The Land (of uncertainty) down under

Australian political uncertainty is ongoing. The Labor Party has proposed changes to the imputation system, which if enacted, would have wideranging ramifications for Australian investors, particularly those reliant on income. In this article, we provide some brief, general comments around the proposed policy, the possible impact on investors and initial portfolio actions that could be taken.

The policy proposal

The Labor government has proposed that the 2001 changes to the imputation system will be reversed under a Labor government. That means that a) if Labor wins the 2019 election (to be held no later than 18 May) and b) if the Labor government is successful in passing their proposals through the lower and upper house into legislation, then after 1 July 2019, any excess imputation credits (for people with a tax rate lower than the company tax rate) will no longer be paid as a cash refund.

The policy impact

The proposed policy would clearly impact greatest on those invested primarily in Australian shares, where members are in the drawdown phase. For investors in the above category, empirical research indicates that there is a reasonable cost to self-funded retirees(1):

  • Self-funded retirees would need to increase their savings by around 8-9% to make up for the loss in cash rebates for excess imputation credits.
  • Alternatively, self-funded retirees would need to reduce their consumption by around 5-6% per annum to make up for the loss in cash rebates for excess imputation credits.

There could also be some second order impacts on all investors. Australian companies have historically had high payout ratios (consisting mostly of dividends in Australia) compared with global companies:

Figure 1: Australian vs US payout ratios (dividends plus share buybacks)

This is largely because Australian equity owners have lobbied for higher dividends due to the benefits of franking credits. The removal of these benefits could result in lower benefits through time, and higher retained earnings on corporate balance sheets. The medium to longer term impacts could include: 1. A lower stream of cash flows to be discounted back to fair value, reducing the valuation of Australian equities (all else being held equal) 2. A potential reduction in demand for Australian equities from Superannuation funds in drawdown phase. This would be price negative for Australian equities. 3. An increase in the investors long-run required rate of return to invest in Australian equities. This would increase the long-run discount rate in most Discounted Cash Flow (DCF) models and reduce the valuation for Australian equities. The nearer-term impacts could include: 1. Necessary changes to corporate governance structures as a result of regulatory and legislative uncertainty. This could increase volatility and impact Australian equity prices negatively 2. A sharp increase in near-term dividends and buybacks as companies bow to pressure to deliver as many credits as possible before the legislative changes take place. For the financial sector and banks specifically, it is worth noting that the sector makes up roughly one-third of the Australian equity market. The major banks have featured in the top 10 largest dividend payers through time, accounting for around a half of dividend distributions. This suggests that investors holding concentrated exposures to the financial sector are particularly at risk of the direct impacts from the proposed legislative changes to imputation credits.

The portfolio actions

It is worth initially pointing out the direct impact of the policy will fall on a subset of investors as described above. But the indirect impact could be felt more broadly. The impact will fall most heavily on investors that have a very large home-country bias in equities. The current policy does support a home country bias. But many investment portfolios have a larger bias than would be supported by the current policy. We think the following actions are worth considering. 1. Increase diversity: Increasing portfolio diversity to include greater allocations to global shares, cash, fixed interest and alternatives can help protect and hedge against investment risk. This includes the risk of devaluation in Australian equities as a result of legislative change. 2. Increase allocations to alternatives: True alternatives have low correlations with Australian equities and can help cushion the impact of falling equity prices under a range of scenarios including legislative uncertainty. 3. Use active management: The potential impact from legislative change described above includes shorter-term impacts and longer-term costs and opportunities. Credible, process driven active portfolio management – in the form of Dynamic Asset Allocation – can help alleviate the impact on portfolios.

Summary

The above actions are challenging and require expertise to implement but performing all of them can provide important protection against both legislative and investment uncertainty. At Oreana, we take an active approach to Asset Allocation and investment selection and positioned our portfolios for Australian clients to prepare for this uncertainty. If you would like to learn more about how we can help you manage risk, get in contact with us here. Alternatively, you can access our expat financial advisor service page for further insights. (1) “Butt, Adam and Khemka, Gaurav and Warren, Geoffrey J., What Dividend Imputation Means for Retirement Savers (August 26, 2018). Available at SSRN: https://ssrn.com/abstract=3238995 or http://dx.doi.org/10.2139/ssrn.3238995

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