Home Sweet Retirement Fund

The new super rules combined with the innovative products that allow access to equity in the family home through reverse mortgages and debt-free equity release [DFERs] provide a range of opportunities for wealth management.

In essence, the two primary investments for most Australians will be their family home and their super. They can be viewed as two empty buckets given preferred tax status by the Government to be filled during a family’s working life and emptied during retirement. Because the traditional rules and order of filling and emptying are inconsistent with maximising family wealth, planning will have a critical role to play in re-assuring and validating decisions.

To illuminate the issues and opportunities I've looked at two affluent Australian families where the new rules specifically through super encourages regulatory arbitrage. First we meet the Optimists, who seem to have a risk-tolerant approach to the management of their financial affairs; and their near neighbours the Pessimists, who appear to be risk-averse.

A positive and pro-active approach

The Optimists are a 50-year-old couple who own their own home, have money in super, money outside super and generate a reliable and above-average earned and appropriately insured income in excess of their living costs.

The Optimists’ plan is to move to a more expensive home, borrowing “interest only” for 20–50% of the value. They are confident that the value of a new home in their preferred suburb is likely to grow at an above-average and robust rate in the medium to longer term.

The Optimists plan to maximise their super by salary sacrificing the maximum they can into their own super each year. In so doing they reduce the tax paid on earned income to the contribution tax rate of 15% compared to their higher personal marginal tax rate. They intend to supplement their living expenses by accessing their non super assets as they need to.

The Optimists’ family plan will see their balance sheet, at the time of their retirement at age 60, largely consist of a diversified portfolio of growth and defensive assets within an SMSF, a family home and borrowings secured against the home. Their super assets will have grown in a tax sheltered environment, which will probably have had an ongoing tax rate of plus or minus 5% a year. In the de-accumulation stage, the assets in the funds will not incur any tax liability on realisation and imputation credits will be paid back into the fund resulting in a negative tax rate, which will offset the costs of running the fund. The payments out of the fund, both regular and irregular, will be tax-free. Their home, they hope, will have grown substantially in value and of course will be tax-free on sale and exempt from the assets test if social security entitlements are available.

Overall, the arbitrage of tax rates on earned income and the maintenance of solid gearing on the home should result in both a more diversified portfolio and substantially greater net worth than would otherwise have been achieved.

In addition to having enjoyed living in the superior home for 10 years at age 60, they will be able to, among other strategies:

• Continue the interest-only loan and make repayments through tax-free withdrawals from their super.
• Refinance the loan through a reverse mortgage and make no further payments.
• Pay out the loan, at least in part, through a debt-free equity release.
• Pay out the loan through a tax-free lump sum drawdown from superannuation.
• Sell the home [realising the capital growth tax-free] and move to a lower-cost one.

In addition, from age 60 the Optimists will be able to offer tax shelter to their children who will be able to invest part of their discretionary savings through the family superfund via undeducted contributions.

A negative and cynical view

The Pessimists live in a similar house to the Optimists. Although their family circumstances are very similar, their attitude and behaviour suggests that they are risk-intolerant. They seem to be comfortable to live within the financial outcomes that are consistent with managing their financial affairs in line with their risk-aversion.

The Pessimists believe that the budget’s super changes are unsustainable and will be a burden on their children and their children’s children. They are deeply suspicious of the policy intent. They fear that once moneys are locked away into super, the rules will change to their detriment. They choose to retain a conservative and diversified approach to their family balance sheet. They intend to remain in their current home, which has no borrowings, contribute the minimum obliged by law to their super via an industry super fund and add any new savings to their non-super investments. Above all, they have no intention of seeking the advice of a financial planner because they believe all planner’s advice is directed towards products where they receive commissions.

Beyond age 60 they plan to stay in their family home and spend all of their super and non super assets very slowly. They have no notion of either regular drawdowns of money through a reverse mortgage to supplement their super and social security or the use of a DFER to diversify their investment risk.

The challenge

The Optimists and the Pessimists provide a unique challenge for both the general and financial planning communities.

Their initial circumstances are identical, but the implemented plans are significantly different. So what could go wrong in each case and what are the consequences for financial planning?

The new super rules could change. Of course they could but let’s work out what might happen which would have a retrospective impact. Clearly, changing the contributions amounts or tax will have no impact because it is prospective. What is possible includes:

• Changing the earnings tax
• Increasing the tax in the accumulation stage.
• Creating a tax in the drawdown stage.
• Changing the exit taxes.
• Imposing tax on all or some withdrawal.
• Changing the exit rules.
• Increasing the amount that must be drawn down regularly.
• Limiting the proportion that can be taken as a lump sum.

When we look at the possible options open to a government, it’s difficult to imagine the back bench living with the responses from the rump of the baby boomers who will be screaming 'It’s not fair!’. As a consequence any future changes are likely to be incremental and minimally retrospective.

Concluding thoughts

The family home is now an intrinsic part of the planning process. In both the accumulation phase and the spending phase there is reason to explore the options, the rewards and the risks. In both phases the intrinsically better strategy is the non-intuitive. In accumulation it is not paying down the mortgage but is in taking on a higher exposure to both property and interest rate risk. It is in maximising super across the whole family. In retirement it is not spending all other assets and leaving the home as the last resort, it is either borrowing against the home or selling part and even re-investing those sale proceeds as a form of diversification. Is it possible that these will become the default options going forward?

Paul Resnik is an investment industry consultant.