Beware of borrowing to invest

The Government’s halving of the annual caps on concessional super contributions from July 1 will inevitably lead to more investors taking higher risks by gearing up their super and non-super investments.

Numerous investors are now likely to either lift their existing level of investment borrowings or gear for the first time, in an effort to claw back some of the tax concessions and potential higher returns lost with the cutting of these caps.

Until the reduction of the caps, the prospect of investors ramping up their gearing at this time had seemed highly unlikely given the world financial crisis, the savage bear market and the spectacular collapse of Storm Financial with its geared-to-the-hilt investment strategies.

The likelihood of an outbreak of higher-risk gearing appears to have been overlooked by some commentators and financial planners, who have been trying to understand what the change to the concessional contribution caps may mean for investor behaviour.

Apart from the impact on the ability to save for retirement, the halving of these caps means that super fund members have lost a large proportion of the immediate tax breaks for making concessional super contributions.

Concessional contributions are made up of superannuation guarantee, salary-sacrifice and personally-deductible contributions by the self-employed and eligible investors.

The Federal Budget and subsequent legislation halved the caps for these contributions to $50,000 for fund members over 50 and to an indexed $25,000 for members under 50.

And significantly in three years’ time, the concessional contribution cap for members over 50 will halve again to $25,000 or to match the indexed cap then applying to other fund members.

Just think how many investors could react to the abrupt and shock loss of an annual tax deduction (or its equivalent if an employee) of $25,000 to $50,000 a year with the cutting of the concessional contribution caps. And this loss of an annual tax deduction (or its equivalent) will climb to close to $75,000 in three years for members over 50.

Members making a large concessional contribution into super could get a huge tax deduction at little or no risk – depending upon the asset allocation of their super funds. (Members can choose, for instance, for all of their new super contributions to go into cash while holding their existing super savings in, say, diversified portfolios.)

But the level of risk can rapidly rise if investments are geared.

Here are six strategies to minimise the new gearing risks following the cutting of the concessional contribution caps:

1) Take extreme care if gearing within your DIY fund

More fund trustees are likely to be drawn to gearing fund assets in an attempt to increase fund earnings following the reduction of the contribution caps. In this way, they would be attempting to make their super funds assets work harder and produce higher returns though gearing.

For almost two years, self-managed super funds have been unequivocally allowed to borrow to invest using installment warrants or similar arrangements. In short, only non-recourse loans are permitted.

This is a watering down of the previous ban on borrowing to invest by a super fund.

Superannuation law stipulates that a fund’s geared investments must be held in trust until the final installment or payment is made, and that the lender cannot make a claim against any other assets of the fund apart from the geared asset itself.

Tax and superannuation lawyer Richards suspects that many trustees would not understand the consequences if their DIY funds were to default on the loan payments – perhaps after the failure of investments or the inability of the funds to make all of the payments.

Richards says the funds in such circumstances could lose: the initial instalment; any subsequent payments to the date of the default and any fees or interest paid to the promoter and lender.

“I have heard of fund trustees putting all of their funds’ assets into geared shares in just one listed company,” Richards says. These funds had used installment warrants for their gearing.

“Some trustees want the tax advantages of super yet to be aggressive in their gearing,” Richards adds. “To switch to gearing just because concessional contribution caps have been halved is excess stupidity,” he says.

2) Make sure your DIY fund can meet any gearing obligations

Richards warns that the cutting of the concessional contribution caps may make it harder for a super fund to meet its obligations to make payments on a geared investment.

The reason is simply because the ability of members to contribute to their super funds in the most tax-effective way has been cut right back.

3) Think twice about whether you really want to gear your super

Dominic McCormick, chief investment officer of Select Asset Management, believes that investors should limit any gearing, if appropriate for their personal circumstances, to their non-superannuation investments.

McCormick says that given the annual contribution caps, a person can only contribute a limited amount to super and cannot simply top-up fund balances if money is lost through the failure of a geared investment.

4) Don’t forget the lessons of Storm Financial and many of the bear-market casualties of aggressive gearing

An investor who tries to maximise the negative-gearing of their non-super investments in an attempt to make up for much of the lost tax deductions with the halving of the concessional contribution caps is asking for trouble.

A common strategy recommended by the failed financial planning group Storm Financial involved encouraging clients to borrow as much as possible against the equity in their homes. And then Storm recommended using this borrowed money to finance shares that were, in turn, geared to the maximum allowable by the lender.

This truly double-jeopardy borrowing was often adopted by Storm clients nearing retirement, and was clearly beyond their personal tolerance to investment risk.

5) Make sure you understand the risks of gearing

McCormick says that, “all things considered”, negative-gearing into the sharemarket certainly makes more sense than it did 15 to 18 months ago.

However, McCormick is convinced that negative-gearing only makes sense for a small proportion of investors. “You should only gear if you understand the risks,” he says.

Sydney financial planner Graham Horrocks warns that investors should really understand both the investments themselves and the extra risks involved if gearing those investments.

“If you understand how an investment is likely to behave, it will help get away from the problem of panicking [when markets fall],” he says.

Horrocks suggests that investors ask themselves whether the potential extra return from a negative-gearing strategy is worth the extra risks. “And don’t be too greedy and impatient [with gearing],” he adds. “Don’t try to become wealthy overnight.”

6) Give yourself plenty of time

Horrocks says that as a general rule, investors should aim to hold negative-geared investments for at least 10 years. Over such a long period, markets might experience some sharp falls and sharp rises.

Investors within, say, five years of retirement may not have enough time for a negatively-geared investment to succeed, Horrocks adds. And many investors in the countdown to retirement may have difficulty coping with the additional risks of negative-gearing.