Podcast: Investment Bonds Examined – The Benefits and Drawbacks

Dave: [00:00:00]  Hey guys, welcome to this week’s episode of fire and chill. Hope you’re doing well out there. This episode was actually prompted by an article that pat wrote recently about investment. And so today we’re just going to follow up on that article and essentially do a really deep dive into investment bonds.

If you’ve been around personal finance sites for a while, you’ve probably heard of them before, but if not, that’s all good. We’ll cover them in a fair bit of detail today. And investment bonds are often promoted as a, like a very tax effective way to invest. And they’re quite popular with some people, but unfortunately it’s not quite as simple as that.

So today, essentially, I’m going to be asking pat a whole lot of questions since he’s done the research on the investment bonds. And so this will be almost like an interview where Pat will share what he’s found from the work that he’s done. And he’s covered the investment bonds in more detail than I’ve seen elsewhere.

So it’d be good to peel that back a bit and dive in. I did look at investment bonds briefly a few years ago, pat, when someone pointed them out to me, but after looking at them, they just seemed like something was not quite right. Like they just seemed a little bit confusing or a little bit like a little bit complex, unnecessarily complex.

Pat: [00:01:31] Yeah. so probably a good idea to point out from the beginning that Dave and I have a huge bias towards simplicity and Dave and I were laughing about it before the episode started, like we almost have a stoic, unwavering dedication to simplicity, and I feel this is completely justified, but you can make your own deductions. When you’re looking at something that you’re going to be doing over the course of decades, when you’re 20, 30, 40, 50, 60, 70, 80 years, you really cannot underestimate how important having a simple, straightforward plan that you can follow consistently for all of those decades is. And even beyond that, a plan that your partner or your heirs can follow, that is simple enough for them.

They might be an extremely intelligent person, but this just might not interest them all that much. They don’t want to get into the weeds. So having a simple plan that you can implement over decades, that doesn’t have all of this unnecessary risk or dependence on particular providers of products. That can’t be underestimated.

Dave: [00:02:41] Yeah, I think that’s a good point. So let’s just get straight into it because there’s a fair bit to cover. So first of all, what exactly are investment bonds?

Pat: [00:02:49] also known as insurance bonds and investment bond is essentially a another investment structure that you can park your money in to make other investments within the structure. So you could think of this as as example of other structures would be the superannuation structure or like a family trust structure.

So an investment bond is a particular structure that you can utilize and park your money in there. And then within the investment bond structure, you can make your other investments that you would otherwise typically make such as in an Australian index fund, such as VAS or a VDHG, just depending on what that particular provider of the investment bond structure allows in their allowable investment.

Dave: [00:03:36] and you can also invest in other assets as well can’t you Pat, like listed property and other sorts of, I think they do other portfolios of assets where it’s not just shares or it’s not just property. There’s a combination in there too.

Pat: [00:03:49] Yeah. And they have managed funds and they have, yeah, investment bond providers are a little different, but there are a variety of investments.

Dave: [00:03:59] tons of options.

Pat: [00:04:00] there are tons of options. It’s definitely not as broad as your options.

outside of the investment bond structure, but it’s probably sufficient sufficiently diverse enough for most people’s circumstances, I’ll say.

Or the vast majority of people circumstances

Dave: [00:04:16] Yeah. And of course these investment bond providers do this for a fee, of course. And some of them are not too bad, but some of them are quite high, like up towards 1% or so. What kind of fees did you notice when you were looking at these pap

Pat: [00:04:31] Yeah. The 1% or even much higher if you’re going for the managed fund options within these investment bonds, but certainly the best ish fees that we were seeing were around the half a percent mark or a little higher, or a little lower, depending on the exact fund you saw. So not outrageously terrible, but not as competitive as you can get just investing directly with, into those asset classes.

Dave: [00:04:56] right. And so one of the first things that you might notice, if you look at investment bonds is one of the main lines. Well, one of the main selling points that they’ll say is that you can invest into your investment bond every year and after 10 years you can withdraw your money from the investment bond completely tax-free.

But that sounds pretty good, but apparently it’s not quite that simple Pat.

Pat: [00:05:20] No. It’s a very careful selection of words in some cases where they’re very careful to say, oh, you can draw your investments after 10 years. Tax-free, which is technically true. You can with through all your investments after 10 years, tax-free, there’s no tax paid upon withdrawal. That is,

Dave: [00:05:41] so what’s the problem?

Pat: [00:05:43] I already paid the tax for the whole 10 year period, which is why you can withdraw it.

Tax-free so it’s not necessarily tax-free over the entire timeframe. It’s just, the tax has been paid along the way inside the structure. And it’s not reflected into your personal tax return because the structure pays at the S at the fund level or the structure level, the taxes.

Dave: [00:06:07] Ah. Okay. All right. All right then. So the next thing that you might notice is that investment bonds will say that they have a low what’s called a low effective tax rate, and that they are a, what’s called a tax paid investment because some taxes paid by the investment bond itself. So no tax is paid by the individual investor because the investment bond provider will take care of that for you.

So that doesn’t sound too bad.

Pat: [00:06:33] Yeah, it depends.  The investment bond structure essentially pays a flat tax rate of 30% on all in common or a realized capital gains. So the kind of typical marketing spiel is if our if you’re on a marginal tax rate, that’s greater than 30%, then clearly. Paying, investing through an investment bond is beneficial or it’s more tax efficient.

Dave: [00:06:57] Oh, definitely. It definitely would sound like that.

Pat: [00:06:59] Yeah.

So that, that is ad nauseum, just like just advertised oh, 30% tax rate. If you’re on a high tax rate, this is very tax efficient. So why wouldn’t you invest on an investment bond if you could make this like tax saving, especially being unlike if you’re on the 49 cent tax bracket. And this seems at first blush like a 19% tax saving, if you don’t look any further into it than that,

Dave: [00:07:24] And especially, especially if you can withdraw it after 10 years and not pay any tax at that point either. That’s that kind of sounds like the icing on the cake. Doesn’t it.

Pat: [00:07:33] yeah.

Pat: [00:07:34] But of course nothing is ever that straightforward or ever that simple. So let’s just dig into this a little. So something to be clear about, is that not okay? Currently is income taxed at 30%, but all capital gains are taxed at 30%. This may sound like it’s not a huge issue, but remember that every single individual investor gets a 50% capital gains tax discount on assets held for more than 12 months.

What this means is even individuals in the very top tax bracket pay less a lower tax rate on capital gains, than the investment bond structure.  If you’re on the 49 cent tax bracket, you pay at essentially a 24 and a half percent tax on capital long-term capital gains. So you’re already losing that 5%.

Let’s say. But it gets even worse than that. Because as an individual, you could do something like defer all of your capital gains to a point in the future where you’re on a lower tax bracket, which is essentially what I’m planning to do. And a lot of people plan to do

Dave: [00:08:40] yeah, that makes, that makes sense because in a normal sort of situation where you’re saving and investing for say 10, 20 years building up your wealth, and then eventually you want to live off those investments later. You wouldn’t start selling some investments until you’d reached that point where you want to live off them, and then you want to, take some income from that investment and sell some down.

Pat: [00:09:00] Yeah, I’d say out of very specific circumstances, Where people have very specific purchases in mind, the vast majority of people, especially our listeners in the fire community are saving while in high-income years and then spending or decumulating their assets while in very low income years. And so you could essentially, especially if you’re a couple and you use some tax parcelling, which is just the selection of which units you want to sell, based on the cost base of those units, you could essentially pay zero capital gains tax in decumulation phase.

However, in this investment bond structure, you are paying 30% capital gains tax the whole way through.

Dave: [00:09:47] regardless of what’s going on in your personal tax bracket.

Pat: [00:09:50] Yeah, correct? Correct. Which is like a really bad. Tax outcome. If you want us to , say it that way

Dave: [00:09:58] Yeah. So they’ll say no capital gains taxes paid by the individual, but that’s really because they’ve already taken it out.

Pat: [00:10:04] correct. They’re already taken it out. They’ve provisioned for it so that you don’t see it in the unit price. It’s just been provisioned for in the background.

Dave: [00:10:13] So your investment is essentially continually adjusted to account for these taxes inside the structure. Is that right?

Pat: [00:10:21] yeah.  The unit price you see is continually adjusted, so that attacks has been provisioned away, so to speak.

Dave: [00:10:29] I little bit like Super funds.

Pat: [00:10:30] Yeah. Precisely like Super funds.

Dave: [00:10:32] Okay. So we’ve covered that investment bonds have a tax write a flat tax rate of 30%. And so that might sound not too bad, because we’re going to be paying tax on the income from our investments anyway, but the investment bond is also taxing the capital growth at 30%, regardless of weather.

Those capital gains have been realized or not like  there’s texts being harvested essentially from the value of your investment every year on the capital growth as well. Is that right, pat?

Pat: [00:11:02] This is what I originally believed because the numbers led me down this path. I’ll say, cause the returns were clearly lower than the equivalent index funds that you could see. But I have been told by a few people that the provision is just accounting and it still remains invested, but it’s just, isn’t shown to you in the unit value. So, it may not be the case.

Dave: [00:11:27] so do you ever benefit from it then? Like how, how are you refunded that money later? How does that work?

Pat: [00:11:32] No, no. You’re not refunded, But it may remain invested for the benefit of the fund, like the whole for everyone in the fund. If that makes sense.

Dave: [00:11:40] that means it’s the same thing for that individual investor, that they’ve, their capital gain has been taxed at 30%, even if it remains in the background, in the atmosphere for the benefit of the S of the structure holders, or am I misunderstanding that? Cause if that, if that tax provisioning has never returned to the investor, they never benefit from it that they’re essentially still being taxed at that rate.

Pat: [00:12:02] Yeah. They’re always they never get the tax back, but the tax provision isn’t necessarily held in like a savings account. It’s still remains invested in the growth is still distributed to all the unit holders. And that is reflected in the increasing unit price over time. It’s a bit, yeah, it’s a bit

Dave: [00:12:22] That’s so that’s another layer of murkiness, isn’t it.

Pat: [00:12:25] Yeah, it is. It is another layer of murkiness, which I’m not a fan of, but I suppose the key point is  it’s bad in that you, the tax, the capital gains is taxed at 30%, but it’s not bad in that it’s dragging on performance year by year. So to speak, it remains invested. And the capital gains tax is taxed at 30%, but it’s not dragging on performance by being removed immediately all the time.

Dave: [00:12:56] okay. Okay. Fair enough. So what was the next point you wanted to cover here?

Pat: [00:13:00] This really sounds quite tax friendly, but really it isn’t. Because you’re not entitled to the CGT discount, that is a very huge, which is the 50% discount we’re talking earlier for assets held for longer than 12 months. That’s actually a huge tax benefit to lose.

In most cases, I don’t think it’s actually made up for, with any tax benefit you get on the income, especially considering that for most investments that we’d be interested in the Capitol gain makes up a much larger proportion of that investment than the income component.

So for an international share fund that could be made up of 5% capital gains and 3% income. So you’re actually losing a huge tax benefit on the larger proportion of your return. And you’re getting a substantially smaller tax benefit on a smaller portion of your return.  These investment rules they’re also, and like investment rules to these investment bonds. So you have to Keep adding money into the investment bond every year. So you don’t need to keep adding money, but there’s like this thing called the 125% rule, which means you can add up to 125% more than the previous year’s contributions, ETU

Dave: [00:14:12] okay. So if you invested $10,000 one year, you can invest 12 and a half thousand the next year.

Pat: [00:14:17] correct. Exactly. And then this will allow the insurance bond to continue in. This are what they claim to be this advantageous tax regime, which we disagree with, but regardless it allows the investment bond to continue to be invested in this regime. And after 10 years you can then take the money out.

Tax-free if you break this rule, the 10 years basically repeats itself. And if you take the money out before that 10 years, then you owe your personal income tax on that amount of money minus any 30% rebate or tax offset you get for tax already paid within the investment bond structure.

Dave: [00:14:59] Okay. So there is a bit of a penalty if you don’t quite follow the rules as I’ve laid it out.

Pat: [00:15:04] Yeah, Correct. You might actually lose any of the benefit of the investment bond and end up paying your income tax rate on it. Now, some people have actually gotten a bit clever and they’re like you can purposefully. If you’re in a low-income tax year, you can purposefully break this rule. You can get the 30% tax offset and take the money out.

So if you were say on a 19 cent marginal tax rate, you purposely break the rule. You get a 30 cent in a dollar tax offset. And you’re paying 19 cents in a dollar to actual text. So you might actually be able to use the tax offset for other income in that year as well, to bring down your total tax rate by purposefully breaking this rule. , this sounds great, but if you just apply a little bit of scrutiny, it’s probably not as good as it sounds you think about it. You can only, you would only ever do this purposefully. If you are in a low income tax year, you wouldn’t purposefully do this for the tax benefit in a high income tax year, because there is no tax benefit.

So it only works in low-income tax years. But if you’re in a low-income tax year, you don’t actually have other income to offset with the tax offset because you’re in a low income tax year. You’re only on the 19 cent tax bracket, or you don’t have a lot of income to offset. You’re trying to game the system, use the additional tax offset to offset some of your personal income tax.

But it’s limited by what is already a very low amount of tax you’re paying that year. So the maximum offset you can produce is only ever equal to the total amount of tax that you’ve paid in a year, which isn’t a lot. If you’re in the 19 cent tax bracket, it’s at most a few thousand dollars.

Once you’re in those lower tax brackets, like you’re not actually paying our lot, an absolute large amount of tax

Dave: [00:16:53] because the first 20 grand is essentially tax-free and above that you start paying tax, but even up to, like 30, 40, even 50 grand, the percentage of tax you’re paying is actually very low on that. On your total level of income. It’s actually probably much lower than people realize

Pat: [00:17:09] Yeah, exactly. And the problem with tax offsets or most tax offsets is you can’t actually bring them forward into future years. You’d just essentially lose the tax offset.

Dave: [00:17:20] it’s not like a, it’s not say a capital loss on your shares where you can carry that loss to forward to future years where you make a capital gain in the future.

Pat: [00:17:30] no, exactly. So this isn’t actually a way around the tax deferral problem into low income tax, low capital gains tax years and low marginal tax rates is because the tax offset isn’t that useful for most people or all people. I can’t think of very many situations in which it would be actually be all that useful.

Dave: [00:17:53] all right. Is there any more rules and details we need to cover before we get into a couple of examples of how this would work in practice?

Pat: [00:17:59] No. We’re trying to keep this as entertaining as possible, but it is quite a dense topic. Isn’t it?

Dave: [00:18:04] It’s pretty heavy. It’s pretty, it’s a little bit nerdy.

Pat: [00:18:07] Yeah. We’re sorry, everyone. We just, we thought this was an important topic to cover because there are a lot of podcasts and a lot of articles, which just really heavily promote investment bonds.

And as perhaps a voice of reason within the financial independence community, we thought that we should at least provide a sound counter argument to all of those voices promoting investment bonds. So you can at least make your own decision based on both sides of the story.

Dave: [00:18:39] And not just the counter-argument for the sake of it, but covering some stuff regarding this topic and investment bonds that don’t really seem to be covered elsewhere. I think that’s the main point.  To cover some of the details that people don’t realize, because it’s not really fleshed out, it’s not really mentioned or spoken about in any sort of data.

Pat: [00:18:58] yeah. Yeah. Sorry. You’re right. If they were something that Dave and I actually thought were good, we would definitely come through and saying, oh yeah, these are tax efficient, but we’ve, I’ve looked into them in particular. And I just haven’t come to that conclusion. Sure.

Dave: [00:19:10] So let’s get into a couple of examples where you would be using an investment bond. And so the first example we’ve got is where you use an investment bond and invest into a high growth fund. And we can use we can use say Vanguard diversified high growth fund, as an example, which is a common high growth fund that people in the financial independence community use and say, if we use this fund as an example the returns you might get on this fund, like a long-term return estimate might be something like 3% in income and a 5% growth each year.

That sounds like a reasonable sort of benchmark to work from.

Pat: [00:19:50] yeah, that’s very reasonable.

Dave: [00:19:52] Do you want to walk us through this example?

Pat: [00:19:54] Yeah. I created what was a fairly basic model to be fair. And I included it inside the blog post. Right. Of someone who was in the highest tax bracket of 47 cents in a dollar. And basically they were investing for 10 years, a hundred thousand dollars for 10 years inside, like just an individual investment, which therefore marginal tax rate would apply to.

And compared it to that same person investing in the exact same fund Vanguard high growth index fund inside an investment bond provided by one of the most popular investment bond providers available and using all their values and fees to make the comparison.

Dave: [00:20:39] So this is essentially really an apples to apples comparison. It’s the same. It’s the same underlying investment.

Pat: [00:20:44] it’s the same underlying investment and we’re comparing the fund returns inside the investment bond to someone who’s paying 47% tax. Outside the investment bond. And what I came up with was even on this very highest tax bracket, this person was marginally better off not using the investment bond structure.

So he just ended up with 168,000 after 10 years verse the inside the investment bond, which would, he would end up with 161,000 after 10 years.  Even what should be like the best case scenario for an investment bond, like someone on the absolute highest tax bracket. I still really couldn’t find that he would have been better off using the investment bond in this sort of simplistic model.

Dave: [00:21:31] all right. This is interesting. So what do you, what would you put this down to? What has caused this result to be for the investment bond not to deliver a better result in this example.

Pat: [00:21:42] So I think the major problem is what we discussed earlier was the loss of the 50% capital gains discount inside the investment bond structure versus the personal investor, having that available to them. So that essentially means that the investment bond structure had to pay  capital gains tax on all capital gains.

Whereas the personal investor only had to pay like 23 and a half percent capital gains tax on the capital gains. And because capital gains make up the most of the return, that means that had a disproportionately larger effect than any savings that would have been made in the investment bond on the income.

Pat: [00:22:24] The investment bond does pay less tax on the income component. 30% on the income component. Then this marginal investor who pays 47% tax on that income component.

Dave: [00:22:35] all right. Cool. Okay. So that makes sense. So that kind of leads me to think that maybe an investment bond would perform better in a scenario where it’s a lower growth, higher income investment. Is that, would that be the case?

Dave: [00:22:51] All right. So we’ve got another example here with a lower growth, higher income investment scenario, where you might be investing in say a, we use Vanguard Australian shares index fund,

Pat: [00:23:04] Yep I assumed here a yield of 5.7% and the growth of 2.3% which gives you the same total return, which is like 8%.

Dave: [00:23:16] yeah. it’s just a different, yeah, just a different balance of income and growth there.

Pat: [00:23:20] So exactly the same inputs, like 100k, 10 years for the highest marginal tax rate investor, they actually did end up marginally better off inside the investment bonds in this scenario. So it was, they ended up with the same, like roughly 161,000 inside the investment bond, but 159,000 are outside the investment bond, paying therefore marginal tax rate on that.

Dave: [00:23:45] okay. And so this is an example where the investment bond could be expected to be a bit better where I’d say a high-income kind of investment option where there’s the investor is saving saving a legitimate amount of tax on the income from there. And then missing out on the capital gains discount doesn’t really hurt them too much because it is a, not such a high growth investment.

Is that the way to think about it?

Pat: [00:24:10] that is the way to think about it.

And in both of these cases, keep in mind that we’re also taking into account the slightly higher fees paid inside the investment bond than what you would pay as a personal investor. So this is already taking those into account and we’ve passed that all through.

However, there’s a few things to note here. After 10 years, there is a small benefit inside the investment. But, really it’s quite marginal. Like it’s not a huge benefit at, by any means. And this has also assumed that you have sold as a personal investor and the investment bond, but more importantly, as a personal investor, you’ve sold all of your assets inside that high marginal tax rate, instead of waiting till you’re on a lower marginal tax rate to sell those investments.

Dave: [00:24:58] in these examples, you have assumed at the end of that 10 year period, that the entire investment is sold and the investor receives the proceeds, paying that high level of tax.

Pat: [00:25:07] Yes. Whereas it’s actually more likely that the investor wouldn’t just pick up and sell all their investments after 10 years for the hell of it. Like they would keep it compounding in both of these structures until they actually needed to.

So this would actually preferentially benefit this case in which you are not in the investment bond, because you would only sell out in low-income years as I, as we discussed earlier, or you’d most likely sell out in low-income years and pay close to zero tax we should also keep in mind here that in these simplistic models, I didn’t actually include another pretty important factor that would actually benefit the personal investor again,  that a personal investor can use ETFs where these investment bonds generally invest through a managed fund type structure.

Vanguard has managed fund type structures as well. So it’s not like a bad structure or anything. It’s not like nothing dodgy going on, but managed funds structures are less tax effect, tax efficient than ETFs because of the impact other investors activities have to distributed capital gains to all the remaining investors inside managed fund

Dave: [00:26:14] Yeah. So when money leaves that managed fund, when people want to redeem their money and do something else with it, that managed fund has to sell those shares, to give that money back to the investors. But when they sell those shares in the portfolio, the, all of the capital gains are passed on to every investor, not just the investor who sold, but whereas with ETFs, that doesn’t happen.

Pat: [00:26:38] That doesn’t happen. ETFs are super effective at creating walls between investors and only your actions have an effect on your tax outcomes, in an ETF. Whereas yeah, in the managed fund, people you’ve never even met if they sell out of the managed fund, which would happen with these investment bonds, when people want to redeem their funds, say that has an effect on all the remaining investors in their their returns.

Dave: [00:27:03] all right. That’s a good point.

Pat: [00:27:04] after some feedback from these investment bond providers, I actually did do another, a model using real world data for the last 10 years. And it actually came back in both cases. It looked even better for the personal investor then my model, it was marginally better. I’ll say because

Dave: [00:27:23] So what did they, so what did they come back to? Cause I know I was going to speak about this a little bit later, but I would just bring it up now, since you did they, the, after you wrote your article, was it just one of the investment bond providers or was it multiple reached out to you to give you some feedback on on the pace that you did?

Pat: [00:27:39] yeah, it was one in particular and it was driven by, I think one of, one of my readers reached out to them and said, Hey, you guys should have a look at this and respond yeah. Kudos to them for actually having a go at responding. But they basically just had a few complaints with first of all, which we’ll go through a bit later.

They wanted to highlight some of the other advantages of investment bonds, which Dave and I will definitely go through and a little bit later in the podcast, but they also just had a few minor complaints with the modelling that I’d done stuff like all the timing of reinvestments and the non-inclusion of brokerage in my investment model, which, you could claim is fair, but how much brokerage is someone realistically going to use over a 10 year period?

Dave: [00:28:24] So $2,000 is probably fair. One investment a month?

Pat: [00:28:31] Yeah. So it’s like some kind of minor complaints about my modelling, especially considering that I used the return data from the managed fund, even though the managed fund will paint a lesson. Advantageous case to the personal investor than the

Dave: [00:28:49] Hmm. So you were quite conservative with your modelling and examples that you use.

Pat: [00:28:54] I was quite conservative. I made a bunch of assumptions that would paint the investment bond in a better light. And these assumptions weren’t made were just made for simplicity sake. So I could actually produce the model, but I actually made sure that I made the assumptions in a way, which didn’t disadvantage, investment bonds.

If anything, it gave them a slight looked slightly better than otherwise, but you can go through like the spreadsheet model. I made yourself on my website and you can be your own judge of the assumptions I make because I listed them all out

Dave: [00:29:24] Yeah, well, we’ll link to, we’ll definitely link to that in the show notes. So people can go and check that out for themselves.

All right. So pat, I’m starting to feel a little bit of negativity creeping in mate. So I think we need to bring it back with some positivity. So when is it the case that investment bonds make sense? Cause it can’t be the case that they never make sense. So when do they, when could investment bonds be a good idea?

Pat: [00:29:47] So I think when investment bonds make sense is if you’re a very top tax bracket taxpayer now, and you will still be a very top tax bracket payer when you retire and you only invest in high yield options for some reason, like that’s just your personal investment style or your, what you like to invest in.

But this essentially seems like absolutely no one.

Dave: [00:30:12] out of those three things, or if there’s three criteria. The idea that someone would be in their very top tax bracket when they retire seems a little bit like it seems to me that would apply to essentially no one, to, because let’s break this down a little bit to be on the top tax bracket when you retire.

And so you’re living completely on your own investments. You don’t have any other income. You need to be earning like say $180,000, which is when you’re in the top tax bracket and that’s as a single, so you would have to be earning that would be $360,000 as a couple from your investments to be paying the top level of tax and to generate that sort of income.

We are talking like extreme levels of assets. You would have to have somewhere between five and 10 million of investments to receive that level of income and be paying that level of tax in your retirement scenario.

Pat: [00:31:09] Yeah, exactly.

Dave: [00:31:10] That’s probably none of our listeners or very, very few

Pat: [00:31:14] There might be some listeners who are in that very high income in retirement scenario,

Pat: [00:31:21] very, very few. So at this level,  maybe these make sense for you, but you might also just be at a point where you can, you’d want to start using trusts instead to optimize tax.

Dave: [00:31:32] I think when people get to that sort of level, that’s when they really start looking at more complex scenarios like you’re using trusts and companies and stuff like that to own their investments in

Pat: [00:31:41] Yep. Not something we really interested in though.

Dave: [00:31:44] Not really mate. Nah, we can probably go into detail about that sort of stuff in another episode. But in general, we’re not really early fans of adding a bunch of structures like that to our investment plans.

Pat: [00:31:55] no, definitely not.

Dave: [00:31:57] If I thought of a scenario where I’d want to try and save or w scenario where I’d be like extremely concerned about paying a lot of tax, and where an investment bond might make sense, like what we’ve just described. But if that was the case, I’d probably consider something like using an LIC that has like a bonus share plan. So something like AFIC so there’s another one that they have essentially a bonus share plan where you can forego your dividends and franking credits.

And instead of the dividend, you will receive the same dollar amount of shares. Instead, and you don’t have to pay tax on that dividend because you’re receiving the equivalent level of shares. And so that essentially caps your tax at 30% because you forgo the franking credit.

And that’s the case where I could see myself using it. If I was going to be in a very high tax bracket for a very long time, and I wanted to invest in Australian shares. But I can’t think of too many other scenarios where that would be the case

Pat: [00:33:01] yeah, no, I can’t either. It’s not even something that I would bother doing either. Like I would just stick with an index Australian index fund.

If I wanted to invest in Australia, just pay the tax. Or I might just shift a bit more toward international shares because they have lower income overall.

And at that sort of wealth level, Yeah. like you’re not so dependent on the diversification effect anymore because your wealth is so large.

Dave: [00:33:28] yeah, yeah. it’s a pretty high quality problem to have. You’re trying to, you’re trying to save tax and you’re, you’re sitting at five, $10 million and you’re trying to save tax.

Pat: [00:33:37] yeah, Dave and I are just trying to be super generous and gracious with this, but I don’t want to exclude any listeners here, but our podcast isn’t really for the 10 million net worth individuals here. If you’re at that wealth level, there might be some better advice out there then what Dave and I can offer.

Dave: [00:33:58] But there was another scenario you painted where investment bonds might make sense. And that was a scenario where we have much higher interest rates. Do you want to elaborate on that? Elaborate on that a little bit.

Pat: [00:34:12] Yeah. So let’s try and be super gracious again. Government bonds. These are like the fixed interest type government bonds I’m talking about now that you could buy. There was a scenario in which the income from those was extremely high, like in the early nineties and even into the late nineties, there were certainly very, very high.

And it might actually, if you’re going to hold government bonds inside, like your portfolio, it poured probably actually makes sense to hold them in an investment bond because the income from these is so high.

Dave: [00:34:46] that’s more or less. The return is just pure income.

Pat: [00:34:50] it’s pure income, and if your PAYG worker on a very high tax rate above 30%, then yeah, would actually make sense to hold government bonds inside of an investment bond structure. With the one caveat being that you lose one of the benefits of holding government bonds. which is to sell and rebalance as the portfolio moves around.

Once you’ve got investment bonds in an investment bond structure and your other assets outside the investment bond structure, you can’t easily, or you can easily, but then you lose like the tax benefits. If you sell the investment bonds to buy more shares, when the share market crashes you don’t only hold investment bonds, clearing accumulation for the hell of it.

You hold them for the diversification benefit, which is you can sell one and buy the other when the time is right.

Dave: [00:35:36] Yeah, that’s interesting.

Pat: [00:35:37] we’re really grasping at straws here.

Dave: [00:35:39] All right. So what about the other idea that investment bonds are a good way to invest for your children, pat,

Pat: [00:35:44] Ugh.

Dave: [00:35:45] work with me here?

Pat: [00:35:48] Really annoys me

Dave: [00:35:50] What part?

Pat: [00:35:52] because it’s like, it’s tugging at heartstrings. It’s like emotional advertising. Oh, great way to invest for children. Pay less tax avoid like extortionate children, tax

Dave: [00:36:03] So you’re saying if I don’t invest in these, I’m not a good parent and I mustn’t care. I mustn’t care about my children’s future.

Pat: [00:36:09] No, but as we demonstrated earlier, even in the highest tax bracket, you’ll most likely, still better off not using investment bonds. So the children’s tax rate is essentially just equivalent to the highest marginal tax rate. it’s still no better investing in an investment bond for children from a total return perspective than it is just investing in your own name, losing all that extra complexity and just like keeping a spreadsheet as you’re saying this much of my assets, I want to dedicate to my child a.

Dave: [00:36:37] All right. I Fair enough.

Pat: [00:36:39] so  I don’t like it.

Dave: [00:36:42] All right. So what about asset protection?

Pat: [00:36:44] Okay.

So now we’re actually going to get into it where we’re a little less negative about the benefits of investment bonds, because these are actually some genuine benefits of investment bonds. And I feel like this is what they should focus on more instead.

Dave: [00:37:03] Hey, just as a side note, didn’t you, I think in your blog post, you mentioned that on one website, I think, was it on one page or was it on there on one page you saw the word tax benefit or tax effective like 20 times or something?

Pat: [00:37:19] over 20 times. Yeah. I counted them up. It was basically, that was, it became a meme at one point. It was a joke.

Pat: [00:37:28] not to be completely unfair. I do actually think their claims about asset protection do hold up, like they are actually good for asset protection. So for example, if you’re in an industry which is at high risk of litigation, or like you’re a sole trader or small company owner, which has to sign a lot of personal guarantees, then you may consider an investment bonds to hold your investments separate.

So if you ever become bankrupt or you ever get sued, et cetera, your investment bonds and your personal investments are protected inside disinvestment, bonds, Locklear.

Dave: [00:38:03] that, in that sense, it becomes like a trust

Pat: [00:38:05] Exactly. It becomes like a trust.

So this is and that’s a good point that you mentioned there for these people in this situation, you would compare using an investment bond to setting up a discretionary trust and see what’s better for you in that case. So there’s investment bonds definitely simpler than a discretionary trust, but they’re less flexible than a discretionary trust.

And there’s some performance trade offs as we discussed earlier. So this is something that if you’re in this scenario, you probably need to calculate yourself and what’s a priority to you. And what’s important. I’m not a fan of either to be honest, but of course some people do want or need this sort of asset protection.

And so it could be useful for them.

Dave: [00:38:48] All right. So how about estate planning? I’ve heard it mentioned that they might also help with estate planning and passing on assets to, to your kids, for example.

Pat: [00:38:58] Yeah. Again, this is another like proper benefit. I’ll say I an investment point is a good way to direct your inheritances say to particular individuals without the risk of your will being contested after you’ve died. So if you know what you feel that like you come from a, like a ha a very combative or argumentative uncooperative family, and you feel that your will will be contested after you die, then you might want to.

Put an investment bond for a certain person. So for example, if you feel that your killed, you’re not dirt bags, but you want your grandchild to have some money you could put away in investment bond for the grandchild and without like your dirt bag, children getting a hold of it or contesting it or trying to get their grubby fingers

Dave: [00:39:50] Oh, okay. That’s interesting.

Pat: [00:39:52] So yeah. Again this is, I’m not being completely negative. This is actually a genuine benefit of this

Dave: [00:39:58] so how does that work exactly. When you set up the investment bond, do you have to name a, what is it like with your super fund, your name, like a beneficiary?

Pat: [00:40:15] Yeah. It’s just set up in very similar way. Very much the same way? And Again I think they might be some other structures that can achieve the same thing, like discretionary trusts and stuff.  I’d also just like to point out again, because it’s never pointed out in the advertising material.

There is a performance cost to this. So you are deciding to take a small performance hit or a large performance hit depending on how you look at it for the certainty of directing your money to a certain individual after you pass away, without it being murky in contested wills and legal fees and All that sort of business.

Dave: [00:40:50] Well, what about the case where people are receiving they might be receiving government benefits of some type or a pension. So how does you know, how does that work with investment bonds, where you’re receiving benefits from the government in some fashion, because you don’t have to declare any income from your investment bond, obviously because it’s tax paid by itself.  So how does that?

Dave: [00:41:15] You’re not having to declare any income to the government essentially. So does that affect your benefits at all? What happens there?

Pat: [00:41:22] Yeah. Okay. So firstly, I’d just like to point out that I haven’t looked into this in enough detail to give definitive like responses or definitive answers. So these are more just conversation topics That we’re going to go through here or research topics for myself and for others. And it’s really complex because government handouts are always complex with like multiple rules and multiple scales and Yeah.

Anyway, in terms of parenting. I believe you still have to count the total asset value in the investment bond and declare that. as opposed of a total asset value it won’t help you get below an asset test value say, but it may help you get below an income test level, if that is what you’re trying to achieve.

So you can definitely consider an investment bond in that case. Or I think you can definitely talk to another professional. We’ll do more research, as I said I’m still trying to get my head around this as well. so that’s one case for pension benefits in terms of family tax benefits, which is another important case.

I don’t actually think there’s an asset test to family tax benefit. There’s only an income test. There you can, in theory, if you’re in an income tax bracket with your regular employment, which means you’d qualify for family tax benefit, you could like shelter away, all of your investments inside an investment bond.

So that family tax benefit doesn’t get affected. As long as you’re losing less in the performance drag of the investment bond, then you’re getting, and family tax benefit. There is a potential gain to be made there. Like I said, it’s so complex with all of the moving scales and all of the moving parts, like family tax benefit is  as far as I can tell, it’s essentially limitless.

Like you just keep getting more money. The more children you have, if you’re on the like low income tax bracket and it’s hard to pass out. So all I can say is. If you do happen to fit into this scenario where you’re getting a significant amount of family tax benefit, and you’re afraid that you’re ever increasing like investment portfolio is going to start affecting those government payments.

You might want to look into this a bit closer and do some calculations and research, I think I will do another blog post, which tries to dig into this and produce some graphs and some calculations that can be a guide,

Dave: [00:43:44] A few scenarios for people to see which like which scenario they might fit in and whether it makes sense overall,

Pat: [00:43:51] Yeah, exactly. But I also just want to say if your investment, if your investments are so large, that they’re starting to affect your family tax benefit.

Dave: [00:43:59] Do you need the family tax benefit?

Pat: [00:44:03] Yeah.

Dave: [00:44:04] another one of those good problems to have the example of the person with the huge investment portfolio.

Pat: [00:44:09] Yeah, exactly, exactly. I suppose we are in the fire community, so some people on some pretty average incomes can end up with very large investment portfolios. So it is quite specifically related to our community. But I don’t know if I would be complicating my entire investment life with the goal of juicing government returns, especially if I’m in what I feel is a personally well-off position.

But I suppose just to be fair, this may be an avenue to explore for some people

Dave: [00:44:38] All right. And just circling back to what we were about to get into before about the the investment bond providers contacting you after your article came out. So do you want to elaborate a bit on how that went?

Pat: [00:44:50] Yeah.

Look, there was a bit of clarification, which was good, especially around the whole issue of tax provisioning, which I definitely appreciated because I’ve really found it hard to get a good response, even from superannuation providers about how they are handled tax provisioning and they actually get the investment bond provider gave me a very clear and straightforward answer to how they handle tax provisioning, which was great.

And that was that they could keep the money invested, but they make an accounting adjustment on the unit price value so that there’s no drag long-term track, but the capital gains is allowed for say Number two, they spent some time pointing out some of the advantages of investment bonds, which we went through today that I call real advantages, which I never contested, but it was appreciated anyway, that they pointed them out.

But then they started also you talking about, or making some complaints about the modelling I used, as I said before, and I don’t think their complaints are warranted or I feel like they just negligible it’s like complaining about the crumbs that are falling off a cake.

Whatever. Okay. I’ll put down, I’ll note down the assumptions. I already did no down the assumptions, but I’ve noted down all my assumptions and all of these simplifications I made on the modelling so people can make their own judgment. And then we spent quite a lot of time talking about a new investment product called the like tax optimized, Australian shares fund, or tax effective Australian shares fund offered by

Dave: [00:46:20] Well that sounds, that sounds attractive. My ears just pricked up, right?

Pat: [00:46:23] It was just claims of like super tax effectiveness, using a bunch of different strategies. And I don’t know, it’s been out for a year.

Dave: [00:46:31] So you can’t really judge if it’s good or bad that it can’t really be proven whether it’s good yet.

Pat: [00:46:36] you can’t prove whether it’s good. You can’t really prove whether it’s as bad. You only have one years of returns. They took some time to explain that they were using tax parcelling to sell individual investments.

Only if it made. tax sense if that makes sense.

Dave: [00:46:51] So, a little bit of sort of tax loss, harvesting with a portfolio, something like that?

Pat: [00:46:56] not specifically for the goal of tax loss harvesting, they said, but if they have to sell to rebalance or something that they would choose those components that had a tax loss preferentially over the components that

Dave: [00:47:13] Just like a normal person would.

Pat: [00:47:14] Just like a normal person would. Yes. Correct.

Dave: [00:47:19] Genius.

Dave: [00:47:23] Well, if it, if this is happening for you in the fund, in the background, maybe it’s not too bad, but, but I suppose, like you said, we can’t really know yet because it’s a new product,

Pat: [00:47:30] yeah, it’s a new product. They do have one year of returns. And from that one year, all I can see is a lot of tracking. Not necessarily a trend either better or worse than the index just different.

But it just comes back to, I would personally prefer just a plain vanilla index fund with low churn.

They’re producing this tax effectiveness with a somewhat higher amount of churn. Let’s say they said somewhere around 10% or 10 to 15% from memory. but anyway, I suppose time will tell not personally for me, I don’t like casing claims of tax efficiency or tax optimization, especially without the return data to back it up.

But even with the return data to back it up, I don’t know. I’ve gotten to a point in my Grumpy old man life where I value and am biased to simplicity, to such a large degree

Dave: [00:48:23] And I suppose it’s, I suppose it’s a little bit more than simplicity. It’s. Another layer to all of this stuff is transparency. It’s not that it’s not that this stuff is misleading or that they’re trying to trick you really.

It’s just that it’s not easy to understand. And so it’s quite murky and you don’t quite know what’s happening behind the scenes, and it’s just not as easy to understand, and it’s not as straightforward and clear of what you’re getting and how it’s working as a normal investment.

Just like a normal, plain boring index fund you can understand it, you know exactly what’s happening. You know how tax works because you’re paying for it by yourself. There’s no kind of, there’s no kind of murkiness to it. There’s no, there’s nothing to be confused about really.

Pat: [00:49:08] Yeah, exactly.

Dave: [00:49:09] appealing in itself, the fact that it’s so straightforward to grasp and you can see it quite easily, what’s happening because it’s your investment in your account and you’re doing the tax and yeah.

Pat: [00:49:19] Yeah. Precisely. And to be clear like this tax optimized option, I was just talking about is just  a few Australian asset share funds. So it’s not even like covering the full gamut of investments that you would want to invest in as a normal investor, which is like a fully diversified global portfolio.

So it’s uh, extra complexity, extra costs. You’re not getting the full diversification. You need a loan from this provider. You’d still have to spread out your investments through them and other ones, if you really wanted to juice it. And then it’s not like a guaranteed juice, so you’re like just believing the claims.

And I feel like, I don’t know, flashy advertising scares me a lot, especially flashy aggressive advertising.

Dave: [00:50:05] I’m a bit like that too. Especially when there’s maybe big claims being made or, you know, that something is perhaps too good to be true.

Pat: [00:50:14] The, what we’ve talked about before the sort of fetish with tax savings that a lot of people have.

Dave: [00:50:20] So just to follow on to our little summary here in investment, bonds can make sense in some cases, but they’re not quite as good or as tax effective as they claim to be. And like we were just saying a couple of minutes ago they’re quite complex really to know exactly what’s happening. Pat’s done a lot of research on it and there’s still, there’s some details that are, not quite clear and not quite easy to wrap your head around.

And there doesn’t seem to be a long list of scenarios where you get a decent benefit. I’ll say it seems to be quite marginal benefits in only a handful of cases.

Pat: [00:50:56] Yeah, exactly. I think overall what I have walked away from this and I still haven’t walked away, but so far what I’ve gotten from this. The claims about tax effectiveness are not there for the vast, vast majority of investors. They can be there if you use, if you’re a particular person in a particular tax bracket and you use your investments in a certain way, that isn’t exactly the most optimal way to use your investments.

However, if the other benefits make sense to you, like the estate planning or the asset protection, then these might not be a terrible way to invest, but it’s, for those other reasons, you’re paying a cost for those other outcomes and you’re accepting the cost of all those other outcomes. You’re not having your cake and eating it too.

Pat: [00:51:45] and that’s well, that’s what, that’s where I’m at at this point, with my view on investment bonds.

Dave: [00:51:50] And so I suppose my little takeaway is I’m glad I didn’t bother doing further research when I came across them a few years ago.  I’m even, I’m even less interested in it now than I was before

Pat: [00:52:03] Sometimes I I give myself anxiety.  I drag myself into these overly complex, things, and now I need to follow it through because people will be interested in what I’ve said. I owe it to my readers, my listeners, and to just be fair to the investment bond providers in case I’m wrong.

I owe it to everyone around me to finish this, follow it through

Dave: [00:52:25] to follow up on the details. That you didn’t get to quite cover initially, or some of the things that they’ve come back to you with  that you can flesh out in a bit more detail of scenarios where it could make sense or whatever. Yeah. So that, that would be good too, to see part two of that in the future.

Pat: [00:52:41] Yeah. Yeah, I’ll get to it. Like I said, I give I’m so busy and, but now I’m forced to produce this and spend time on it and actually follow it through properly.  I very, very much doubt I’m wrong on this. But if I have said something incorrect, then I definitely like to know that and say it in public, like that whole tax provisioning thing, I was a bit confused about tax provisioning. And like I said, it was pointed out to me that they’re not taking out the money. It’s just removed from your view, so to speak, but it’s still invested in the same way apparently. But it’s that murkiness again, we were talking about.

Dave: [00:53:18] That’s the thing say if you’re listening to this. If you’re still listening to this, most people would probably dropped out about, I don’t know, about 10 minutes into it, pat, what do you reckon?

Pat: [00:53:26] Yeah. Yeah. Yeah. Dave and I will have a much easier listen on our next release

Dave: [00:53:33] We promise. But just to finish off, if you ask still listening to this, you probably get the idea by now that may impact just like super simple investment options where we know exactly how it works. We can see exactly what’s going on. There’s no kind of murkiness and confusing things to understand.

We like to keep it pretty simple. And even if that means we pay slightly higher tax along the way, that’s not the biggest that’s not the biggest problem in the world there’s a definite benefit to keeping things simple.

Pat: [00:54:01] yeah. I like simplicity and that’s where I’m at now in my investing.

Dave: [00:54:07] Anything else, mate?

Pat: [00:54:09] No, I think we’ve covered as much as we possibly can. Just talking to each other

Dave: [00:54:13] Yeah. Just thanks for tuning in today, guys. We hope that we’ve done some justice to this topic and covered it a bit better than perhaps you’ve seen in other places and dispelled a few myths along the way, and we hope you found it helpful. If you did maybe share it with someone else who you think could benefit from listening to this episode.

Of course you can check out Pat’s a full article on investment bonds. At his blog, lifelongshuffle.com, but I’ll also put a link to that to that article in the show notes. And of course you can check out the rest of his blog while you’re on there too. And you can find me at strongmoneyaustralia.com as well.

So we’ve got lots of more episodes in the works and we promise the next one will be maybe a little bit more relaxed and easy listening. So stay tuned for that one. Have a great week guys, and we’ll talk to you soon.