a preliminary view of their “Net Investment Wealth”. It quickly gives us an idea of how far along the road to financial freedom or financial independence they have come and how far they have to go.

Net investment wealth is your net worth less your lifestyle assets. It’s the stuff available to live off when you are no longer earning income from your work.

To make the concept more concrete, consider Steve and Kate Wilson. Their assets and liabilities are shown below:

The Wilsons, despite a net worth of a little over $2.7 million, have accumulated only $95,000 in net investment wealth! Virtually all their net worth is accounted for by lifestyle assets i.e. their home and cars.

How much do you need for financial freedom?

If the Wilsons are in their late 30’s-early 40’s, and looking to work for another 20 years, a net investment wealth of $95,000 may not be cause for concern. But it is definitely a focus for a meaningful conversation.

However, if they are in their mid to late 50’s and hoping to retire within 10 years, there may be some major issues to confront. Because when the Wilsons retire, it is their net investment wealth and its hopeful growth that will be used to finance their desired lifestyle.

If they tell us that they want to spend around $125,000 p.a. in today’s dollars in retirement, a (very) rough rule of thumb is to multiply this amount by 25 times to obtain an idea of how much net investment wealth is required to support their lifestyle. In this case, required net investment wealth is $3,125,000 (i.e. 25*$125,000). This compares with current net investment wealth of $95,000 – a shortfall of $3,030,000.

What has to happen to accumulate this shortfall?

If the Wilsons are now aged 55 and wish to retire at age 65, assuming investment returns of 4% p.a.(after-tax and inflation) they need to save an average of about $250,000 p.a. in today’s dollars for the next 10 years. They better have a substantial income. However, if they are aged 40 and also wish to retire at age 65, the required saving reduces to about $69,000 p.a.

Such “back of the envelope” calculations will help you to quickly get a good idea what needs to happen for you to achieve your retirement or financial independence goals.

Net Investment Wealth: a “financial independence” indicator

Financial independence, that we equate with financial freedom, is achieved when you have sufficient net investment wealth to support your desired lifestyle, without the need to work. Work is a choice, rather than a necessity.

Your current net investment wealth provides a guide to how far along the financial independence road you have come. Together with other inputs, such as how much you would like to spend when you no longer wish to work, it can provide guidance to how far you have to go.

The simple analysis described above will highlight issues to address to increase the chances that you will achieve the financial future you want, such as:

• Do I need to save more? If so, how much?;
• Do I need to earn more income? If so, how much?;
• Are there structural changes I can make in my financial arrangements to increase my after-tax income and, hence, savings;
• Do I need to work longer? If so, for how long?;
• What sort of investment risk do I need to take to earn higher expected returns and, potentially, accumulate net investment wealth quicker? Am I prepared to take that risk?
• Is there scope to convert lifestyle assets to investment assets e.g. down size the family home?;
• Should I be changing my retirement expectations?

A focus on your net worth or total assets, in isolation, can give a false sense of your options for financial freedom. A heavy bias to lifestyle assets may give the feel and appearance of wealth but it is wealth that is unlikely to be consistent with aspirations for early financial independence.

And if financial independence at a particular age is a goal that is important to you, then knowing your current net investment wealth and having a plan that addresses how you are going to grow it is critical.

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But how helpful is this when investing?

To be a good investor over the long term you need to abide by some intelligent investment rules. Unfortunately, devising the rules is a much tougher act than coming up with forecasts and opinions. Following the rules is even tougher, especially when they may conflict with your forecasts and opinions.

The three golden rules:

1. Never invest until you have an articulated, long term strategy with a clear set of rules for investing;
2. Never disobey the rules;
3. Never ignore the rules. To do so makes them obsolete. Replace them with revised and improved rules, but never ignore them.

While this advice may appear a little trite, it is amazing how many people invest without any long term strategy or rules. We think it’s because:

• It takes time and effort to devise a strategy and rules. Many people just couldn’t be bothered, don’t know where to start or don’t comprehend the lifetime cost of missing this step;
• They are used to things changing so quickly in their life and careers that committing to something long term is seen to have little value;
• Immediate opportunities are given much higher priority than long term strategic decisions. This is driven by the tendency to be distracted by issues that are urgent ahead of those that are important;
• A need to be in control and to control one’s own destiny. This drives a preference for decisions that offer more immediate evidence of success. Opportunism generally wins out over prudence in this battle.

A practical example

Common logic given for the shift from shares to cash throughout 2008 was that share values were falling and cash rates were better. This apparently rational reasoning was given more strength because it was strongly correlated with investors’ emotions at the time.

But how useful is this reactive reasoning in a strategic sense? Could you rely on it for managing your wealth over the long term?

Let’s have a look at the rules that flow from this reasoning:

1. Follow the most recent trend.
2. Sell assets that show poor recent past performance; and
3. Buy assets that show good recent past performance.

That seems relatively clear but it’s not really specific enough. To be a practical set of rules, you need to specify the period that will be used to measure recent past performance. So, for the sake of adding clarity, let’s add a fourth rule:

1. Recent past performance is determined by the return over the past 12 months.

You also need to consider how often you want to trade. If the past 12 month performance of cash and shares fluctuates month by month, then you’d be up for some sizeable trading costs. So, to avoid excessive trading, we’ll add two final rules:

1. Hold each position for a minimum of 3 months; and
2. Only implement decisions after 3 months of confirming past performance.

So, now you have some practical investing rules derived from some commonly accepted reasoning.

Intelligent investment rules

It’s not just a matter of following the rules, you also need an intelligent set of rules.

We tested the above rules, using the two asset classes of cash and Australian shares (S&P/ASX 300 Accum. Index), over a 29 year period. We compared this approach to a more traditional buy and hold approach. We constructed the comparison so that both exposures exhibited the the same level of risk for the tested period, (as determined by the level of volatility).

The results are shown in the graph and table below:

The lifetime cost …

Over the 29 year period, you would have been 40% worse off by implementing the rules based on recent past performance. This loss of wealth has nothing to do with taking more or less risk; it comes down to the application of poor investment rules over a long period of time.

While reasoning and opinion are powerful and emotive drivers, they often lead to investment results that are far from optimal. Actions are generally driven by popularism and emotion.

It’s important not to let the plethora of information and opinion take precedence over the disciplined application of an intelligent investment strategy. Seasoned investors rarely credit their investment success to opportunism or striking it lucky. Rather, it’s about having a smart, long term strategy and sticking to it.

A good adviser can help you build a sound strategy that suits you. They will provide you with an intelligent set of rules (based on rigorous research) and they will help you to implement those rules over time.

The lifetime cost of ignoring the three golden rules can be substantial.

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1. Directly, either as an individual or jointly;
2. In a private investment company;
3. Through their family trust; and / or
4. Via a self managed or public superannuation fund.

Which structure is best? It depends. But given our emphasis on focusing on the things you can control, the structure choice is one that needs serious consideration. There are a number of often competing factors to take into account, with taxation, asset protection and succession / estate planning usually most prominent. This article considers some of the issues.

After-tax, super looks the winner …

Superannuation is, generally, the most tax advantageous structure. To obtain a feel for this, we examined how much an initial $450,000[1] investment would grow over a 15 year period, assuming a 4% p.a. fully franked dividend, 6% p.a. growth and 3% p.a. inflation, for each ownership structure.

The following chart compares the growth paths, end investment values and after tax returns, all after inflation. Below the chart, we have outlined some key assumptions of the analysis.

1. The individual is a top marginal rate taxpayer, currently 46.5% for ordinary income and 24.25% for long term capital gains
2. The company pays tax at 30% on both income and capital gains
3. It is assumed the family trust can distribute dividends to taxpayers with a marginal rate of 16.5% p.a., with a blended capital gains tax rate of 21.5%. Actual rates will depend on the tax status of beneficiaries, but the trust should be structured so a worst case outcome is the same as that for a company.
4. The capital gain in the superannuation scenario is taken in the pension phase, with 0% tax applying.
5. Dividends are re-invested on the same basis as the original investment.

After tax and inflation, the superannuation end period value is almost 38% more than had the investment been owned by an individual! The individual’s investment would have had to grow by 8.6% p.a., rather than 6%, to achieve the same end value.

Given the analysis, why wouldn’t you put everything into super? For a start, because it is so tax effective there are some fairly severe restrictions on how much can be accumulated in this environment.

And for anybody born since 30 June 1964, they cannot get their hands on their super until after age 60. A successful 40 year old, looking to retire at 50 and live off investment income, would need to ensure there was sufficient wealth accumulated outside super to at least bridge the 10 year gap.

Super also has a potential estate planning sting. If your super goes to non dependents on your death, a tax of 16.5% applies!

Tax wise, the family trust also looks an attractive wealth holding structure provided income is distributed to relatively low tax paying beneficiaries. In addition, it has asset protection and estate planning advantages.

The usual family trust structure allows wealth to be owned for the benefit of all family members rather than just the primary wealth generators, even though they may retain significant influence as to how wealth is distributed. This separation of ownership and control to some extent protects the family’s wealth from legal actions against individual beneficiaries.

More importantly for many clients, family trusts have significant estate planning and succession advantages. Unlike super, nothing necessarily needs to happen to trust assets in the event of the death of either or both parents.

As ownership is unaffected by death, there are no forced asset transfers with their potential adverse tax consequences. Trusts therefore provide a mechanism both for tax effective intergenerational transfer of family wealth and for ensuring wealth is retained within the family bloodline on the death of parents.

A company is rarely likely to be a desired structure for holding long term passive wealth. Its limited liability characteristic is more relevant to owning a business, as it restricts the potential loss of owners to the capital they contribute to the company. However, for a family with a very long term view of wealth accumulation and transfer, the unlimited life of a company may hold more appeal than the 80 year limit placed on trusts.

Finally, tax efficiency would appear to rule out direct ownership of long term wealth. But this is not necessarily the case if, for example, tax deductible debt is used to finance wealth accumulation.

Negative gearing by top marginal tax rate paying individuals can be a tax advantageous way to accumulate wealth. And in specific circumstances, negative gearing may provide the opportunity to transfer income from a high tax paying, investment owning individual to a low tax paying entity (e.g. non-working spouse, family trust) without incurring the additional risk normally associated with borrowing.

There is no one size fits all …

Although we have just skimmed the surface here, it should be clear that choice of wealth holding structure is not a straightforward decision.

You need to be very clear about what you are trying to achieve, long term. What is most important to you – tax effectiveness, asset protection, estate planning, flexibility, administrative ease and/or cost? Usually, a blend of structures is appropriate to balance these competing objectives.

Although the structure choice may be complex, the decision to obtain appropriate advice should be easy. If you are likely to accumulate meaningful wealth over your lifetime, comprehensive professional advice obtained as early as possible will, almost certainly, pay for itself many times over.

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Many D-I-Y investors skew their investment portfolios towards shares that pay franked dividends. This is particularly prevalent amongst trustees of self managed superannuation funds who appear to over value the benefit of franking credits.

There appears to be a view that franking offers “a free lunch”, resulting in its overemphasis as a driver of investment strategy.

We believe investors should not favour particular shares simply because they pay franked dividends. The usual thinking behind such behaviour is, in our view, flawed.

Four franking “myths” …

Below, we consider four franking “myths”:

Myth 1: Franking levels indicate better future share performance

Most financial analysts believe a company’s share price is driven primarily by the share market’s assessment of its after-tax earnings prospects. If they are right, then choosing one company’s shares over another based on current franking levels alone does not make sense.

Assume you have two listed companies that have the same current and prospective earnings. Company A pays tax and therefore has the ability to distribute fully franked dividends. Company B pays no tax[1] and can only distribute unfranked dividends. The table below shows the dividend each pays, assuming a 50% dividend payout ratio:

While Company A’s shareholders receive fully franked dividends, Company B’s shareholders would receive a higher dividend (43% higher), albeit unfranked. A shareholder should be indifferent between the dividends as they would provide the same after tax amount per share.

The above example illustrates that franking is simply a mechanism for recognising tax paid by a company and its shareholders, to avoid double taxing the same earnings. It doesn’t actually create anything.

Over the long term, the difference between the returns to Company A and Company B shareholders is related to the fortunes of each company, not to whether their dividends are franked or not.

Myth 2: Franking benefits low rate taxpayers

Some low tax rate shareholders (e.g. self managed super fund trustees) believe they get a better relative advantage (compared to higher rate taxpayers) as a result of receiving franked dividends.

While there is no doubt that they receive an absolute advantage as a result of their lower tax rate, this will be the case regardless of the level of franking.

The table below compares the after tax returns for two tax payers with different tax rates. It compares a fully franked 4.0% dividend yield and an unfranked 5.7% dividend yield.

There is no after-tax return advantage due to the level of franking.

Myth 3: Markets incorrectly price the benefit of franking

It’s often suggested that shares offering fully franked dividends provide a benefit not available from unfranked shares. We hope that the above discussion will cause those with this point of view to reconsider.

However, even if you remain unconvinced by that discussion, it is unreasonable to expect that the share market would not adjust to allow for the claimed disparity.

Share markets are extremely efficient. They rapidly incorporate all known information and biases into share prices. The franking level of shares is not a secret and any benefit (real or perceived) is almost certainly already reflected in prices.

If you believe that you will receive a greater benefit by buying a franked share over an unfranked share, then surely you would be prepared to pay a little more for the franked share compared with the unfranked share. Investors will continue to pay up for any franking benefit until the higher price exactly offsets the benefit.

Share markets simply do not allow any obvious inefficiencies or “free lunches” to persist.

Myth 4: A smart super investment strategy – fully franked, high yielding Australian shares

An investment strategy that emphasises the level of franking is also likely to focus on higher dividend paying shares, to maximise the perceived benefit.

In addition to defying other elements of a sound investment philosophy, such an approach implies an expectation of higher income and lower growth returns, effectively ignoring the relative tax advantage of capital gains tax over income tax.

Capital gains tax offers better opportunity for tax management than franking. Tax can be discounted and deferred (sometimes indefinitely) to reduce the overall tax rate.

A franked dividend investment strategy is flawed …

In our opinion, an investment strategy based predominantly on exploiting the perceived advantages of fully franked shares is naïve.

While franking should be a consideration, as a driver of investment strategy it down plays (and even ignores) the importance of the primary variables in the portfolio construction equation – risk, liquidity, costs and a comprehensive tax approach.

An investment strategy that considers these broader issues is far more likely to meet your long term requirements.

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The financial planning industry (and a number of accountants dubiously playing on the edge) has come under intense fire recently.

The downturn in investment markets has exposed a number of products that have not turned out to be in clients’ best interests. These include high yield mortgage funds, absolute returns funds, agribusiness and protected equity products and excessive margin lending.

Criticism of planners and offending accountants that promoted these products is well justified. In many instances, it is difficult to resist the conclusion that their sale was driven or too heavily influenced by what was best for the promoter.

But, judging from public responses to a number of recent newspaper articles adverse to financial planners many people also blame their financial adviser for recent poor investment performance and/or failing to get them out of share markets prior to the downturn.

This reaction suggests a failure of advisers to explain or admit that they cannot predict the future. Or, maybe, some claimed they could! And their clients irrationally chose to believe them!

What do professional financial planners do?

But if personal financial advice is not about picking winning investments and successfully timing entry to and exit from share markets, what is it about? What do professional financial planners offer that they can reliably deliver to enhance their clients’ lives?

Indirectly, our clients provide the answer. When they first appoint us, we ask them to nominate their “top 5” financial planning objectives. To assist their deliberations, we provide a list of typical objectives to choose from or add to.

The eight most frequently chosen objectives, with their accompanying description, are listed below:

1.    To be financially well organised
To create a Financial Plan that will give you a clear grasp of your present financial situation and help you make the most effective use of your resources to achieve your goals and objectives.

2.    General Lifestyle
To define you and your family’s version of a desirable lifestyle and achieve it as soon as possible.

3.    Financial independence
To achieve Financial Independence no later than age      …………….

4.    Lifestyle Protection
To ensure that adequate provision is made for the financial consequences for the family of the death or disablement of you or your partner.

5.    Income Tax Planning / Current Cashflow Management
To minimise your income tax liability, produce an analysis of your personal expenditure planning assumptions and to ensure that your cash inflows are sufficient to cover your desired cash outflows.

6.    Investment Planning / Future Cashflow Management
To estimate future cash flow on realistic assumptions and to develop an investment strategy that will enable you to invest your capital and surplus income in accordance with risk/reward, flexibility and accessibility standards with which you are comfortable.

7.    Estate Planning
To reduce the tax liability likely to arise on the death of yourself and your partner and to ensure that your estate is distributed to your beneficiaries as intended.

8.    Wealth Management
To decide how to effectively use cash flow that will result in an accumulation of wealth that is considerably beyond any perceived lifetime financial requirements of your family.

Clients usually find it difficult to rank these objectives. They realise that most or all are important to them. And at the beginning of the relationship, they often are not achieving their most important objectives (and, sometimes, unknowingly).

The distinctive role of the professional planner is to help clients identify and close the gaps between where they are now, relative to their stated financial planning objectives, and where they would like to be. This service can be reliably delivered in a manner that is both expected and valued by clients.

The “profession” of financial planning

Too much of what comes under the umbrella of “financial planning” or “wealth management” is product, rather than advice, driven. And it’s this reality that gives the industry a bad name and justifies the view that it is some way off being considered a true profession.

But the need for comprehensive, well considered personal financial advice remains and grows. The level of knowledge, wisdom and trust required to competently deliver that advice warrants the status of a profession. The fact that the role also offers the opportunity to positively influence and transform people’s lives will, one day, make it one of the most intrinsically rewarding.

But until the nexus between advice and product sales is clearly broken, by legislation if necessary, the “professional” financial planners will have to live with the taint created by the “product floggers”.

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A lot of people ask this question. Unfortunately, as with many wealth management decisions there is no straight forward answer. The appropriate choice depends on a number of issues, some of which we address in this article.

The obvious starting point is to look at the numbers. Assume you have 15 years until you can access your superannuation benefits free of tax. You have a mortgage that is costing you 7.0% a year (after tax) and a small amount of super. Over the next 15 years, you expect to have at least $13,375[1] a year of surplus cash flow.

What should you do with this additional surplus?

We assessed two scenarios:

Scenario 1 assumes that you use the $13,375 p.a. surplus to make additional payments to your mortgage.

Scenario 2 assumes that you contribute $25,000 a year to super, as salary sacrifice or as a personal tax deductible super contribution. As a result, your surplus after-tax cash flow reduces by $13,375 a year. We have assumed you are on the top marginal tax rate.

We also assume that you take no additional investment risk in your super account. In other words, you invest the additional after tax super contributions in cash (earning a rate 5.0% per annum).

At the end of the 15 year period, your situation is projected to have changed as follows:

The repayment of the loan will earn you a healthy 7.0% p.a. (after tax) with no risk. The super strategy, however, will earn you 10.2% p.a. (after tax) with the same risk.

Based on this comparison, you are clearly better off using your surplus cash flow to make pre-tax contributions to super rather than repaying your mortgage.

But the numbers alone may not be the only consideration …

There may be other issues to take into account, including:

1. How much flexibility do you need or want in your affairs? To obtain the tax benefits of contributing to super you need to be confident of your future cash flow. You don’t want to experience a lack of cash when you need it most. An investment in longer term planning can help you make the decision with confidence;
2. Your long term super contribution strategy. The “use it or lose it” nature of super contribution limits means that you cannot delay making contributions until just before retirement. Imagine directing surplus cash flow towards the mortgage only to find that you have significantly underestimated your annual cash flow surpluses. You may now find that your ability to contribute to super is undesirably restricted;
3. Don’t forget about legislative risk. While the recent trend has seen superannuation improve in attractiveness, this may not always be the case. The rules can change, invalidating an earlier decision;
4. Don’t unwittingly expose yourself to more risk than you need to. If you choose the super contribution alternative over the mortgage reduction option and invest the proceeds in growth assets, you increase your risk exposure. You are effectively funding the super contributions by using non-deductible debt (i.e. by choosing not to repay it). So, the strategy has an element of gearing to it.
   If you want to increase the certainty of the strategy paying off you need to direct the additional super contributions to low risk assets. Investing in higher risk assets will increase the chance that you may end up worse off; and
5. Don’t ignore the emotional burden of debt. Despite the mathematics, some people will sleep better with less debt. While it may have a financial cost, the emotional pay off may be greater.

Take a comprehensive and long term view

The mathematics suggest it’s better to make pre-tax contributions to super, even if they’re funded by non-deductible debt. Yet there are a lot of other considerations to take into account.

Often, the numbers based answer may not be appropriate in light of your broader personal circumstances and objectives. Also, the more qualitative factors (e.g. the emotional burden of debt) may outweigh the purely quantitative factors.

Potential future opportunities (and problems) are revealed from a taking a comprehensive and long term view. In our experience, decisions that are thorough and specifically applied to your affairs not only prove to be less complex and less costly, but also produce results that are far more likely to achieve your objectives.

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Yet, unfortunately, some of the people and organisations generally regarded as finance experts are the main proponents of this gobbledegook. Let’s consider a couple of examples.

In a recent article in the “Sydney Morning Herald”, a private client adviser of a major stock broker explained why the share market had fallen for the past three days, after a period of strong gains, as follows:

“I think it comes down to a bit of profit-taking. I guess the market is acknowledging we’ve had it pretty good for the last couple of months and it’s time to take a breather.”

In a similar vein, the finance reporters on the evening television news will often attribute a rise in the share market, after a period of weakness, to “bargain hunters” taking advantage of lower prices. Sometimes, more glibly, since they believe they are stating the “bleeding obvious”, they will explain a rise in the market as due to “more buyers than sellers”.

But all these types of comments overlook one indisputable share market fact. That is, for every buyer, there must be a seller – there are no orphan shares. So if a seller is “profit taking”, what is the buyer doing? Or, if the buyers are “bargain hunters”, what does that make the sellers?

Share markets do not move because of the weight of buyers or sellers. Rather, they respond to changes in expectations of the factors that drive share prices i.e. expected profits and the discount rate used to convert those profits to today’s dollars.

Lower current share prices compared with two years ago almost certainly reflect lower expected company profits. And, perhaps, a higher discount rate (or expected return) to entice investors to take the necessary risk. It is not because investors have “fled” share markets as is often suggested in the financial media. Because, in aggregate, they simply can’t.

“The Arithmetic of Active Management”

Another prevalent example of investment gobbledegook is the claim that depressed share market conditions are best suited to active, stock picking investors as opposed to passive investors who simply hold share portfolios designed to replicate the market’s overall performance.

Since the share market peak of November 2007, hardly a day goes by without a financial journalist opining or quoting some stock broking source that “it’s a stock pickers’ market”. No proof is provided. It is simply asserted.

We recently received an invitation from a major financial institution to a seminar to hear three prominent active fund managers present on why they believed they would outperform the overall share market in these difficult times. The invitation explained:

“At the peak of the bull market most fund managers were able to produce strong absolute returns with ease. Moving forward active management and fund manager skill will play a far greater role.”

The implied claims appear to be:

1. now is a good time for active funds management; and
2. you can pick the most skilled active managers.

A response to Claim 2. will need to be the topic of another article. However, in summary, the best available research suggests it is very difficult (some say, impossible) to distinguish luck from skill.

But rebutting Claim 1. doesn’t require research – simple arithmetic will do. The essential message of Nobel prize winning financial economist, Professor William Sharpe’s classic 1991 paper, “The Arithmetic of Active Funds Management”, is that:

• since active and passive investors make up the entire share investor universe; and
• passive investors earn the return of the total share market less their relatively small costs

it follows that active investors, in aggregate, must also earn the same total share market return less their relatively high costs.

This will always be the case. There are not good times and bad times for active investors, compared with passive investors. In our view, given the higher costs of active investment, there are only bad times!

The moral of the story …

Often, in investment markets, propositions that sound plausible, and are being put forward by people or organisations with apparent expertise, prove to be total bunk when subjected to appropriate scrutiny.

As a smart decision maker, serious questions you should ask yourself are:

• do I have the knowledge and wisdom required to distinguish between often self serving investment gobbledegook and the opinions and research of the world’s leading financial economists and behavioural scientists;
• if not, is it the best use of my time to acquire that knowledge and wisdom;
• what are the costs, risks and foregone opportunities of not accessing that knowledge and wisdom; and
• am I prepared to accept those costs, risks and foregone opportunities?

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