Investing Compass: Doubling down on exposure
In a listener Q&A episode, we explore whether your exposure in your super should impact your assets outside of super.
Shani Jayamanne: Welcome to investing compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.
So, Mark you’re back from the US.
Mark LaMonica: Are you excited?
Jayamanne: Yeah! I mean we have this one week where Mark and I are both in the office before I go on leave so we’re recording a couple of podcasts now, but I am excited.
LaMonica: It’s like two ships passing in the night.
Jayamanne: Exactly, but how was your trip? Did you enjoy it?
LaMonica: My trip was good. I ate a lot.
Jayamanne: And you messaged me when you were in Boston. And you mentioned some cannons.
LaMonica: I was actually north of Boston in this town called Marblehead and its like a bit of a yachting town where my wife’s parents live. And at sunset they... all the yacht clubs fire off cannons, while lowering the American flag. And everyone has to stand up and I was just sitting at dinner because I didn’t know that’s what you were supposed to do.
Jayamanne: Wow.
LaMonica: It’s hard to describe.
Jayamanne: It’s very American.
LaMonica: Firearms?
Jayamanne: Yes.
LaMonica: Okay – we’ll take that.
Jayamanne: Should we move onto the episode?
LaMonica: Yeah, let’s do it, so today we are going to talk a bit about taking a holistic approach with investing and how you should think about super and non-super investments. And we will cover a bunch of different topics but let’s start with some basics. So, let’s talk about super Shani, cause you love super.
Jayamanne: I do love super, who doesn’t love super?
LaMonica: I love super too.
Jayamanne: Great, well at the heart of it super is getting favourable tax treatments in exchange for adhering to certain rules.
LaMonica: Okay let’s start with the good side, so let’s talk about the tax benefits Shani.
Jayamanne: Well, that is a pretty great deal for investors. While you are working and contributing to super you get a reduced tax rate on the money you earn and contribute to super. And that reduced tax rate is 15% instead of your marginal tax rate. You also get a benefit on investment income earned on super and on capital gains. Also at 15%, and 10% capital gains for an asset held for more than 12 months.
LaMonica: And that is a great deal as well because you don’t pay your marginal tax rate. Then the best deal you get is at retirement because once you’ve entered pension mode you pay no taxes for investment income and capital gains and pay no taxes on withdrawals.
Jayamanne: And finally, there is the new tax on super balances over $3m with an additional 15% tax on earnings which include unrealised capital gains.
LaMonica: Now as we mentioned you need to abide by some rules in order to get this benefit. The first is that there are limits on contributions but there are two specific rules we want to explore because it is relevant to our conversation today. The first is the fact that you can’t take money out of super until you retire.
Jayamanne: And there are certain narrow exceptions, but we will ignore them today because in reality they are not circumstances that anyone assumes or incorporates into retirement plans.
LaMonica: The other big rule we need to talk about is that there are requirements about how much you take out of your retirement account in super. If you are below 65 you need to take 4% of your balance out each year, that jumps to 5% between 65 and 74, 6% between 75 to 79, 7% between 80 and 84, 9% between 85 and 89, 11% between 90 and 94 and if you somehow live past 95.
Jayamanne: And still have a super balance, lucky you.
LaMonica: And still have a super balance, you need to take 14% out of whatever you have left.
Jayamanne: That was a lot of numbers, well done. So, the reason that people save in super is pretty obvious. There are mandatory contributions of course but many people choose to take advantage of the great deal on tax and make additional concessional and non-concessional contributions. That leaves us with the question - why would you want to save and invest money outside of super.
LaMonica: Well, the first reason you may have savings outside of super is because you’ve reached the limit on how much you can put into super and have additional savings. But the other reason that people might want to consider investing outside of super is flexibility.
Jayamanne: Just the fact that you can get at the money. So that is if you want to spend the money during your working years or if you perhaps want to retire early before your preservation age.
LaMonica: So, let’s say for whatever reason it appeals to you to have some money saved and invested outside of super. So, retiring early as Shani just mentioned is a perfect example. Well, the first piece of guidance is if you have two goals – savings for retirement at your preservation age and saving for early retirement. So, preservation age is the age at which you can access your super if you declare retirement. This depends on the year that you are born. For anyone born after 1964, and yes, that does include me Shani, it’s 60. You can take a year off that age for a birthday in the 1964 financial year, another year off for the 1963 financial year and so on until you get to 1960. Regardless of your preservation age, the guidance is to save for your retirement at preservation age.
Jayamanne: In other words, try and get as much money in super as possible when you are young. And the reason for this is pretty simply – the tax savings will compound so you want to give them as much time as possible for compounding.
LaMonica: The next consideration we are going to talk about is what we call asset placement. As much as possible we want to view all of our assets holistically. What that means is that we don’t want to compartmentalize our holdings even if some is in super and some outside of super.
Jayamanne: So, any time we look at asset allocation we want to consider all of the assets that we hold. We want to view diversification in that same vein – holistically looking at all your holdings. If we don’t do that, we can start to get a lot of overlap between our various accounts which can lead to concentrated positions which increases our security level risk.
LaMonica: And this can happen without people necessarily realising it if they have a share or ETF portfolio and then perhaps have an industry fund and invest in a pre-mixed option. You can find yourself very exposed to certain parts of the market. And this is a bit hard because we don’t have full disclosure on holdings in Australia.
Jayamanne: But we do have a tool for our subscribers called portfolio x-ray that looks through funds and ETFs and can help to show this overlapping of positions. So, no matter where an asset is held make sure you take a holistic view of your finances and don’t compartmentalise things.
LaMonica: And this is known as mental accounting when we don’t look at our holistic financial position and instead categorize and evaluate different pools of money separately because we mentally grouped them into non-interchangeable accounts.
Jayamanne: And one way that people use mentally accounting is to put it in two broad categories – money that goes into growth assets and money that goes into defensive assets. Now your emergency fund should certainly be kept in the bank, but the rest of our holdings should be looked at holistically and we should hold assets in tax situations where we gets the biggest benefit.
LaMonica: Let’s say that you decide that you want asset allocation of 70% in growth assets like shares and 30% in defensive assets like cash or bonds. Well in this case we would put as many of those growth assets in super as possible and have as many of the defensive assets like cash or bonds outside of super.
Jayamanne: And the simple answer is that we want the assets with the highest expected returns over the long-term to be in the lowest tax environment. And that is generally super. The exception is if you are not earning income from a job because anything under $18,200 a year has a 0% marginal tax rate.
LaMonica: And this works well especially if you take the approach of maxing out super when you are young and then saving more outside of super later on. Now there are some considerations here on how you actually approach this early retirement plan. Are you planning on spending all your money down between the early retirement and your preservation age or are you planning on spreading the withdrawals out over a long period of time even after preservation age.
Jayamanne: Certainly, if you were planning on just bridging that gap before preservation age having more defensive assets makes a good deal of sense.
LaMonica: Now asset placement also applies to people who are not trying to retire early and are simply retiring at preservation age. And this is a question that I feel like I’ve been asked a million times. We talk a lot about safe withdrawal rates. We’ve talked about the 4% rule, and we’ve talked about the annual Morningstar report that looks at forward returns to calculate a safe withdrawal rate which and that was 3.8%, last year’s report.
Jayamanne: And those are obviously different numbers then what is included in the super rules. In fact, if you are over 65 you are taking out 5% which is already higher than the conventional wisdom safe withdrawal rate of 4%. And that is the question you always get – how do you reconcile those two things? A forced withdrawal that is higher than what we would consider safe.
LaMonica: Well Shani the answer is pretty simple. Just because you have to take money out of super doesn’t mean that you have to spend it. This is another situation where you can use super withdrawals and keep it in cash or other defensive assets.
Jayamanne: But one important thing is that even through in retirement you will not be paying taxes on income generated within super or capital gains there is potentially a smaller tax advantage than when you are working depending upon your income levels and the marginal tax rate you are paying.
LaMonica: And given that smaller tax advantage there may be situations where you would want to hold growth assets outside of super. And that situation can occur if you are taking a bucket approach to retirement, if you have focused on asset placement and if the market has dropped significantly are you are worried about sequencing risk. So, we mentioned a couple terms in there so perhaps a quick reminder of what they mean.
Jayamanne: Well, let’s start with sequencing risk. Sequencing risk is the notion that it isn’t just the average return you receive during retirement but also the order of those returns. And the reason why it impacts you in retirement and not before retirement is because you are withdrawing money from your account. So, during the beginning of your retirement if the market drops significantly, you are selling low and don’t have as much money in the market to take advantage of a rebound.
LaMonica: And that is where the bucket method comes in. It calls for holding some cash – some multiple of your annual spending needs. So, if the market drops significantly you use the cash to fund your life instead of selling off shares to pay for your day to day living expenses. The theory is that the market is then given time to recover, and you can commence selling off shares.
Jayamanne: Then there is second bucket that holds less volatile investments like bonds, hybrids or even dividend paying shares.
LaMonica: The third bucket holds growth assets. In a normal year when the market hasn’t dropped significantly you would use sales of securities in bucket two and three to replenish the cash bucket. You just wouldn’t do that if the market dropped significantly.
Jayamanne: The problem with the bucket method is that the forced asset sales that may accompany the mandated withdrawal can be an issue. But if you are forced to sell off shares at a bad time you could technically just buy them back outside of super if you aren’t taking too much of a tax hit because of your low marginal tax rate.
LaMonica: So, there we have it. As a brief summary it is important to look at reasons why it may be beneficial to save and invest money outside of super if the flexibility is important to you. It is also critical that you view your investment holistically whether they are in super or outside of super. Then you can take a complete look at asset allocation and diversification. And finally, it is important to be mindful about asset placement to make sure you are minimising your taxes on capital gains and income earned from your portfolio.
So, thank you very much for listening to this episode of Investing Compass. My email address is in the podcast notes, so you can send me an email of topic ideas or questions or just comments about Shani being mean to me, which is an email I recently got, and the email said that you must like me more because you’re not being as mean to me.