Don't rush out to gear your super

Across many areas that were considered, the Murray Financial System Inquiry took a particular interest in the existence of ‘leverage’ (borrowing to invest) in superannuation funds – specifically the use of leverage in self-managed super funds (SMSFs).

It noted that in the four years between 2008 to 2012 the proportion on SMSF’s with borrowing rose from 1.1% of funds to 3.7%, with the average amount borrowed increasing from $122,000 to $357,000. The total value of loans in 2012 was $6.2 billion.

The inquiry was concerned that if borrowing was allowed to continue to increase, it may create ‘vulnerabilities’ for both the super and financial systems. One example of this concern given by the inquiry considered what might happen if “many funds” were exposed to the same assets, or highly correlated assets, that all fell in value. If this led to “forced selling” of these assets at the same time, it would further push down their value and lead to more selling.

The report also suggest that the fact there was almost no borrowing in the super sector during the Global Financial Crisis was a positive, meaning that losses were not magnified and the assets of super funds played an important role in stabilising the broader financial system.

The inquiry then looked at “Policy Options for Consultation” around borrowing in superannuation funds, specifically asking for views on:

Restor(ing) the general prohibition on direct leverage of superannuation funds on a prospective basis.

My take on this statement, and the discussion that precedes it, suggests at least a consideration of winding back the rules allowing super funds (and therefore SMSFs) to borrow to invest.

Is borrowing a good strategy?

Rather than consider this at a system level, it is interesting to consider the role of borrowing to invest in a super fund – most likely a SMSF – at a personal finance level. Is it a good strategy? What are the issues to keep in mind? Is it something that we should be looking to do now, in case there is a restriction on the ability of funds to borrow in the future?

Here are some of the key issues that I think are worth considering when looking at whether to use leverage in a super fund – either for buying property or shares.

Issues of liquidity and diversification – Including pricing yourself out of cash

A key issue with borrowing to invest in residential property is that often SMSFs that do this end up with one main investment asset in their fund – one, or sometimes two, properties. This leaves little liquidity (easy access to money to pay for things like SMSF fees, property repairs, pensions if the fund is in pension phase) in the fund. As well as potentially creating liquidity problems, a fund that has borrowed for one or two main investments is not well diversified.

There is a second, more subtle, issue around borrowing to invest. If your fund has borrowed for an asset/s, either directly or indirectly, you are almost certainly paying 4.75% or more for your loan at current interest rates. That means that it will not make sense to invest any of your money in cash or fixed interest investments – crucial in portfolios for providing liquidity, diversification and reduced volatility – because the returns from these investments will, almost certainly, be less than the interest cost of the loan that you are using. The rational option with any spare cash will be to use it to reduce the loan, rather than having a cash/fixed interest investment in the portfolio.

Dealing with early death of a member

The primary purpose of a person’s superannuation balance is to pay a benefit that will fund retirement. However, another important role a fund can play is to pay a benefit in the case of a person’s death. This can be a very important cash flow – consider a family which has just lost its breadwinner, who has accumulated $200,000 in their super account. This $200,000 will certainly be useful in dealing with the difficult situation. However, if the accumulation is in the form of an illiquid asset tied up heavily with gearing, it will be much harder, and potentially more expensive (think of things like the break costs for a fixed interest loan, transaction costs of selling a property) to access.

The reduced tax impact

Part of the love of ‘negative gearing’, be it with a property or share-based investment, is that there is a tax benefit associated with making a loss on the income/expenses of an investment. The value of this loss comes from the fact that it then reduces the taxable income of the person who owns the assets. For an individual who owns a loss-making property or share portfolio, the top tax rate is expected to be 47% (because of the temporary deficit levy) plus Medicare levy. However a super fund has income taxed at only 15%, reducing the value of any loss. For example, a $10,000 loss for an individual on the top rate saves $4,700 of tax, whereas for a SMSF the tax saved is only $1,500.

Paradox of leveraged returns

I think one of the paradoxes of borrowing to invest is that if you need to borrow to invest, you probably can’t afford to. What I mean by this is that when you borrow to invest you are hoping to increase your returns. For example, if you thought you would get a return, after costs, of 8% a year from a share or property investment, and over time expect to be able to borrow money at an average cost of 6.5% a year, then the return from an investment where you invest $100,000 and borrow $100,000 will increase from the 8% return of the underlying investment to a return of 9.5%. Borrowing to invest has increased your hypothetical expected return from 8% to 9.5%.

Of course, it is not a free lunch. The risk of borrowing to invest is that assets can fall in value and completely wipe out an investor who has borrowed 50% of their investment value. Consider the recent 50% fall in the ASX during the GFC (and there have been similar falls in residential property markets around the world) – a person who had a $200,000 investment made up of $100,000 of their own money and a $100,000 loan would have seen that $200,000 basically halve in value during the period of the FGC – leaving them with a $100,000 investment and a $100,000 loan, and nothing for themselves. While this is a simplified example, it does show the reality of how borrowing money, even at what is touted as a ‘fairly conservative loan-to-value ratio of 50%’, can lead to the total loss of an investment during the worst of times.

This is what I mean by the paradox of borrowing to invest. Consider a couple who want to retire on $50,000 a year in five years’ time. They realise that they will need around $1 million in assets to do that. They currently have $500,000 of assets, and with expected investment returns of $220,000 (around 8% per annum) over the five years, and contributions of another $160,000, they are going to fall short by about $120,000. Perhaps they can increase their returns by borrowing to invest? They might, however the risk is that if investment returns are poor over this period (for example, a negative five years of sharemarket returns similar to what we had from November 2007), they will end up further from retirement than when they started.

Conclusion

I think one of the great benefits of superannuation is the ability, over a working lifetime, to invest regularly in assets. When asset prices fall, as they did between 2007 and 2009, it provided a great opportunity to buy them cheaply using regular super contributions.

Borrowing to invest is different to this – it assumes a large amount invested at a single time, with the chance of higher returns or the risk of reduced returns. Apart from an investor who has a strong desire to access direct residential property (which, because of the high price of property, is difficult without a loan), I don’t see a strong case for the average super investor to rush out and buy a residential property or invest in a geared unit trust to buy shares in an effort to pre-empt any changes to the rules around borrowing in super funds.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.