Thoughts about the 2019 Australian Federal Election

In my previous post (How to Adapt to the Labor Party’s Reforms to Franking Credits) I spoke about how to adjust your portfolio if Labor won the 2019 Australian federal election. The polls and the betting odds were showing a Labor win, but remarkably the Coalition won, so everything is business as usual. I will admit the result came as a huge surprise for me and although I did not vote for the Coalition, I accept the will of the people as this is a democracy.
I have mixed feelings because personally I imagine I will benefit from the Coalition’s policies e.g. cash refunds from franking credits as well as capital gains discounts and reductions in the top tax rates down to 30%. A large portion of my wealth (maybe 70%) is in Australian shares. The focus of the election was on the property market and in particularly on negative gearing, but negative gearing does not impact me because I positively gear into stocks. Leveraging into high dividend shares to get franking credits usually results in a positive gearing position because the dividend income typically exceeds the interest expense.
Something that bothers me and makes me feel some sense of guilt is that I understand that more money in my hands to live off dividends means there is less money for others. Some may flippantly say that if I want to fund these programs, I should do so with my own money, but welfare is not sustainable without taxation. Medicare, for example, would never work if it relied on private donations.

Labor proposed a number of policies that would have helped the poor, the sick, and the environment e.g. subsidised dental care, subsidised treatment for cancer patients, subsidised childcare, and funding for climate change action. That many people would vote for money to be given to investors to leverage or gear into the property and stock markets and live off dividends rather than fund these other worthwhile causes is, in my opinion, quite disappointing because it reveals something quite negative about human nature. It is yet further evidence that human nature is darker than I imagine. I am not naive, but I do wrestle between wanting to belive that humans are inherent good vs inherently bad, and it seems that every day there is a stream of evidence that points towards the the idea that humans are innately bad.

Many people think I am lame for thinking this way. My father tells me I should forget about others and think about myself. He constantly tells me I need to “man up” and get married, have children, etc. However, when I think about human nature, it makes me think about whether I should have children or whether I should start a family. With childcare costs rising and with climate change presenting an existential risk for the next generation, does it make sense to have children? If people are truly bad, what sort of world would my child inherit? What sort of social ills would my child be faced with?
I am still childfree and single but haven’t ruled out a relationship, marriage or children, but I am not the sort of person who would just jump into something big without careful consideration.
The way I see it, there are two options. One is believing in the goodness of humanity and instilling these positive values in my child so they grow up and contribute to a positive society and world. Financial independence becomes a means of funding procreation, and procreation is pursued for the sake of perpetuating the human species because the human species is good.
The other option is to believe that humans are inherent bad, and in this case financial independence plays a defensive role with passive income used to retire early and to shield myself from society.

How to Adapt to the Labor Party’s Reforms to Franking Credits

According to the Sportsbet odds, there is a very good chance that the Australian Labor Party will win the next election, and there are a number of proposed policies that will have a large impact on investors.

Sportsbet odds as of 6 April 2019 have Labor winning the next Australian federal election

I don’t want to focus too much on my personal political views as I feel I should only discuss personal finance here, but personally, even if I benefit economically by voting for the Liberals, there are many other non-economic issues that bother me about the Liberals e.g. it is highly likely that there is a Nazi faction within the Liberal party. This raises the likelihood that the Liberals will engage in Trump-style divisive politics based on racism and sexism. Furthermore, something I care about more than money is the environment, and the Liberals are filled with climate change skeptics.

Back to the topic of personal finance, one proposed Labor policy is banning refundable franking credits. This has mislead many people who think that franking credits will be banned. In order to understand what this policy is, it is important to understand what franking credits are.

Australian companies pay a corporate tax rate of 30% on their profits. A portion of the profits is then distributed to to shareholders as dividends. However, when shareholders receive dividends, they pay tax on their dividends. As a result, there is “double taxation” i.e. the company pays taxes on profits and then the shareholder pays income tax. To fix this problem, when companies pay dividends, they can attach franking credits to it, which allows the tax paid by companies to be refunded back to the shareholder.

Companies pay 30% corporate tax, but shareholders pay income tax, and given that there is progressive taxation is Australia, shareholders may pay anywhere from zero tax to 45% tax depending on their income. The higher your income, the higher your income tax rate. If you are on the highest income tax rate of 45% then the franking credits that refund the 30% corporate tax back to you will not cover all your taxes and you will still need to pay money to the government. However, there are many people who retired who have low income and live off dividends. Because they earn little, they may pay zero income tax, but because dividends have franking credits, they are in a position to receive money from the government. It is these cash refunds that Labor is targeting, not franking credits in general.

How to adapt to the new policy

Franking credits do not apply to all investment income. For example, income from property has no franking credits e.g. REITs. Furthermore, income from outside of Australia e.g. US equity ETFs such as IVV pay dividends with no franking credits.

In order to adapt to the new policy, simply increase the amount of unfranked investment income you receive. Once the amount of unfranked investment income increases, the income tax you pay will rise. Remember you only get a cash refund when your personal income tax is below 30% so if you increase how much unfranked investment income you receive such that your personal tax rate is at or above 30% then any franking credits you receive will simply offset the taxes you pay on the unfranked income you receive, so you don’t need to worry about receiving a cash refund.

As I said, the easiest way to achieve this is to invest not just in Australia but to go overseas and invest outside of Australia. Examples of ETFs that achieve this are VGE (as well as the ethical equivalent VESG) as well as INCM, which is globally focused equity income ETF. Another option is to invest in AREITs e.g. SLF, which invests mostly in Australian commercial property and pay quite high rental yields.

Is Salary Sacrificing into Super Worth It?

Because I live in Australia, there are some financial ideas that are unique to Australians e.g. franking credits, negative gearing, and superannuation.

Firstly, what is superannuation? Superannuation (or super) is a retirement fund similar to the US’s 401k. When your employer pays you, they are required by law to put 9.5% of your salary into your super. This super is locked up until you are old (about 60 to 70).

Why salary sacrifice into super? Compared to many other countries, income tax is high in Australia. Any amount you earn over $37k has a 32.5% income tax rate applied to it. If you earn over $90k then any amount over $90k attracts a 37% income tax rate. However, suppose you earned $100k per year and you arranged with your employer to salary sacrifice $10k into your super fund, then this means that rather than paying $3700 tax on that $10k and receiving $6300 in your bank account, you instead have that $10k go into your super fund and where it is taxed at only 15% i.e. you pay $1500 tax. This means you save $2200 per year assuming you salary sacrifice $10k per year.

If the tax benefits are so good, why not salary sacrifice everything into super? The answer is that there is a limit. The amount your employer puts in (9.5%) and the amount you salary sacrifice cannot exceed $25k per year. Take the example of someone who earns $100k. This figure does not include super. The employer is paying $9500 (9.5% of $100k) per year into superannuation by law. However, if the worker wants to top this up by salary sacrificing, they should simply find the difference between $25k and the compulsory contribution amount ($9500) and then salary sacrifice this amount. In this case, the person earning $100k should salary sacrifice $15500 per year to fully take advantage of the tax benefits. If you get paid every fortnight, simply divide this by 26 and therefore salary sacrifice $596 per fortnight. In my opinion, you should always salary sacrifice a little bit below the limit because your salary will likely increase bit by bit over time. If the amount you salary sacrifice is exactly $25k then the next salary increase (e.g. due to inflation correction) can tip you over the $25k mark, which leads to punitive taxes applied to you. Therefore, I recommend aiming for $23k or $24k just to be safe.

Using the example of earning $100k per year, if you are salary sacrificing $10k per year you’d save $2200 per year. If you salary sacrifice to the max then you’d be making $3410 per year.

Assuming you save $3410 per year over 30 year, then assuming 8% per annum returns, you’d have $250k.

What are the downsides of salary sacrificing into super?

Even though there are tax benefits, the main disadvantage of salary sacrificing into your super fund is that you do not get access to this money until you are around 60 to 70. However, there are hardship provisions in superannuation that allows you to access your super under severe financial hardship. Given that I am a long-term investor, I normally buy and hold investments forever. I will only ever sell if there is severe financial hardship. Therefore, keeping money in super doesn’t make much difference. For most people who do not salary sacrifice into super, their main reason is that they need to pay the mortgage, but they are simply building up savings in their house, and because houses have high transaction costs, chances are they will only sell the house under severe financial hardship as well.

One common argument people use against superannuation is that the “rules can change.” That is, while your money is locked up in superannuation, the government could change the rules and e.g. increase taxes on it. However, this is not a good argument. The risk of government changing rules or legislation apply to all investments. For example, if you do not salary sacrifice and invest in property and shares outside of super, the upcoming proposed changes to negative gearing, capital gains tax and franking credits will affect you. Unless you invest in offshore accounts or cryptocurrency, you are at risk of “rules changing,” and even if you invest in, say, offshore accounts, then offshore jurisdictions are subject to changes in legislation, and cryptocurrency protocols can change, leading to “hard forks.” You can never escape the risk of legislative or protocol amendment. The only way to mitigate this risk is to diversify.

The key downside of salary sacrificing into super is that you do not get passive income, which impacts on your ability to be finacnially independent. If you salary sacrifice $10k into super, that $10k does not produce dividends that go into your bank account for spending. It simply accrues in the super fund and accumulates until you are, say, 60. This means that if you seek to be financially independent quickly or retire very early, salary sacrificing into super can be a problem. However, there are workarounds.

The four percent rule

The four percent rule states that when you retire you spend 4% per year. Suppose you retire with $1 million in net worth. You simply spend $40k per year. Now suppose you had $500k in super and $500k outside super. One strategy is to continue to use the 4% rule but to retire at a time such that you can use the 4% rule and then time it so that you run out of your $500k outside of super just before you have access to superannuation.

Coast FI or Barista FI

Another option is called “coast FI” or “barista FI” which are terms used among the online FIRE community (financial indepence retire early). Basically you can salary sacrifice to the max early in your career such that you have, say, $200k in super by age 30. Assuming 8% per annum growth, then this $200k in super will become $2 million by age 60 assuming no extra contributions. Therefore, through aggressive early savings, your 60s are covered. Having $2 million when you are 60 is more than enough. However, because you have locked up a considerable amount of money into super, you may live a lower standard of living up until you are 60.

One solution to this suggested by the FIRE community is “coast FI” which sadly has nothing to do with the Gold Coast. Rather, you coast to your 60s by taking it easy and doing easy jobs (e.g. a barista, although based on what I have seen being a barista is quite difficult). However, in my opinion, this is not a good strategy because even easy work is still work, and there is no guarantee that you will be able to find easy work in the upcoming age of automation. The whole point of financial independence is to enable you to live without a job so that you can pursue whatever you are passionate about.

Although there are problems with barista FI, the insight that barista FI brings up is that you don’t need to retire early. Once you live off dividends, rather than retire and stop working, you can keep working but simply don’t work as hard. You don’t need to work as a barista, but you can work the current job you work but simply work in a more relaxed manner. This may mean you spend more time at work chatting to coworkers or it may mean you work part-time and take more holidays. A more mainstream term for this is “semi-retirement.” Another option is to change jobs and do something you are passionate about e.g. you may build online social enterprises that help the world.

The solution to the superannuation dilemma

Superannuation presents many Australians with a complicated dilemma. Either you salary sacrifice and increase your wealth thanks to tax benefits but lock your money up unitl you are very old, or you do not salary sacrifice, reduce your wealth, but reach financial independence faster.

In my opinion, you should salary sacrifice to the max early in your career. However, to accelerate your chances of becoming financially independent as fast as possible, live as minimalist a life as possible (e.g. living with roommates or with parents, riding bikes or taking public transport, never having children, etc) and then with your money outside of super apply the Peter Thornhill approach by investing all your money into high dividend paying Australian equity ETFs and LICs (e.g. VHY, IHD, RARI, EINC, RINC, BKI, AFI, and ARG). Because Australian equities are blessed with high dividend yield and franking credits, this coupled with a highly minimalist lifestyle will allow you to quickly achieve financial independence. To use some example numbers, the cost of a sharehouse found via Gumtree or Facebook is about $700 per month. The cost of meal replacement drink Aussielent (which I use as the basis for the cost of food) is $256 per month. Then if you get a bike then you can cover all necessities for $1000 per month or $12,000 per year. Assuming dividend yield of 7% then this means you need to save up $170k. Adding income tax and offsetting it with franking credits, this means you’ll only need to save up about $200k in high dividend ETFs or LICs to be able to be financially independent. After you have $200k, you can start to diversify your portfolio away from Australian equity to reduce risk (e.g. into bonds and international equities). Then over time, as your dividend income increases, you can slowly increase your living standards, e.g. live by yourself rather than with housemates or parents. You can eat tastier food rather than Aussielent, etc. However, for the sake of financial indpendence, your living expenses should not exceed your passive income because you must minimise the amount of time you are dependent on your job.

Because you salary sacrifice into super, there is a good chance a large chunk of your net worth will be in illiquid assets, so your living standards will be low up until you are 60 and then suddenly after 60 you will have a very high standard of living.

Retirement (or semi-retirement) in Southeast Asia

If you salary sacrifice into super, you will have a considerable amount of money in your 60s or 70s, but before you are old, you will likely live a minimalist lifestyle assuming you live off dividends. A way to increase your standard of living is to retire early in Southeast Asia where the cost of living is lower. Before I spoke about how $1000 per month is enough to live a very minimalist lifestyle in Australia, but in many Southeast Asian cities e.g. Chiang Mai, Ubud or Sihanoukville, $1000 per month can afford a more comfortable standard of living. You can retire early and then come back to Australia in your 60s to collect your superannuation and then retire in Australia. Because Southeast Asia is a bit “rougher” than Australia, younger people in their forties or fifties can tolerate it better, so if you end up retiring early in your forties or fifties living off dividends, you can go to Southeast Asia for retirement and then come back to Australia to cash out your super. One of the benefits of living in Australia is its socialist healthcare system (Medicare) that provides free medical care for all. This is particularly useful for older people. That being said, if you reach the age of 60 or 70 with net worth of $2 million, that sort of money can buy good healthcare even in e.g. Thailand. Cities such as Bangkok have international-standard private hospitals that many people from all over the world travel to for medical treatment.

Disclosure: I currently own IHD.

Top 10 ASX ETFs or LICs

See below a chart providing a ranking of the best income-producing ETFs or LICs on the ASX. The chart below updates in real time and estimates future income returns (including franking credits) based on historic returns. Past performance does not guarantee future performance. The chart below is not exhaustive and does not include all ETFs and LICs.