The strategic fit of investment bonds - Part 1: timeframe of 10 years or more

Strategies

David Barrett
Tuesday 31 October 2017

The reduced capacity for super contributions from 1 July 2017 will inevitably cause financial services professionals to consider alternative strategies to superannuation contributions for some clients. In a previous article The long term impact of Super Reform 2017 it was concluded that the alternatives to high personal marginal tax rates include strategies which leverage the corporate tax rate.

Following that theme, we have now produced a series of articles which examine where and how investment bonds can fit into the list of investment strategy options of a financial services professional.

This article is Part I – it introduces investment bonds and their relative attractiveness if held for 10 years or more. Part II examines using investment bonds when splitting a portfolio into defensive and growth assets. Finally, in Part III we will examine the opportunity for holding investment bonds for up to eight years.


What is an ‘investment bond’?

The term investment bond in this series of articles includes investment only policies offered by life offices and friendly societies. Our research indicates there are currently six organisations offering investment bonds, four life offices and two friendly societies: AMP, Austock, Australian Unity, Centuria, CommInsure and IOOF. For the purposes of the discussion here, there is no difference from a tax perspective between investment bonds offered by a life office and a friendly society.

Investment bonds are an investment-only product where contributed capital is invested by the life office or friendly society, with the investment returns taxable at the corporate rate. If the investment bond is realised 10 years or more after inception, the returns are not taxable in the hands of the policy owner (ie the individual investor). If realised within 10 years, a portion of the returns may be taxable, but a tax offset equal to 30 per cent of the taxable amount is generally applicable.


Investment bonds versus personal investment over 10 years

If realised 10 years or more after inception, the only tax paid is internal tax at the corporate tax rate. However, no capital gains tax (CGT) discount is available for the bond provider, which is unfavourable compared to the personal taxation position where up to 50 per cent of a capital gain may be exempt from tax.

So a direct comparison of the corporate tax rate, where 100 per cent of returns are taxable at 30 per cent per annum, and a personal marginal tax rate, where some reduced percentage of the returns are taxable, is not appropriate. For a valid comparison, the calculations must allow for the discounted capital gain when investing personally or via an accumulation account in superannuation.


Return assumptions – comparing apples with apples

Assume that the underlying investment is a balanced portfolio of diversified assets in six asset classes: cash, Australian fixed interest, international fixed interest, Australian equities, international equities and property.

The after-fees illustrative projection rate for the portfolio is assumed to be 6.7 per cent per annum, comprised of 3.3 per cent income (including imputation credits) and 3.4 per cent capital growth (assuming 20 per cent turnover of assets per annum). Refer to the Projection Rate Assumptions below for further details.

Capital gains amount to approximately 51 per cent of the after fees return in this balanced portfolio. There are two tax benefits from the capital gains: firstly, some level of exemption from tax for individuals, generally 50 per cent of the capital gain where the asset has been held for at least 12 months, and secondly, a deferral benefit resulting from tax being payable only when the asset is realised. We have assumed that 20 per cent of the assets within the balanced portfolio are turned over each year, so the average holding period is five years.

Based on these assumptions, Table 1 below shows the effective tax rate applying to the gross after-fees return (6.7 per cent per annum) for the various personal marginal tax rates (with 50 per cent CGT discount applying), superannuation and investment bonds held for 10 years or more.


Table 1: Effective tax rates assuming 6.7 per cent per annum

Investment strategyGross tax rate (%) (includes Medicare levy where applicable)Effective tax rate (%) (allowing for CGT discounts and deferral)
Personal investment - $0 - 18,200 0 0
Personal investment - $18,200-37,000 21 14.9
Personal investment - $37,000-87,000 34.5 24.5
Personal investment - $87,000-180,000 39 27.7
Personal investment - $180,000+ 47 33.4
Superannuation - Accumulation 15 11.8
Superannuation - Pension 0 0
Investment bond 30 28.8

The table shows that the effective tax rate in the investment bond (28.8 per cent) is appealing only in comparison to personal investment subject to tax at the top marginal tax rate (33.4 per cent). Based on the return assumptions here, an individual would not choose an investment bond as their investment strategy unless their marginal tax rate (including Medicare) was 47 per cent.

The impact of different levels of capital gains is shown in Table 2 below, where the capital gain is varied by plus or minus one percent of the standard return assumption.


Table 2: Effective tax rates assuming 6.7 per cent per annum and minus/plus 1 per cent

Investment strategyCapital gain 2.4%Capital gain 3.4%Capital gain 4.4%
Personal investment - 0 0 0 0
Personal investment - 21 15.9 14.9 14.0
Personal investment - 34.5 26.2 24.5 23.1
Personal investment - 39 29.6 27.7 26.2
Personal investment - 47 35.7 33.4 31.6
Investment bond - 30 29.2 28.8 28.3

Reducing the capital gain amount in the total return increases the relative attractiveness of investment bonds as an investment strategy. At the lower level of capital gain (2.4 per cent per annum) in Table 2, an individual might prefer the investment bond strategy if their marginal tax rate was 39 per cent or above.


Impact of reduced corporate tax rate

Note that legislation is currently before Parliament which, if passed, will progressively reduce the corporate tax rate to 25 per cent by 1 July 2026 for all corporate entities. For larger entities (aggregate turnover of more than $1 billion), the reduction from 30 per cent will begin to occur from 1 July 2023, if the proposed legislation becomes law.

Investment bonds will become relatively more attractive as the corporate tax rate reduces. The effective tax rate on an insurance bond invested in the balanced portfolio described below in the Projection Rate Assumptions will reduce (from 28.8 per cent currently) to 23.9 per cent when the corporate tax rate reaches 25 per cent. Based on these return assumptions, investment bonds will be more attractive than personal investment for investors with taxable income of $37,000 or more.


Conclusion

At our assumed return assumptions, investing in the balanced portfolio via an investment bond would not be the preferred strategy to personal investment unless the investor is subject to tax at the top marginal tax rate. However, we have demonstrated that reducing the level of capital gains increases the relative attractiveness of the investment bond strategy.

In Part II of this article series, we explore concentrating defensive assets in an investment bond and growth assets in personal name.


Further reading

Read more about the strategic fit of investment bonds in our 3 part series

Part 1: timeframe of 10 years or more

Part 2: split portfolios

Part 3: timeframe of up to 8 years



Projection Rate Assumptions

The assumed after-fees pre-tax projection rate of 6.7 per cent per annum used in this article is based on the asset class weightings, long term income and capital growth projection rates and other assumptions in the table below.

These rates aren’t guaranteed, are provided as an illustration only, and may vary from actual results. The projection rates aren’t intended to be and shouldn’t be relied on when making a decision about a particular financial product.

Values in today’s dollars are shown after discounting future values by the assumed consumer price index (CPI) projection rate of 2.5 per cent per annum.


Asset AllocationCapital GrowthIncomeFranking PercentageTax free proportionTax deferred proportion
Australian Equities 30% 5.0% 3.5% 60.0% - -
Property 10% 2.0% 7.0% - 0.0% 20.0%
Cash 5% - 4.5% - - -
Australian Fixed Interest 20% - 6.5% - - -
Overseas Equities 25% 7.0% 2.5% - - -
Overseas Fixed Interest 10% - 6.0% - - -

Fees per annum 1.5%
Holding Period in years 5.0
Turnover p.a. 20%

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