Investment Road Test: RBS Vanguard Instalments

PORTFOLIO POINT: Limited recourse instalments are proving popular with investors building wealth for their retirement.

The reality is that most Australians don’t have enough invested for a comfortable retirement. The government is seeking to address this with a series of new policies that put the focus back on superannuation.

For many SMSF investors, the surprise is that the Rudd government has its own agenda, which includes the halving of tax-deductible contribution levels and constant speculation that tax rates within super may be increased. It’s no wonder that investors faced with these twin problems are attracted to instalment warrants to leverage their investments.

RBS is seeking to capitalise on this and recently expanded its range to include self-funding instalments over the Vanguard index fund.

It’s a shame that the release of this interesting new investment comes amid signals from the government that these too may come under further scrutiny. Phase 3 of the Cooper Review focused on SMSFs, and its recently released report shows a complete misunderstanding of the simple concept on which instalments rely.

To fit within section 67 (4A) of the Superannuation Industry Supervision Act (SIS Act), instalments have to use a “limited recourse” loan. This type of loan provides consumers with great benefits in comparison to normal, or even margin loans. In the latter, if an investor does not repay the loan, upon that default the lender can take over the secured property and they can also sue the borrower for any shortfall – leading to the prospect of personal insolvency and financial distress experienced by many Storm Financial clients.

In contrast, “limited recourse” loans don’t even make it compulsory to repay the loan; if the borrower defaults, the lender can only sell the underlying asset to recoup their money and cannot take action against the borrower or the borrower’s assets to recover any shortfall. Instalments using limited recourse loans are one of the most powerful and pro-consumer advances in financial services ever to hit the Australian markets.

Which makes it laughable to read the misguided statements emanating from the report for Phase 3 of the Cooper Review. In section 8.1 the opinion is expressed that “'¦the Panel has concerns with the concept of direct borrowing within any superannuation funds '¦ if direct borrowing had been more widespread before the GFC then a substantial amount of retirement savings could have been lost”.

We can illustrate how irrelevant these statements are by looking at a simple example of using the RBS Vanguard instalment in an SMSF. An outlay of $20,000 as the “first instalment” will give an investor exposure to about $38,000 worth of units in the Vanguard Australian Shares Index Fund.

This reflects a gearing ratio of 50% and the calculation is based on the inclusion in the first instalment (ie $20,000) of an amount to cover interest on the related loan (current rates are about 9%, so total year one interest will be about $1800). Fees and charges are also included in the first instalment. The term of the RBS Vanguard instalment is seven years. At the end of each year after issue, RBS capitalises interest for the following 12 months (at prevailing rates plus RBS margin). During the term of the investment RBS applies dividends to reduce the amount of the loan. Any remaining loan balance is repayable at any time, or at the end of seven years.

With modest gearing and assuming that dividends and interest costs do not significantly deteriorate from current levels, it is normal in self-funding instalments of this sort for the loan to have been significantly reduced by the end of the investment term. Investors are normally offered the ability to roll over their instalment into a new series at maturity.

Instead of spending $38,000 to buy that number of units in the Vanguard Australian Shares Index Fund, using the RBS Instalments allows the investor to acquire an interest in that amount of units, for an outlay of only $20,000. All dividends, franking credits and capital growth are the property of the investor – with dividends being reinvested compulsorily to reduce the loan.

Since the repayment of the loan is entirely optional (and since it is “limited recourse”), investing in this manner is significantly lower risk than outlaying the full price. Of course, if you do outlay the full price, you can stand to lose that full amount if the investment falls in value. But contrary to the statement in Cooper Phase 3, in this example, an outlay of $20,000 generates $38,000 of market exposure, with the risk of loss limited to the initial $20,000.

To cover its risk, RBS will sell down the underlying units if they fall in value. A “stop loss” mechanism is triggered if units fall in value by 25% or more from starting levels. Although an investor can elect to make payment of the final instalment if this occurs, (and in this respect the RBS Instalment is a little like a margin loan when a margin call occurs), the stop loss may be triggered rapidly in a falling market.

The stop loss level in the RBS Vanguard Instalments is significantly higher than for other, similar products and can result in a loss of some accrued value within the instalment if it is triggered. Compared to other instalments, this is a weakness for this product. The PDS isn’t the easiest to read and digest, either.

A final note: the underlying Vanguard Australian Shares Index fund is a “garden variety” index fund. It is low-cost and efficient to use but because it doesn’t generate any investment “alpha”, investors who want a properly diversified portfolio should used it in conjunction with good quality shares that do generate “alpha”.

The score: 2.5 stars
0.5 Ease of understanding/transparency
0.5 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
0.0 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals.