The focus on pre-tax return numbers, by most of the investment community, could be costing members of some super funds millions of dollars a year - courtesy of inefficient tax management.
While the responsibility for tax management rests with the trustees of a super fund there is a broader issue. There is a lack of transparency around the tax efficiency, or inefficiency, of fund manager processes; and the implications for after tax results reported to trustees.
Speaking at the Association of Superannuation Funds of Australia (ASFA) 2006 convention in Perth, Vanguard's Head of Retail Robin Bowerman said: "The fundamental issue that clouds the debate is that fund managers are typically measured (and rewarded) on the returns they generate on a pre-tax basis."
Research by Vanguard suggests that some funds are paying too much tax - in the tens of millions of dollars - and paying much of it too early. High turnover of portfolios by fund managers results in the realisation of short-term capital gains, taxed at a higher rate than long term gains. A lack of focus on tax management at the fund level leads to lost opportunities to defer the payment of tax.
The after tax return issue has received considerable media coverage over the last year but the focus has been on the need to provide individual investors and advisers with the after tax return data to enable a more transparent, informed decision making process.
The challenge for superannuation fund trustees is not the reporting of after tax returns - as tax-paying entities, super funds already do that - but rather the bigger challenge of taking control of the tax management process by demanding custodians and fund managers act to minimise the tax burden and report on tax efficiency.
The fundamental issue that clouds the debate is that fund managers are typically measured (and rewarded) on the returns they generate on a pre-tax basis. The basic objective of the individual fund member and the portfolio manager are not aligned at this point. So, it is not surprising that some managers remain tax unaware when making their portfolio decisions.
New after-tax research
At the ASFA conference, Bowerman provided background on the after tax debate in the retail market and delivered the findings from sample research on the tax positions of six major super funds. Co-presenter, Richard Friend, Head of Portfolio Management at Warrikirri Funds Management, presented a detailed breakdown of the impacts and value of participating in share buybacks.
In his presentation - Busting through the After Tax Myths - Bowerman explained why the after-tax issues are quite different in the retail funds area compared to super funds.
"One of the reasons for the increasing interest in the after tax return issue is that the Australian market has enjoyed four successive years of strong returns."
For example in the 12 months to June 30 2006 the largest Australian equity funds (above $1 billion in size) returned an average return of 23.2% - but 70% of the return was delivered as taxable distributions, according to Morningstar data. For a top marginal rate taxpayer that is clearly a poor tax outcome - the after tax difference between a low turnover, efficient portfolio with no realised short-term capital gains compared with a high turnover portfolio with 100% realised short-term capital gains would have been about $30,000 on a $500,000 investment for the 2005-06 financial year.
One of the reasons for the increasing interest in the after tax return issue is that the Australian market has enjoyed four successive years of strong returns - for many investors there are few residual capital losses that can be used to offset realised capital gains.
But there is an even more basic reason fund trustees are being urged to take control of the tax issue - tax is typically the largest bill any super fund will pay in a year.
How tax efficient are super funds?
With the cooperation of the ASFA research team Vanguard analysed a small number of funds to test their tax efficiency. The Vanguard Growth PST was used as a real-world benchmark to check the analysis against.
Using figures published in the funds' annual accounts for the year ended June 30 2005, Vanguard calculated a ratio of tax payable (the tax liability on income and realised gains for the year) to investment income for each fund. The funds analysed included public sector and industry funds and the results showed a wide variation in tax efficiency.
Some funds are clearly managing the tax position well. Others are not. The best fund delivered an income tax payable/investment income ratio of 1.5%. The worst was 11.3%. Vanguard's Growth PST was 1.7% - in line with expections for a low turnover fund with moderate cashflow.
Given the strong returns for the financial year ending on 30 June 2006 it is reasonable to expect that the tax bills for the last financial year would be higher again than 2005.
"The first step to efficient tax management is clearly to minimise the realisation of short-term capital gains. "
In order to understand the potential drivers behind this range of outcomes, let's consider Australian shares - the largest single asset class allocation for most funds. The five year returns (to 30 September 2006) for Vanguard's Australian shares index fund were a pre tax return of 15.9% pa and, with franking credits and realised capital gains accounted for, an after-tax return of 16.4% pa.
Compare that to a synthetic - and therefore tax inefficient portfolio - that was constructed using cash and SPI futures to match the Australian equity index portfolio. Assume the same pre-tax return of 15.9% pa but then compare the after tax position - it drops to 13.5% pa. So the out performance required on a pre-tax basis in order to match the after-tax outcome of a very low turnover Australian shares portfolio is 3.4% pa, as 13.5% + (0.85 x 3.4%) = 16.4%.
Modelling by Vanguard for a $4 billion fund with a 70/30 growth to income asset allocation split shows that simply taking advantage of the capital gains discount and therefore paying CGT at 10% not 15% could save the fund $10.4 million a year. This is based on the income assets returning 6% p.a. and the growth assets delivering 11% (3.5% income and 7.5% growth). The fund's expense ratio was assumed to be 0.5%.
The first step to efficient tax management is clearly to minimise the realisation of short-term capital gains. But there are other benefits for better tax management - namely the deferral benefit from continuing to have the unrealised tax liabilities invested and generating compound returns for members. For funds with good cashflow - and therefore having no need to realise assets and crystallise tax liabilities - it is not unrealistic to target zero tax on growth assets.
The modelling suggests that the reward for an appropriate focus on tax for a $4 billion fund is somewhere in the order of $18 to $30 million a year. For fund trustees this is really a matter of taking control of tax management - custodians potentially have a significant role to play here - and it may require some investment to properly account for and measure after-tax returns.
Clearly some funds are already managing the tax issue well. But for others, tax efficiency is often ignored or at best is a second order issue. The simple fact remains that tax will be the biggest cost most super funds will have to pay in any year so it is clearly an area where a stronger focus and more accountability will deliver a better after tax result to fund members and that is the overriding aim of the entire super industry.
