Superannuation’s Legislative Risk

I recently got back from a short holiday in Canberra, our nation’s capital. Amongst other touristy things, we visited Old Parliament House, where there is an Australian Democracy Museum. One of the displays is on the past Prime Ministers, and when you see them all together, you realise that we’ve had a lot of them, in the century and a bit that we’ve run our own parliament.

In fact, from 1901 to 2010, we’ve had 31 changes of government. For those not doing the math as we go along, that’s one every three and a half years.

And for someone who is, say, 35 years old, and facing 25 years before they can get access to the money in their superannuation, there’s an expected 7 or so new governments that will have a chance to meddle with it in the mean time.

The risk of current and future governments impacting the performance of an investment through passing laws is called Legislative Risk. Unfortunately, laws that affect superannuation have been prime candidates in the past for government fiddling. In the future, given the rumours about the Henry Tax Review, it will almost certainly get further tweaking still.

If you’re an employee, participation in superannuation is compulsory, where 9% of the total salary package (or thereabouts) is locked away in the system. Unless employees are willing to go to the expense and effort of setting up a Self Managed Super Fund, their money is generally invested in Australian stocks and bonds. So, if you want to invest in say fine art, residential property, a family company or venture-capital backed start ups, you aren’t going to get any joy with super.

Despite the limited investment options and the long period that you can’t directly benefit from it, an investment in your superannuation gets beneficial tax treatment. This is its key advantage, and the very thing that is vulnerable to legislative risk – a risk that is real, based on past actions and rumoured future actions of our governments.

I think that most Australians would benefit from having some level of investment outside of superannuation (even if it’s just their home), in order to reduce their exposure to this risk.

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Funds and Property

I’ve written about it before (“I am not a nutter” and “That’s not a Housing Affordability Crisis”), and I’m about to write about it again. Today I received a letter from my accountant (who, admittedly, is more savvy than the average accountant when it comes to property) confirming, and even encouraging purchase of geared property in a super fund. I quote:

If you have over $120,000 sitting in Superannuation you can now buy property through your superannuation fund … the SMSF makes the first installment of 20% deposit plus stamp duty/ legal costs plus the first year’s interest repayment.

And I have also come across a company called the Quantum Group that is setting up a similar structure for superannuation funds, calling them property warrants. So, there’s also an option for people whose accountants aren’t quite as savvy.

The residential property market has been performing quite well recently. For example, the average annual growth of median residential property prices in Melbourne over the last ten years has been 10.65% (according to this article, reporting Residex figures). If a property purchased at $450,000 (the current Melbourne median property price) grows at the average figure of 10.65% annually, and is purchased at a gearing level of 80% (as in the example from my accountant), then the growth is considerably higher. Ignoring tax, rents and interest payments, the $90,000 invested would become equity of around $880,000 after ten years – that’s about 25% annual growth. Not bad, and will be hard for super fund investors to ignore.

I would expect that once superannuation funds start investing directly in residential property, the big players in Australian superannuation will want to address the demand by packaging up property so that it is easy to invest in, i.e. indirect investment in residential property, or funds of geared residential property which a SMSF can buy units in. The catch will be that while the SMSF area is regulated by the ATO, the wider superannuation funds industry is regulated by APRA, and they are not going to want to see superannuation funds gearing up and putting people’s pensions at risk. The gearing cat is already out of the bag, so perhaps all they can do is cap it at a more conservative level, of say 60% (this would have produced a return of around 18% in the example above).

It is worth considering what sort of property funds the industry would be looking to set up. Generally they look to the blue-chip end of the market, so in property this would be houses or whole apartment blocks (rather than individual apartments) and in well-established suburbs such as Hawthorn, Toorak and South Yarra in Melbourne, and their equivalents in Sydney and possibly Brisbane. Such property typically goes for multiple millions of dollars, but I would expect that people living in such houses would prefer not to rent it. I don’t really know – I’ve never been in that position myself! Innovation in rental / purchase contracts will probably be required to give residents in such houses the certainty, control, or capital gains that they require. However, where there’s money, there’s incentive to fix such problems.

So, initially, I expect to see the big funds going after apartment blocks, then eventually houses, then when supply is exhausted in the blue-chip areas, moving into neighbouring areas or the other cities in Australia. A side-effect of this staggered buy-up is that these funds may not be particularly diversified. There could be a “Toorak houses” fund, or a “South Yarra apartments” fund. It may not be a bad thing – it doesn’t matter if a particular fund is not diversified as long as someone’s overall portfolio is diversified. And it could enable people buying that type of property in that type of area to invest in something that tracked the investment performance of their dwelling without having to invest in (i.e. renovate) the dwelling itself.

Is this complete speculation, or have similar things happened overseas? Well, to be honest, no. Real-estate Investment Trusts (REITs), as they are often known overseas, tend to invest in hotels, office blocks, shopping centres, and sometimes apartment blocks. Although I’m no expert, I’m not aware of big REITs buying up houses. So, this is all in the realm of speculation. But the fact that it hasn’t happened overseas should not be an indicator that it won’t happen here, as Australia tends to lead the world when it comes to putting real estate into retail funds. According to Wikipedia, the first real-estate trust was launched in Australia in 1971.

Anyway, for the everyday investor, who can’t pony-up a few million to buy a house in Toorak, the impact of competition for real-estate from the major fund managers is likely to be limited. You’re more likely to be bidding against someone running a SMSF. Unfortunately, the number of SMSFs is growing rapidly.

Finally, one thing to watch out for will be unscrupulous operators. There are already dodgey property marketers who prey upon interstate investors, e.g. Perth people buying overpriced property in Melbourne, or Melbourne people buying overpriced property in Brisbane. This will give them one more tool to exploit: that vulnerable people can invest their super into a dodgey scheme, and possibly not realise for many years that the property that they’ve bought was massively overpriced because the whole thing is so hands-off. Hopefully people know not to invest in something they don’t fully understand. It’s a vain hope, I know.

I am not a nutter

My previous post on the possibility of superannuation funds taking out loans to buy property (“That’s not a Housing Affordability Crisis”) has now been shown to be more than the ravings of a complete loony. A mere 6 days after my post, Robin Bowerman, no less than Head of Retail for Vanguard in Australia started talking a similar line. I’m going to quote from his article on “Super changes open the gearing door” from November 16:

… by investing through an instalment warrant structure it means super funds may be able to gear any of the usual investments a super fund can buy … perhaps a residential property for example. The super fund receives all the rental income and gains.

He has based this on a tax office ruling from September 24 on whether and how installment warrants could be bought by SMSF (self-managed super funds), which are regulated by the ATO. This wasn’t something I included in my grab-bag of references, so it adds to the weight that there’s a-change a-foot.

The implications are interesting to speculate about (other than significant price rises for residential property). For example, will we get a whole heap of funds appearing that buy up houses in a particular suburb, e.g. Toorak. Then, instead of parking their money in a bank account after selling their home and before buying a new one, a vendor could put it in such a fund so that it tracks the rise in house prices to help them avoid a movement in the property market in the mean-time.

That’s not a Housing Affordability Crisis

I won’t draw any conclusions here, but I will draw your attention to the following points:

  • There are 7.9 million households in Australia, and on average each household owns $298,000 in residential property, e.g. their own house and other rental properties (from ABS Household Wealth and Wealth Distribution, Australia, 2005-06).
  • This puts a total value on all residential property in Australia of something like $2,400 billion. However, the market cap for the entire Australian stock market is currently about $1,600 billion (from ASX Historical market statistics).
  • Australia is the “fourth-largest retirement savings market in the world” (from the Eureka Report) while superannuation funds are prevented from borrowing any money to buy assets, which is the main way that residential property is bought in Australia.
  • When it comes to shares though, the ATO has softened its stance on some types of gearing. Contracts for Difference (CFDs), when bought with cash, are apparently alright (in Interpretive Decision 2007/56), even though CFDs behave very much like borrowing to purchase a share.
  • Westpac has bought 441 houses from Defence Housing Australia (according to The Australian and a DHA media release) with the intent of launching Australia’s first residential real-estate investment trust.
  • House prices are driven by supply and demand. The superannuation industry has the potential to add a little bit of demand…