29
May 2015

Your questions answered

Your questions answered

Answer by Phillip McGann

Dear Adviser: If a property is worth $400,000 in the current market getting net rent of $1,912.00 per month, would it be more practical to keep it for regular income into the future, (nearing retirement) than sell and put into Super? The general Question is the property versus super issue - when one is on the lowest tax rate.

We are asked this question a lot from members nearing retirement - Why sell a property that is already renting well to simply crystallise a CGT expense and then contribute proceeds to Super? Why not just keep it as a non-super asset? 

In some cases this scenario is warranted as the CGT payable may well be sizeable and the ability to easily contribute the full proceeds to Super may not being available due to potential breach of contribution limits or eligibility reasons (income test or age etc).

In this case however, due to the absolute value of the property and the actual gross yield a sale and subsequent contribution to Super may well make more sense - assuming the individual is able to make a super contribution.

Whilst the 5.7% gross yield appears reasonable in the current property market, it must be remembered that in the absence of any debt and assuming the property is fairly old, the allowable taxation deductions from interest and depreciation would be minimal hence this gross yield may well decline to a lower NET YIELD (even for an investor on the lowest tax rate). Also, allowance needs to be made for other expenses (rates, management, maintenance etc) that may improve the tax situation slightly but further lower the net yield. It is this net yield that needs to be compared to the TAX FREE yield available in Super (that is in the pension phase). Also, the diversification and liquidity needs of the investor in retirement need to be taken into account - areas where property does not rate highly. 

For those on lower tax rates the issue is less acute, but NO TAX still beats low tax, and highly liquid diversified assets are a high priority for many in retirement as it allows for maximum flexibility.

If you are nearing retirement and wish to discuss your options, please book a consult with your financial adviser. 

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29
May 2015

Has Federal Politics in Australia hit a new low, or is this as good as it gets?

Has Federal Politics in Australia hit a new low, or is this as good as it gets?

Written by Hudson Adviser Phillip McGann

Why this matters to investors... I wrote this in 2010 after the Federal Election and it pays to reconsider it........

We have an urgent need in Australia for broad sweeping reform of many areas of our economy and society including reforms of:

  • Our complex and inefficient tax system
  • The inefficient relationship between the Federal and State governments over taxation, responsibility for service delivery and regulation 
  • Welfare - to get more Australians into the workforce
  • Dismantling of inefficient industry assistance
  • The underfunding of our University and training sectors and their ill-equipped inability to provide relevant training for the new century
  • Our population policy that addresses the intertwining needs of business and concerns of the community at large.

These issues are vitally important to all Australians, but even more so to investors who are looking for certainty and clarity to make their investment decisions easier and lower risk. Investors will flock to sectors and countries that offer certainty over uncertainty. They are looking for encouragement to invest, to put their capital in productive sectors that will provide a decent return. We need to grow the ‘economic pie’ to provide a bigger overall ‘share’ for everyone. And we cannot do that without continuation of the reform that began in the early 1980s. 

To enable this necessary reform, we need more clarity from the government, as well as the Opposition. But what do we get? - A Rabble.

Is it just me, or is this parliament and the individual parliamentarians about the worst we have seen for many years in Canberra? Whatever your political stripe, you must be disappointed that this is the best we can come up with in a great country like Australia. 

Where are the great leaders of past years - the men and women of vision, commitment and character who helped shape this country into the modern society we enjoy today?

Look around the chamber and ask yourself, where are the Menzies or the Curtins, the Hawkes, the Howards, the Keatings and the Costellos? And what about the quality of the debate and the generation of new ideas?

It is all pretty thin on the ground with the modern politician all about sound bytes and a catchy phrase. They are all about a mile wide and two inches thick. All froth and no substance.

The quality of our politicians is important as they can, and do, dictate the overall direction of the country. They can, and do, shape our future destiny, and this matters for all and very much so for investors in the local economy. 

Unfortunately, the current crop on both sides of the spectrum appear to be symptomatic of the political class in Australia at the present time, with not a lot of diversity of views or backgrounds to tap into.

More is the pity as the country deserves better.

Has anything really changed in five years?

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29
May 2015

So are the banks really gouging or are we just winging about nothing?

So are the banks really gouging or are we just winging about nothing?

Written by Hudson Adviser Phillip McGann

Bank bashing has been a national Australian sport for a long time. It’s better than the AFL, the NRL or the State of Origin – because everyone is cheering for the one side and against the “bastard banks”. 

We all hate the banks – right? Well not everyone. 

You see not everyone in Australia has a home mortgage and is being (supposedly) squeezed by the current property prices and hence higher debt level. Likewise not everyone is a small business operator paying high lending and overdraft fees. 

There are people who actually quite ‘admire’ the banks – ‘love’ would be too strong a word. They are the closet bank supporters who ‘whisper to each other’ about how they are pleased when the banks increase profits. These people live amongst us and are hard to distinguish from the everyday person, but they exist in large numbers.

They are the depositors and shareholders of the banks and they number in the millions.

They have been ‘happy’ of late as they enjoy larger and larger absolute bank profits that have fed into increased dividends after the tighter payout's of the GFC era.

So not everyone everywhere hates the banks – just some of us. 

But is this ‘hate’ legitimate? Is this loathing really justified? I feel a strong case could be made to say No. The strong feelings against the banks is mostly a reflection of poor understanding of how banks operate, how they make the ‘massive’ profits, and this lack of understanding is not helped by banks being very poor communicators.

How Do Banks Make Money?

In very simple terms, banks raise funds from many sources, leverage those funds up, add on a margin and lend out those funds, and their profit is the net margin after costs. Sounds easy? Well yes and no.

Where The Money Comes From?

The source of bank funds come from local depositors as well as onshore and offshore wholesale markets. The deposit base in Australia is from everyday banks accounts, at call accounts, term deposits, and cash management accounts etc. The cost of each of these is the interest the bank must pay the depositors. This varies from nil (or very low) on ever day transaction accounts (check out how much interest you don’t earn on your cheque account), to higher rates on at call and term deposit accounts, as the competition for these relatively scarce sources of funds is fierce amongst the vast range of deposit taking institutions that operate in this country. Added to these funds are the local wholesale markets where large institutions (ie insurance companies and super funds) provide funding.

These local sources of funds are insufficient to meet the demand from borrowers in the Australian economy and thus the banks must source an increasingly larger slice of these funds from offshore credit markets. These markets are deep and liquid but over the past few years, have become more and more expensive to access as the GFC has added to the credit risk perceptions around the world. So the local Australian banks are finding their relative cost of funds has risen over the past few years from very cheap money at the height of the GFC, as central banks of the world flooded the market with liquidity and interest rates tumbled. Now these same source of funds when they are ‘rolled over into new credit lines’ by our banks, are dearer and this has added to the cost of their funding relative to a few years ago.

Where The Money Goes

All of these sources of funds come into the banking system and are then on lent multiple times. Banks are a unique business in their ability to ‘create credit’. Your deposit is not simply lent out to one bank customer as a loan, but to several on the reasonable proviso that not every depositor will want their funds back at once.

The Australian Prudential Regulation Authority is the body responsible for the regulation of our banks and other deposit taking institutions, and it must ensure that the banks have adequate capital amounts to enable them to prudently lend, but still maintain the integrity of the overall system – in effect to facilitate the workings of a modern economy.

Banks are typically leveraged at approximately 15 times shareholder funds – which means they are very highly leveraged! In fact, due to this high leverage they would be unlikely to be able to borrow funds from themselves if they were a bank customer.

But banks are ‘different’ to other companies and the role they perform in the credit creation process in Australia is very important to the overall economy.

A big risk for the banks in addition to this leverage is the difference in the maturity of their deposits to their loans. In effect, they ‘borrow’ short (from depositors) and lend ‘long’ (to their loan customers) and this mismatch needs to be carefully managed.

A large part of the loan book of Australian banks is indeed in the safest lending there is – home mortgages – approximately 70% of the major banks loan books are directed this way. Default rates are low and historically when Australian banks have run into trouble in the past, it has not been due to problems with their home loan mortgage book but with reckless lending to the corporate sector.

So banks take in deposits at a low rate, then leverage those funds up by lending to many more loan customers, and charge a higher interest rate on these funds + fees and commissions. From the net interest difference (and fees), the banks pay out their fixed costs (overheads, premises, staff wages, etc), and what is left over is the profit – prior to tax being levied.

Bank Profits

Much has been made of bank profits in the current debate, with the simplistic argument that if they are reporting billion dollar profits, than that ‘proves they are bleeding us dry’. But again, are the banks profits excessive?

We need to keep in mind these are massive companies and the profits they report will obviously be in the billions to reward the share holders who have invested billions of dollars in capital in the bank’s shares. A better way to consider it than simply headline dollar figures is to actually look at the return the shareholders are earning.

A clear look at the financial figures (as detailed in a recent report) reveals some interesting insight for the 4 largest banks. The net interest income to assets figure for the 4 major banks is only 1.7%. What this represents is the percentage return of the net interest compared to the net assets of the banks. This is a low absolute figure.

Another important figure is the Return on Equity, which for the 4 largest banks for the year ended December 2014, was 15% (after tax). This is relatively low when compared to other leading Australian companies, and even more so when it comes from highly geared companies where shareholder funds are under even more risk.

To get the full picture we need to look at it from the shareholders perspective. How many bad loans would it take to see these billion dollar profits wiped out? And, (due to the leverage) how many bad loans would the banks need to wipe out the actual shareholder funds? Banks are highly leveraged institutions operating on very tight margins.

Now banks may well be ‘gilding the lily’ when using the higher costs of funds from offshore as an excuse and they may well also be lousy communicators, however, the profits the banks are making are not excessive in themselves given the risks they take on board, and the capital they put at risk – on behalf of their shareholders.

Besides, what would we rather have? - A strong profitable banking system that is (supposedly) raking in profits (a bit) higher than mortgage holders would like, OR a dysfunctional and literally bankrupt banking system like the UK or Ireland experienced during the GFC when the government was forced to step in a re capitalise the leading banks to the tune of hundreds of Billions of dollars, which ultimately will be borne via this and future generations in higher taxes and lower services? 

I know which one I would choose – ‘Bloody Banks’ – Cant live with ‘em, but we can’t do with out ‘em either.

 

SOURCE: APRA Report - Bank Quarterly Update (Page 19)
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