Productivity Commission Report is Flawed

That’s it.

I am no longer reading The Australian or AFR while I enjoy my morning coffee.

From now on it’s the Crossword and Word Puzzle.

What prompted this decision?

Last week the Productivity Commission released its report on superannuation.

This was the headline in the Australian Financial Review on 29 May 2018…

‘Got less than $1m in assets? Forget a self-managed super fund’

Here’s an extract from the article…

‘Self-managed superannuation funds [SMSF] with less than $1 million in assets perform “significantly worse” than institutional funds because investment returns are heavily eroded by the costs of running the fund.

‘This raises the question of whether creating an SMSF is worth it for most investors.’

Previously, ASIC recommended $200k as the minimum needed for establishing a SMSF.

Why has the Productivity Commission bumped it to $1m?

‘…costs for low-balance SMSFs are particularly high, and significantly more so than APRA-regulated funds,’ the report says.

‘These high costs are the primary cause of the poor net returns experienced by small SMSFs on average.’

How much did taxpayers pay for this erroneous report?

I know it cost me at least a cup of coffee.

Comparing the cost and performance of SMSFs to Public Offer (Industry and Retail) funds is an ‘apples with watermelons’ comparison.

For starters, an SMSF with investments in property — residential, commercial, industrial — on average revalues the property every 3 years. During the intervening years, performance is limited to net rental income (after expenses)…no capital gain is accounted for.

Whereas, public offer funds, with more diverse portfolio holdings, account for income AND capital gains on an annual basis.

This is just one of the anomalies between the two super offerings.

In The Gowdie Letter, published on 30 June 2017, I wrote a lengthy article on ‘SMSF v Public Offer Funds’.

The article was written in response to an email seeking guidance on whether to opt out of an SMSF in favour of the (perceived) simplicity offered by an Industry Fund.

When it comes investment products nothing is ever simple.

There are always subtle, but critically important, differences.

What’s the risk v reward equation?

What are the real costs?

What makes me sleep at night?

The Productivity Commission draft report does investors a disservice with its blanket announcement of ‘$1m needed for SMSF’.

Out of a sense of civic duty (and to stop further waste of taxpayer funds) we should send the Productivity Commission a copy of today’s Markets & Money.

As I said, this was a fairly lengthy report, so today and Friday I’ll share with you edited extracts from the ‘SMSF v Public Offer Super Fund’ article.

Hopefully it informs you and makes you think a little more deeply about which of the options is best suited for your individual needs.

Here’s Part 1, watch out for Part 2 on Friday.

SMSF v Public Offer Super Fund

Self-managed super funds (SMSF) enjoyed a surge in popularity after non-recourse lending for residential property was permitted and the financial crisis of 2008/09.

People wanted to exercise more control over where their retirement capital was invested.

According to the latest data there’s nearly 600,000 funds with total assets of around $650 billion.

The once exponential growth of SMSFs has now, understandably, steadied.

SMSFs growth rate


Source: SMSF Adviser
[Click to enlarge]

The biggest loser in the superannuation industry has been the retail funds…MLC, BT et al.

The lower cost Industry Funds have also made in-roads at the expense of the retail funds.

With most people looking at switching from a ‘public offer’ fund (retail or industry) I’m often asked about the merits of establishing a SMSF.

The following email from Jim provides us an opportunity to reverse engineer this question…is it worthwhile exiting a SMSF in favour of an industry fund?

‘Dear Vern

‘I have followed your guidance for several years.

‘The investments in my SMSF are mainly TDs for 6 months, each with less than $250K. Several financial institutions are used. About 30% of the total is in silver and gold. The turning over TDs every six months is quite time consuming, as I always go for the best rate available. And, I am getting older and a bit less mentally agile.

‘I am considering moving the investments to an industry fund, possibly Australian Super. My objective is preservation of capital. I get income to live on from another source.

‘I would go for a DIY option in Australian Super, in which one can switch between 2 categories of shares, property, a diversified fixed interest fund and one other category. Given the great uncertainty at the moment, I would initially put more than 80% of my funds in diversified fixed interest.

‘So to my question: how does that approach sound to you? Do I go with Australian Super or stick with TDs in my SMSF? Most importantly, what are the risks in making this change? Conversations with others over 70 indicate that several are considering this option.

I think that your readers would like your views on this one.

Many thanks Vern’

Jim

Taking control of your retirement capital does come with a personal cost.

For some, the time and inconvenience are a cost that’s more than offset by the savings in fees and the peace of mind that comes from being in control.

Whereas, for others the personal cost can outweigh the benefits.

Personally, I prefer an SMSF because of the low fees (more on that later), transparency (knowing what my risk is) and investment flexibility (being able to buy direct property or foreign currencies or precious metals). However, every yin has a yang. The SMSF does come with additional administration.

If this becomes too onerous, then delegating the process to a professional manager is understandable…on the provision you know what you’re giving up and going to invest in.

Caveat emptor.

At present, Jim has spread his cash around several institutions to remain under the Government’s deposit guarantee limit of $250k. Let’s assume ‘several’ means four.

Based on that assumption, Jim has $1m in cash and 30% ($500k) in gold and silver.

In total the SMSF has $1.5m.

The cash deposits are secure — provided the Government honours its guarantee.

The precious metals are subject to two influences — price movement in the commodity and the rise or fall of the US dollar.

The risks are known.

The accounting and audit fees should be around $2000.

If you’re paying more than that, then take a look at the SMSF Review fee comparison table — here. This is an excellent reference source on the fees charged by various SMSF administration services.

There are no costs in holding the cash and depending on where the precious metals are stored, there could be some holding costs.

Let’s say total costs for the fund are $3,000.

This equates to 0.2% of the fund’s asset base.

So far, so good. Low fees, transparency and investment flexibility.

Let’s look at the public offer alternative.

Jim’s objective is ‘preservation of capital’.

To achieve this objective, Jim states that [due to] the great uncertainty at the moment, I would initially put more than 80% of my funds in diversified fixed interest’.

According to Australian Super, the Diversified Fixed Interest fund, among other bond offerings, can invest in high yield bonds.

Obviously, high yield carries high risk. There are no free lunches.

Diversified Fixed Interest


Source: Australian Super
[Click to enlarge]

The exact exposure to high yield bonds is difficult to obtain from the website. A quick glance at the various bond holdings suggest it’s not a large amount.

Most people pigeon hole ‘fixed interest’ with ‘term deposit’…a fixed rate of interest for a specified period of time.

In theory that’s correct. However, nothing is ever that straight forward in the world of professional investing.

Fixed interest funds CAN LOSE money…even those holding Government Bonds.

Conversely, they can also make capital gains IN ADDITION to the interest paid.

How?

Through a combination of duration to maturity and interest rates (yield).

If interest rates rise, the fund loses value.

If interest rates fall, the fund gains value.

The longer the duration (time to maturity) the greater the loss or gain can be.

The theory on how the fund can lose money:

The fund invests in a 10-year Government Bond paying 2% per annum.

Within a year of the bond purchase, the 10-year bond rate increases to 3%.

The fund is holding an investment that’s paying 1% per annum less than the current market rate for the next 9-years.

In simple terms, the current value of the bond is calculated as follows:

Amount Invested Interest rate Interest received each year Years to maturity Total interest to be paid
$100M 2% $2M 9 years $18M
$100M 3% $3M 9 years $27M

No investor in their right mind would buy the 2% yielding bond for $100M, when they could invest in the 3% bond and receive an additional $9M over the next nine years.

Therefore, the market would discount the value of the 2% yielding bond by around $9M (the amount of lost interest) to $91M…a loss of 9% in value.

If, there was only one year to maturity, the loss in value would be minimal — as there is only $1M in lost interest.

PLEASE NOTE this exercise is for illustrative purposes. The actual calculation is a little more complex.

Conversely, if rates fall…

Amount Invested Interest rate Interest received each year Years to maturity Total interest to be paid
$100M 3% $3M 9 years $27M
$100M 2% $2M 9 years $18M

The fund is holding a winning hand…it’s bond is paying $9M more than what the market is currently paying. Therefore, the bond value rises to $109M…an increase of 9% in value.

Hopefully, the above calculations have demonstrated why it’s important of know the duration and interest rates (yield) of bond funds.

The following is an extract from Australian Super:

‘Under each[bond] issuer, there may be multiple holdings with different yields and durations. In order to reduce the complexity and volume of information displayed, only one line item per Issuer is published.’

In the interest of reducing complexity, it’s not possible to determine what the upside reward or downside risk might be with the fund.

Which partly explains why the general overview of the fund states the short, medium and long term risk level is — Medium to High.

Diversified Fixed Interest II


Source: Australian Super
[Click to enlarge]

There’s a couple of other points to note from this overview of the fund:

  1. Risk of negative return — about 3 [years] in every 20 years
  2. Investment aim — to beat CPI by 0.5% per annum

On Friday we’ll analyse the rewards v the risks in more detail and show you why SMSF fees are much higher than public offer funds…you won’t believe how the Productivity Commission could have made this serious oversight.

Regards

Vern Gowdie,

Editor, The Gowdie Letter


Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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