Super funds need to review their priorities as the window for tax-free change and restructuring is coming to an end, writes Raewyn Williams, the director of research and after-tax solutions at Parametric Australia.
The Australian superannuation pool has crossed $2 trillion in assets under management, making this sector a mega taxable investor base. Taxes can be imposed when contributions are made to a fund, on investment earnings which accrue within a fund and (sometimes) when benefits are paid out of a fund. The 15 per cent tax on earnings is unusual globally because pension fund earnings are tax exempt in most other countries.
One consequence of this is that most overseas fund managers have practically no experience in managing investment taxes for their pension fund investors.
Strangely, most Australian fund managers show a similar lack of experience in managing after-tax investment returns even though their superannuation fund clients have paid tax on investment earnings since 1988. The rising tax cost of investing began to attract attention in the mid 2000s equities rally … and then the GFC hit.
Through the GFC years, superannuation funds accumulated significant realised tax losses, which seemed to buy them some time to determine how best to manage returns after tax.
From a unit pricing perspective, these tax losses were recorded as large ‘DTA’ (Deferred Tax Asset) positions in funds’ unit prices and member accounts. While DTAs alleviated some technical unit pricing risks, for example, around Capital Gains Tax (CGT) discount provisioning assumptions, they also highlighted difficult capping issues (how much of the DTA to recognise in members’ account value).
Parametric’s analysis of APRA statistics suggests that most superannuation funds were moving from a Deferred Tax Asset (tax losses) to a ‘DTL’ or Deferred Tax Liability (taxable gains and liability) position by the end of 2014 as the equity markets strengthened (see graph below).
There are two important investment actions for superannuation funds to take when moving from DTA positions back to DTLs.
First, is to reconsider the timetable for restructures, manager appointments and other proposed changes. Change often involves selling out of assets and structures which usually triggers capital gains. When the superannuation funds are sitting on a big bank of tax losses (DTAs) to offset the gains, there’s no tax cost to the change. But now that they have used up their bank of tax loss shelters and are moving back into DTL territory, tax becomes, again, a cost of the restructure/change. As a rule of thumb, the higher the DTL, the higher the tax cost of the change. Funds need to recognise that their window of opportunity for implementing change without significant tax costs could be fast contracting and adjust their priorities and timetables accordingly. This should include a kind of ‘sequencing opportunity’ where certain changes which introduce tax management capabilities should be ‘fast-tracked’ to reduce the tax costs of later changes. An example is adopting a tax-managed Centralised Portfolio Management platform which, as a high-impact change, is often thought of as a change to be implemented at the end of a sequence whereas, when implemented early, can streamline and tax-manage all the changes a fund implements afterwards.
Second, there is a need for superannuation funds to return to the important task of identifying, scoping and implementing solutions to measure and manage the cost of CGT and other taxes on an ongoing basis. The ideal solutions are designed to deliver the triple benefits of fiduciary alignment with members’ after-tax focus, better transparency in the investment portfolio and better expected returns to members. This will also ensure the fund is complying with its recently-introduced SIS Act obligations to demonstrate an after-tax investment focus.
Parametric Portfolio Associates LLC (“Parametric”), headquartered in Seattle, Washington, is registered with the United States Securities and Exchange Commission (“SEC”) as an investment adviser under the United States Investment Advisers Act of 1940. Parametric is exempt from the requirement to hold an Australian financial services license under the Australian Corporations Act 2001 (Cth) (Corporations Act) in respect of the provision of financial services to wholesale clients as defined in the Corporations Act and the Australian Securities and Investments Commission’s (“ASIC”) Class Order 03/1100. SEC rules and regulations may differ from Australian law. Parametric is not a licensed tax agent or advisor in Australia and this does not represent tax advice. This material is intended for wholesale use only and is not intended for distribution to, nor should it be relied upon, by retail clients.