- 01Budget tax changes make selling investments less attractive.
- 02Chalmers’ reforms favour income assets and super over personal investments.
- 03Retirees may need a larger super pool than the traditional three-pools theory suggests.
It has taken almost 20 years but Treasurer Jim Chalmers has finally brought about a change to the three pools theory.
In simple terms, the theory that I published in my book Invest or Die way back in 2007, holds that most people should aim to have three pools of wealth of roughly equivalent size.
The first pool is your home, the second is your investments, and the third is your superannuation account.
The whole idea of having three pools is to balance out your asset allocation to allow for flexibility to confront the situations that most of us will encounter.
Many Australians have fallen into the trap of making the house pool too large at the expense of the other two, thereby tipping them into the all-too-common “asset rich, income poor” trap.
Asset Allocation Flexibility
The superannuation pool speaks for itself: super was then, and still is, the most tax-advantaged and efficient way to save for a great retirement, and to eventually replace the income that comes from working.
If anything, the importance of the super pool has grown further over the years.
I still believe investments outside of super is a vital pool to concentrate on, for several reasons.
Firstly, the personal investment pool can smooth out the road to retirement by bridging any gap between when you stop working and when the age pension kicks in at the age of 67.
Secondly, building up an investment pool teaches you many lessons in how to become a better investor—skills that keep paying off over your lifetime and will also have a positive influence over any children.
Thirdly, the investment pool can provide valuable income that lasts a long time, potentially helping to fund a good retirement and even aged care if that becomes necessary.
Investment Pool Shrinkage
It is the size and composition of this pool that the substantial investment changes in the last Budget have really brought into question.
In simple terms, the changes to negative gearing and capital gains tax have removed the ability to gradually sell down investments without triggering significant taxation.
Investment income is also now treated more concessionally than investment capital gains, changing the equation significantly.
This makes living off this pool harder than it used to be and prioritises income producing assets above really high capital gains.
It also tips the equation into favouring topping up the superannuation pool instead of the investment pool.
Super Needs to Grow
What I am saying here is that under the current rules, you should aim to get the superannuation pool bigger than the personal investment pool by the time you are looking to retire.
In reality, super is just a different vehicle to contain investments and I believe that, unless the rules change again, it has moved up the pecking order up to and until you start to hit the upper limits when taxes increase.
For retirement that is currently a transfer balance cap of $2.1 million that can be transferred into a tax-free pension.
Before hitting that number it is worth both spouses, in the case of a couple, maximising their super contributions up further towards the current annual concessional contribution cap of $32,500 if possible, using salary sacrifice and spouse co-contributions where possible.
Income Investments Skew
Within the personal investment pool, the focus has skewed a little towards investments that might show slightly lower capital gains but that offer a strong and tax advantaged yield.
The days of waiting for a low tax year and selling down some assets with high capital gains tax free are effectively on the way out.
The new best strategy is to aim for long term holdings with a good, tax advantaged (fully franked) yield as a long-term investment that can be held virtually forever.
Broad ETFs across the large local and international share market indexes, and listed investment companies such as Australian Foundation (ASX: AFI) and Argo Investments (ASX: ARG), are ideal for this purpose.
Don’t Let Tax Dominate
Of course, tax is just one of the elements in the investment equation and it is important not to let it dominate your investment thinking.
However, in the case of the latest changes to CGT and negative gearing it has reluctantly forced me to revise the three pools theory so that superannuation takes up a bigger slice than it used to.
It simply makes more sense to enlarge the super pool and shrink the personal investment pool a little to maximise long term flexibility and returns.
However, it remains important to build up personal investments over time to allow for the unexpected, given that the Achilles heel of super is that it is usually only available at the age of 60 after leaving a job or in any circumstances after 65.
Super may offer the best chance for the highest after tax returns, but the investment lessons you learn when building up the investment pool and the flexibility to dip into that pool as required make it still a great thing to have in your asset allocation.
It is also worth remembering that, even under the new tax arrangements, you still only pay CGT after you sell.
That makes buying forever shares with a high fully franked yield an even stronger priority, without neglecting the need for international diversification to ensure you have exposure to large offshore markets such as the US, Europe, and Asia.
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The ASX small-cap stories that matter, filed before 9am AEST. Curated by the Small Caps desk.