A few readers have reached out to ask what I do with my super.
What approach do I take? How do I invest it? And where does it fit into our overall plan?
Which is fair enough, because my dividend-focused investing style is a bit different to some in the FI community.
So today I’ll answer all of those questions, and more! Lots of juicy stuff to cover, so let’s dive in!
The history of our super
A number of years ago now, we were both working full-time and had typical moderate-cost super funds. From memory, these were invested in the high growth option.
Roll forward to 2015. It was becoming clear in our minds that investing for a growing dividend stream was going to be our way out of the rat race. After getting over the most common fears about the sharemarket, that is!
We had started buying individual stocks, and receiving dividends. Then we decided to do the same thing with our super. I enjoyed looking at different companies and thinking about the future for each one. And, at least on some level, I thought it was a worthy game to try and beat the market.
In those days, not many super funds allowed you to pick your own stocks. These days most do. Anyway, we switched super funds and got started. Later on, our new super fund (ING) decided to engage in some old fashioned daylight robbery, and jack up their fees.
Given we’d already created the portfolio, we were reluctant to leave. Especially as there was some capital gains tax owing. At the time, we had only minimal knowledge of LICs or index funds.
So how did we go? Well, some of our chosen companies did great. Some did terribly. And some did okay. On average, our return was just okay, and almost certainly less than the market average.
As time went on, I learned more about low-cost LICs (and later index funds) and realised this whole share investing thing could all be made much simpler, for the same or better return (in my case). Add to that, the conclusion that I’d rather spend my time and mental energy on other things.
A while ago now we decided to end the stock-picking experiment (in and outside super) and invest mostly in diversified funds for minimal fuss. I realised as much as I like investing, I don’t want to be spending hours upon hours reading about different companies, for no certain payoff.
Earlier this year we sold everything in our super fund and switched from ING to a very low-cost fund. We chose Sunsuper, and selected an allocation that suits us. 100% shares. By the way, see a detailed look at low-cost super funds in this 3-part series by Pat the Shuffler.
On this topic, some low-cost super funds seem to use derivatives to get market exposure rather than true ownership. I won’t pretend to know the ins and outs here, but if it looks too cheap to be true, it probably is. Sunsuper is one which avoids this and actually gives you true ownership of the underlying investments, managed by Vanguard. (Pat digs into this too by the way.)
Why 100% shares?
We chose 100% shares because this is likely to offer the highest long term returns. Especially in the current environment of extremely low interest rates. It minimises the drag on returns that I would expect cash and bonds to have over the long term.
Personally, I find it hard to stomach having money sitting around earning next to nothing. But by not including traditional ‘safe’ havens like bonds and cash, this portfolio will be very volatile. So that’s something we need to accept.
It could be debated all day whether going all-in on shares is a good idea or not. That goes for a personal portfolio or a super fund. Going 100% shares is really only suitable for people with a high tolerance for risk. Or, more accurately, a high tolerance for volatility.
My view is, this money is not going to be touched for decades, so we don’t want or need to reduce the volatility of the portfolio. And perhaps more importantly, given we’re already financially independent, we see our super as ‘bonus money’ anyway. So if the market is way down when we can access it, that’s fine, we can wait it out.
Now it’s true that I’ve never been fully invested through a GFC-type scenario. Many of us in the FI space haven’t. So maybe my risk tolerance is less than I think. Who knows? But I do have conviction in my ability to stay the course.
Also, I’m not a fan of the traditional balanced funds that many super funds offer. Even some of the very low-cost ones. It’s cheap sure, but if I’m investing for decades, I don’t want 20-30% of this money in cash and bonds, sitting around sipping tea and doing bugger all, especially when expected real returns are zero! I want it working as hard as possible. There are definitely worse ways to invest, but that’s not for me.
We decided against a high growth fund, as these are higher cost and are invested in a less transparent way (many private assets and other investments I’m not familiar with). There’s nothing wrong with this – I just prefer the simpler, lower cost, all-shares option.
OK, so we’ve chosen 100% shares with Sunsuper. But what shares exactly? Here’s what we’ve gone with… drum roll please…
100% International shares – indexed.
Why did we choose this option?
Well, it’s very low cost. All up, including the account fee, the total cost is around 0.20% per annum. And this is for the developed-world international index, managed by Vanguard.
This is very similar to VGS. Except Sunsuper tracks a slightly different index which includes small-cap stocks (VGS does not). There are some other small differences but sector and country exposures are almost the same (within 1%).
Now, not all super funds offer indexed options, but many do these days. It seems unlikely that super funds can pick a group of managers that combined will do better than the market average, after costs.
Why international shares?
Given my preference is to invest in Aussie shares for a strong and steadily increasing income stream, this might seem a strange move. But here’s the idea…
We’re living solely on our Aussie-focused portfolio outside super. Given the high dividend yield and franking credits in Australia, this gives us a solid level of tax-effective cashflow to live on, without having to sell shares or look at market movements. We can just sit back, collect the income and get on with life.
But this leaves out a whole swathe of great companies that are based overseas. Companies that many of us use daily – like Apple, Google, Facebook and Amazon. Then there’s other household names like Disney, McDonalds, BMW and Nike.
So by making our super 100% international shares, we get to own a ton of profitable businesses around the world, without affecting the cashflow of our personal portfolio. This also gives us a good amount of diversification next to our 100% Aussie portfolio.
Obviously, international shares are based in different countries and currencies. So some of you are probably wondering if we chose hedged or unhedged?
We chose unhedged shares. The main reason is, currency movements tend to even out over the longer term. So leaving super unhedged lets it fluctuate with market and currency movements, and makes sense from a long-term diversification point.
As a smaller reason, if Australia and our economy falls behind the rest of the world over time, then our dollar could also be lower over the long run. In that case, our international shares would be worth more in Aussie dollars, which would be valuable in this scenario. And given we see our super as a bonus and/or backup plan anyway, unhedged seems to fit our situation nicely.
Admittedly, this stuff is not my area, so if you feel I’ve got this wrong please let me know!
The overall plan
OK, we’ve covered what we chose and why we chose it. 100% international shares, indexed, unhedged, for the long term. And the main reason being diversification.
But given our super balances aren’t all that high, does it even matter? I mean, combined we have a comfortable six-figure account, but it’s hardly huge. Overall, this means we have around 15% of our total net worth invested in international shares.
Depending on who you are, that either seems reckless or perfectly fine. Here’s how I look at it…
I believe the long term future of Australia is bright. I’m taking the risk that our economy and sharemarket does poorly over the next 50 years. That’s possible. But I feel comfortable investing this way. More importantly, I’m confident in our ability to deal with whatever happens in the coming decades.
In our situation, international shares is really another backup plan. Some added diversification and extra cushion, compounding away in the background should we ever need it later on, which will come in handy if Australia goes backwards. By the way, check out my 2-part article on Financial Independence backup plans here and here.
“But you’re not really working anymore, so your super won’t do much.”
With only one of us working part-time, it’s true that we’re barely adding to super at all. But here’s what will happen over time…
We’ll live off the income stream from our Aussie-focused portfolio. So the actual value of our portfolio will grow by maybe 2-4% per annum, as we consume all the dividends.
Meanwhile, our super will remain completely untouched. This means it should grow at, say 7% per annum – a fairly realistic assumption for the long-term return from shares. With this growth rate, our super will roughly double in value each decade.
Since our super will grow faster than our Aussie portfolio, it will become a larger part of our net worth than it is now. So, our allocation to international shares will actually increase over time. All without us doing anything!
At a guess, our super and therefore international shares would grow from 15% today, to around 25% of our net worth in 20 years time, with this slothful plan.
I think that’s pretty cool! And this is what we roughly had planned to do anyway (add international shares over time), which I mentioned in this post on international shares.
“But this means you’re still reliant on Aussie shares for your income.”
That’s correct. And I’m very comfortable with this. If we weren’t happy with it, we wouldn’t do it!
The bulk of our income will come from low-cost LICs and an index fund. And a smaller amount from real estate investment trusts (REITs) and Ratesetter.
I find it very hard to imagine that the Aussie economy doesn’t grow over the next few decades. As a result, I find it equally hard to imagine Australian companies won’t earn more money and pay larger dividends than they do today. As I said, I’m positive on the future of Australia for many reasons well articulated by Pete Wargent in our interview.
Keep in mind, we don’t need high returns to sustain our retirement. Our investment income only needs to grow with inflation from here. Actually, to be honest, it probably doesn’t even need to keep up with inflation, as we can manage our spending so that our living costs stay roughly the same.
Add to this the fact that both of us are earning at least some income since leaving full-time work. And that we have our super compounding in the background as an added bonus for later on.
“But super is more tax-efficient, so the high-dividend Aussie shares should go in there, and the low-dividend international shares should go in your personal portfolio.”
I’ve heard this a few times. And I get the idea behind it. But I don’t really see it like that. Let’s do some math and I’ll show you what I mean.
VGS current dividend yield: 2.4%. Expected capital growth: 4.6% per annum.
VAS current dividend yield: 4%. Expected capital growth: 3% per annum.
What are the tax outcomes of this? Here’s a rough tally, assuming a 40% tax rate…
VGS. 2.4% dividend less tax of 40%, net dividend yield of 1.4%. Capital growth untaxed. Roughly 1% lost to tax.
VAS. 4% dividend less tax of 40%, net dividend of 2.4%. Capital growth untaxed. Roughly 1.6% lost to tax.
But the story doesn’t end there. VAS dividends are around 80% franked, which reduces the tax owing, so here’s how it actually works in practice.
A 4% dividend fully franked is 5.7% grossed-up. To get that figure you go, 4% divide by 0.7 = 5.7%. This assumes the current 30% company tax rate. So the full franking credit is worth 1.7%. This means for VAS, the franking credit is worth about 1.4% (80% of the fully franked value).
At tax time, your 4% dividend becomes 5.4%, and the franking credit also counts as tax paid on your behalf. Assuming a 40% personal tax rate, your net dividend will be around 3.2%. This means roughly 0.8% of your dividend was lost to tax with VAS, compared to 1% with VGS.
This doesn’t mean VAS is better. It means the idea that somehow the higher-dividend Aussie shares will kill you on tax is just wrong. Our investor pays less in tax overall, due to our franking credit system and the tax-effectiveness of Aussie dividend payments.
“Well, what about inside super?”
How would these figures look inside super? Let’s take a look.
VGS. 2.4% dividend yield. Tax of 15% would be 0.36%. Roughly 0.4% lost to tax.
VAS. 4% dividend yield. Add franking value of 1.4%. So for tax-purposes, grossed-up dividend of 5.4%, less 15% tax would be 0.8%.
The result is, no tax owing, and under current rules, leftover franking credits of 0.6% would be refunded. This seems to show that wherever you place them, Aussie shares are very tax-effective, despite higher levels of dividend income.
So I don’t personally buy the argument that Aussie shares are best inside super, and international shares are best in your personal portfolio. But you can, of course, choose whichever suits you best.
Even someone on the highest tax rate of 48%, would see roughly the same level of tax paid on cash dividends. VGS dividend of 2.4%, would lose almost 1.2% to tax. VAS dividend of 4% would lose around 1.2% to tax. (4% dividend, plus franking of 1.4%, less tax of 48%, leaves 2.8% net dividend).
Now you could say, “but franking skews the results!”
Of course it does. That’s the current tax system we have. How else should we be calculating it? Under a tax system that is not in place?
It should be noted that over the last 100+ years, Australian shares have had strong performance, among the best in the world, completely excluding franking credits. We don’t necessarily need that to continue, but an interesting point nonetheless.
“What about if franking credit refunds are removed?”
If that did happen, our franking system is still tax efficient. Franking credits would still exist, just franking refunds would not. So Aussie dividend income would still be tax-effective compared to many other income streams.
In fact, a couple could receive around $190,000 of (fully franked) dividend income and pay zero out-of-pocket tax. Their portfolio could earn dividends of 4%, after-tax. How does this work?
Each person receives $95,000 of dividends, fully franked. The franking credit here is worth $40,000. Grossed-up income would be $135,000, and tax owing would be around $40,000, equal to the franking credit. Result: up to $190,000 of cash dividends received with franking covering all tax owing.
Dividend income from Aussie shares inside super would also continue to attract no tax, because tax owing (15%) is less than the value of franking credits (30%).
Yes, it’s likely the market would fall if refunds were scrapped. That would mean a hit to our portfolio value, but it may mean higher dividend yields too. Our strategy wouldn’t change. We’re happy with the ‘cashflow’ approach in our personal portfolio and a ‘growth’ approach with our super.
Tax system changes is a huge topic in itself. Things can change with any tax system in the world, in any asset class in the world, here and overseas, for wages and investments. So there’s no real certainty whatever you do. Tax matters, but should only be a secondary consideration in your investment plan.
What does this all mean for you?
Well, maybe nothing. You likely have a different life situation than me.
You may have a different outlook on the future of the world or Australia. A different income, different tax rate, different time horizon, different investment philosophy, different thoughts on diversification or risk, and so on.
But if you plan to live on mostly dividend income from Aussie shares, consider making your super international shares to balance things out a bit. In the end, only you can decide what’s right for you.
Personally, if I was beginning my FI journey today, our investment plan (including super) would probably be setup the way it is now. One very important lesson I’ve learned is to keep things simple. Avoid complexity and avoid aiming for perfection.
One thing I would do, is find out the total running costs of your super fund, and see if you can do better. With an abundance of low-cost index funds today, your super fund should be costing less than 0.50%, for plain shares-and-bonds/cash portfolios (again ours is 0.20% for true passive ownership).
For our personal portfolio, I strongly prefer investments which pay a healthy income stream, so we can simply switch off and not have to worry about the markets. I find investing for a growing dividend stream to be a low-stress and enjoyable way to create cashflow for early retirement.
But I respect the power of diversification and the dominance of many overseas companies. So having our super invested in international shares, ensures a comfy backup plan should Australia fall behind over the long term.
Bottom line: we’ve combined the benefits of Aussie and international shares in a way that makes sense to us. The higher, tax-effective income stream from Aussie shares for us to live on. And higher growth international shares to benefit from the success of global companies and provide increasing diversification in the background.
How does super fit into your FI plans? Let me know in the comments.
By the way, I created an easy-to-use Dividend Tracker, which I use to keep a running estimate of our annual passive income after every purchase. Click here to get it for yourself.