Franking credits and the uplift in income they deliver are crucial for every retiree’s investment strategy. The income benefits of franking credits are an intrinsic part of the strategy many investors adopt to attain their retirement goals. These credits, from Australian equities and hybrids, boost the average dividend yield on Australian shares by around 1.5%.
But those benefits could be impacted if limitations proposed by Labor on access to franking credits for some individuals and superannuation funds go ahead.
And even more dramatic changes have been mooted. When the Federal Government was discussing its full suite of corporate tax cuts earlier in the year, some commentators recommended that the entire franking system should be scrapped. While that policy discussion has been parked, it highlights the existential threat to the existing franking credit system.
Many retirees, and those planning for their retirement, have been sensibly trying to understand the direct impact of proposed changes to franking credits on their portfolios.
That understanding is vital, but investors should also consider the indirect effects the changes could have on the broader Australian equities market. And, perhaps most importantly, retirees should also be actively considering how they would need to adjust their retirement strategies and portfolios if changes are implemented to the franking credit system.
Franking credits a recap
Franking credits were introduced in 1987 to address the issue of double taxation on dividend income. They allow Australian investors to claim a credit for their share of the tax a company has already paid on its corporate earnings and use that credit to offset their tax bill.
In the early 2000s, franking credits became fully refundable as part of changes to the dividend imputation system. This meant that investors who pay low tax (such as low-income individuals, charities and superannuation funds) could receive a cash payment from the tax office in circumstances where the credits actually exceeded their tax liabilities.
The value of franking credits in retirement
Franked dividends are extremely valuable to retirees. Retirees with a 0% tax rate on the assets in their account-based pensions receive an uplift of up to 43% on the cash value of franked dividends. By contrast, if a retiree receives $1 of capital gains or unfranked dividends, it will only be worth $1 to them.
It’s true that few retirees will have their entire portfolio in franked Australian shares. And it’s also true, as we discuss later, that retirees may adjust their portfolios if access to franking credits is restricted.
However, research has found that a lack of access to imputation credits potentially reduces how much retirees can consume in retirement by 5% to 6%.1
In fact, this probably underestimates the impact that restricting access to franking credits would have on retirees. It is likely some people will have to re-prioritise their retirement goals or accept a lower quality of life in retirement due to lower income from their investment portfolio.
A portfolio of Australian shares with strong prospects for total return (where a large part of the return is delivered through sustainable dividends and franking credits) can go a long way to meeting retirement goals. It reduces the need to sell shares at potentially untimely moments in financial markets to meet retirement cash flows. This boosts confidence about stability along the retirement journey.
But a future Labor Government might allow franking credits to be offset only against existing tax liabilities, stopping low-tax investors from receiving cash payments when their franking credits exceed their tax liabilities. This would be somewhat like the rules in place pre-2000.
A future Labor Government proposes to exempt the Government investment vehicle Future Fund, as well as charitable and religious organisations from the proposed changes. People who receive a Government pension or allowance, and self-managed superannuation funds which, before 28th March 2018 had a member on a Government pension or allowance, would also be exempt.
That leaves two main groups who would be affected. The first are individual shareholders, outside the social security system, with a small portfolio of Australian shares and limited sources of other taxable income.
The second group are members of superannuation funds where the fund either has limited amounts of concessional contributions, has a high exposure to Australian shares, has losses or limited sources of other taxable income, or has a large proportion of members in pension mode.
In other words, a large number of SMSFs are likely to feel the proposed changes, while those industry superannuation funds with a younger member base are unlikely to be impacted.
Proposed changes to access to franking credits would have a direct impact on many retirees’ portfolios through loss of income uplift and the psychological drawback of greater exposure to market volatility.
But there could also be an indirect impact on portfolios through its wider effects on companies and share prices.
Australian companies typically have a high pay-out ratio (dividends as a percentage of after-tax earnings) relative to global companies because shareholders recognise the benefits of franking credits and lobby companies to distribute them. If access to credits were materially restricted or removed, companies may decide to distribute lower dividends and retain more earnings for re-investment.
Not only would this reduce the relevance of Australian shares to retirees’ investment strategies, it could also produce a material change in corporate governance, company performance and share price volatility.
If it became clear that access to franking credits was to be restricted, there would be short-term pressure on companies to increase their dividends or engage in off-market share buybacks to flush out as many credits as possible. Companies might make unusually large dividend payments and raise equity capital in the same year.
Finally, while it is not part of any current proposal, it is worth noting that if the franking system were to be eliminated, share prices in Australia would be expected to decline meaningfully. Evidence from the premium at which dual-listed stocks in Australia trade relative to their offshore listing (whose shareholders can’t access franking credits) suggests for some of these large dual-listed stocks a decline of 15% would be possible.
How should retirees respond?
Considering these possibilities, what should retirees do to prepare?
Here are four things they may wish to consider:
- Lobby against the proposal
Proposals could be softened if important segments of the community express disharmony with their potential impacts.
- Review savings strategies or retirement goals
People still in the workforce have the option to save more money or work for longer. The clear message is that, without access to franking credits, pre-retirees will need to have higher super balances to meet their lifestyle goals in retirement. Research suggests the amount required could be up to 8% to 9% higher.2
But this may not be an option for many retirees. For these retirees, given that franking credits significantly boost their income, they may choose to consider reducing their spending goals.
- Changing location of assets
Another response could be to change the locations of the investor’s assets. For example, members of SMSFs that are negatively impacted could consider moving Australian shares (or their entire portfolio) to an APRA-regulated superannuation fund with significant tax paying capacity. Based on current understanding, members of many large superannuation funds, including retail platforms, are initially unlikely to be affected by the proposals.
However, there are several caveats to this, and retirees should seek advice if they were to consider this course of action. Firstly, management of drawdowns would become more complex if assets were split between two funds. Secondly, as time progresses some of these large funds could also find themselves negatively impacted due to changing member demographics or market declines that trigger investment losses.
- Revise investment strategy
The final option is to change investment strategies. Australian investors, particularly SMSFs, are often criticised for having a home country bias towards Australian equities. But current access to franking credits supports skewing Australian retirement portfolios towards Australian equities.3
If a retiree’s access to franking credits were removed, it would be appropriate to consider reducing exposure to Australian shares. However, careful planning would be required before any adjustment given legislative uncertainties and the possibility of the short-term corporate response mentioned earlier.
It would make sense to re-allocate to a combination of international shares, listed property trusts and listed infrastructure shares. And it might be appropriate to select portfolios with a bias toward income in those asset classes.
Also, if the likelihood of meeting retirement incomes goals is to be maintained, it is important to be aware that the revised strategy will exhibit a somewhat higher level of volatility.
Preparing to act
Franking credits are important to retirees. A well-designed Australian equity strategy can deliver a high level of sustainable income (inclusive of franking credits) to help retirees attain their spending goals in retirement.
Changes that restrict access to franking credits would have a significant impact on retirees’ ability to reach their goals. Many retirees, and those preparing for retirement, should no longer assume those benefits will continue uninterrupted.
Of course, there is no certainty that these changes would make it through the Australian parliament. So, it may not be advantageous to act hastily.
It is important to maintain a balanced perspective. Ultimately, investors should focus on what they can do to maximise confidence that they are on track to attain their personal retirement income goals.
1,2,3 Butt, Adam, Khemka, Gaurav and Warren, Geoffrey J., What Dividend Imputation Means for Retirement Savers (August 26, 2018).
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