Austock Imputation Bonds

PORTFOLIO POINT: Imputation bonds offer a way of investing for the long term in a tax-efficient way.

Over the summer break Mercer Consulting released a paper that showed how the majority of Australian managed funds failed to beat their performance benchmarks in 2010. Eureka Report subscribers will no doubt be all too well aware of this trend.

But it gets even worse when the impact of taxes – especially at personal tax rates – on to meagre returns is assessed. One product that aims to alleviate some of this capital erosion are Austock’s Imputation Bonds, which offer a tax effective way to invest for the long term – even outside the tax-sheltered superannuation environment; although it’s a shame that their investment menu is skewed towards larger managed funds with modest returns.

At first glance the concept of an insurance bond seems crazily complex, even for those looking to legitimately reduce tax costs. Overall they work by compulsorily reinvesting the after-tax amount of all returns from investments, so that after a minimum 10 year period (less, if the life bond owner dies), the final investment return is tax-free. (Redemptions prior to 10 years are still tax-effective, just not as much as for those made after 10 years or more).

Over the term of the life bond, tax on earnings from underlying investments is paid by the bond issuer (in this case, Austock Life) – with the overall benefit being a significant tax rate arbitrage to investors with taxes payable at the corporate tax rate instead of your top marginal rate. Since the power of compounding investment returns is eroded by tax, long-term returns are significantly enhanced by reducing this impost over the life of the investment.

Austock Imputation Bonds use this concept, implemented in an easy-to-use package, with a list of 27 eligible investments to choose from, across a range of asset classes. Investors can skew their portfolio to any of these asset classes, or can implement a diversified portfolio.

Although the investment menu is dominated by large, traditional managed funds, there are some boutiques as well as lower-cost index funds. Each year, the distributions from those managed funds (income as well as capital gains) are reinvested (in accordance with the investor’s chosen menu), after tax has been paid by Austock Life on behalf of the insurance bond.

The PDS for the Austock Imputation Bonds suggests that many higher-taxed investors will have personal marginal tax rates above, say, 38.5%, such that their effective tax rate for income and gains on assets held in the Austock Bonds will be significantly below their normal tax rates. (Current corporate tax rates of 30% are slated to be reduced to 28% as Rudd/Swan budget measures are introduced). You can check your own effective marginal tax rate by looking at tax office rate scales or checking with your accountant.

If your tax rate is above 30% – and you like the choice of investments within the Austock Imputation Bond – then this investment will be more effective than buying those investments in your own name. Tax rates within the Austock Bonds are higher than for superannuation – so they are generally for use in addition to super; for example, where the investor has already reached the maximum tax-free contribution levels in their super fund.

The benefits of simplified tax reporting (Austock pays tax and reports instead of the individual investor) adds another layer of convenience to this tax rate arbitrage. Since the income from those investments may be eligible for its own tax relief (such as imputation credits on Australian shares, tax-deferred components on Australian property investments, foreign tax credits on international shares), the effective tax rate within the Austock Imputation Bond may be even less than the corporate tax rate, delivering additional benefits: the PDS shows that the effective tax rates on its eligible Australian share investments ranges from 21% to 27%.

Austock markets an additional facility with its Imputation Bonds, specifically for investors planning to assist children with educational or endowment-type expenses. The Child Builder facility allows for a designated child to be nominated as the beneficiary of the bond, with tax-free vesting capable of being any time between 10 to 25 years from initial purchase.

The bonds generally allow for ongoing, regular contributions (although to maximise tax effectiveness these must be equal to or below 125% of the previous year’s contributions). This feature is attractive to investors with these types of goals in mind. The full range of planning strategies available through using them is set out in the PDS, including estate planning and creditor protection opportunities.

Austock Life invests into wholesale underlying managed funds and as such bears their usual costs including any buy/sell spreads. The PDS states that underlying fund costs range from 0.05% to 1.23% pa. Initial contribution fees are capped at 4% (with up to 3.3% being payable to introducing financial advisers – presumably this is not applicable for DIY investors).

Annual fees to Austock Life are typically 0.6% pa for most investment choices, with 0.2% pa payable for cash management trust investments and 0.4% payable for fixed income investments. Additionally, Austock receives up to 0.31% pa for “cost recovery” – making the additional cost of the Austock Imputation Bonds (apart from fees it pays to underlying fund managers) close to 1% pa. Switching investments within the bond can be done free of charge up to three times per year, after which a $50 cost per switch applies.

Given the complexity of the structure that is used to create and issue this style of bond, and the power of the investment strategies that are available when using the Austock Imputation Bonds, this level of fee is reasonable. It’s just a shame that this great concept is somewhat underpowered by the dominance of mainstream managed funds in its investment menu. Careful selection and monitoring of the investment portfolio should be undertaken as a priority when using this product.

The score: 3 stars
0.5 Ease of understanding/transparency
0.5 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
0.5 Regulatory profile/risks
1.0 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.