Wealth Building Strategies Limited
|Michael Shaw Authorised Financial Adviser to provide Financial Advice, Discretionary Investment Management Services and Investment Planning Services (FSP28521)|
|Are we getting richer ?|
|Asset rich cash poor ?|
|The true value of seeking advice|
|Prudent trustee decision making - just a rubber stamp ?|
|How do the tax changes work and how do they affect you ?|
|What does a credit rating mean ?|
|Life Settlements & Viatical Settlement Funds - What are they ?|
Life Settlements & Viatical Settlement Funds - What are they?
Not anymore. Seems like some very bright people have figured out a way for you to make money on your life insurance before you die. No, it doesn't involve you faking your death, either. Nope, these very bright people have figured out a way for you to make money on your own death before you die. They will show you how to create vast amounts of cash - hundreds of thousands of dollars if not more - seemingly out of thin air without you having to do much more than take a medical, signs some forms, receive the check, and then of course at some future date die at your leisure.
The one sure thing about anything this good is that it is sure to get a bunch of other folks all riled up, and indeed this strategy has of late come under some serious scrutiny with some other very bright people claiming that there are some significant and hidden downsides to the strategy. What? You can't get something for nothing? If it is too good then it is not true?
Somewhere between the very bright people who claim that you can make money off your death before you die, and the very bright people who claim that you can't, lies the truth. To find that truth you must first understand the concept of a "life settlement", and to understand that, you must understand what its immediate predecessor, the "viatical settlement" are all about.
Let's say that you are diagnosed with a terminal illness, such as serious cancer or AIDS, but you don't have sufficient money for treatment or even to keep yourself comfortable until you die. But let's say that you do have a life insurance policy, although in such a case you'll find that it does you pitiful little good until you do cash it in. So, you find somebody who will buy your insurance policy now at some reduced value, knowing that very shortly they will be able to cash it in. This gives you the money for treatments to hopefully slow the progress of your disease and also maybe keep you somewhat comfortable until you finally kick the bucket.
From the investors' perspective, they have examined your medical records and prognosis and know with some certainty (depending on what you have, and how bad it is) that you are going to die within a couple of years. When you die, the investors know that your life insurance policy will now pay them as the named beneficiaries, so they will get the money that they paid you for the policy plus some. It is then just a simple matter of taking their total profit on the policy, and dividing it by how many years you actually live, and that is their return on their investment.
So, let's say that you have a $300,000 life insurance policy, your oncologist tells you that at best you have two years to live, and so the investors pay you $200,000 for it and you name them the beneficiaries of the policy. If in fact you die in two years, the investors will have made a profit of $100,000 split over two years, or what amounts to a $50,000 per year return - although this will be a pre-tax profit and income taxes will be owed on it. Still, not bad for a $200,000 investment.
This type of investment in the life insurance owned by a person who is probably soon going to die (with "soon" being somewhat arbitrarily set as being within three years) is known as a "viatical settlement". In the 1980s, there was created almost overnight a multi-billion industry in investing in the life insurance policies of AIDS patients, and later this industry spread to cover terminal cancer patients and in fact nearly any other disease where sure death was a soon-to-be-realized certainty.
The fly in the ointment for investors is of course that you might outlive your physician's prognosis, meaning that when the Angel of Death came for you at the appointed time you told him to take a hike and don't come back until much later. This danger, from the investors' view, arises primarily from advances in medical technology. What might have been sure death a couple of years ago, might become defeat able or at least put into long term remission.
Such was the case with many of the AIDS patients. As medical technology progressed, some of the patients start living longer while with others the AIDS went into remission altogether and they are still alive. Doubtless, there are few investors out there who have been waiting a couple of decades now to cash in on the life insurance policies that they long-ago bought, and there probably are not just a few cases where the AIDS victims have now outlived the investors in their policies.
Eventually, the same thing started happening with cancer patients who also refused to cash in their chips at the appointed time, and investors were no longer willing to take anything but the very worst cases, where no advance in medical technology was going to make a difference. This selectivity started causing a lot of fraud in the US viaticals market, as people who actually weren't very sick at all started portraying themselves at death's doorstop and repeatedly sold policies on their own lives. Then, some US viatical fraudsters simply collected money from investors and never even invested in policies. This and similar fraud caused the US viaticals market to be viewed as very sleazy (as if dealing in death wasn't sleazy enough in the first place), thus inviting US regulators in to further muck up the process with red tape, and driving would-be investors out.
So the viaticals mess left a multi-billion dollar business with relatively few real victims of disease to buy policies from. But one of the great things about America is the ingenuity of their capital markets, and their ability to not just let money sit around but to put it to work. It was just about when the viaticals markets were starting to fall apart that some very bright person looked at the situation and said,
"Hey, what about people who aren't terminally ill, but whose health has gone down since they originally bought their policy? Since the insurance companies are prohibited from lowering benefits to reflect their poor health, their policies are worth a lot more than their surrender value."
Thus was born the concept of investing in the life insurance policies of the elderly, or what is known as "life settlements".
Assume that you have an old codger who is 65 and had a significant decline in health, such as a stroke or major heart attack (their medical records include physician's comments to the effect of "one foot in the grave" or "quite surprised to see him again"), but who once upon a time bought a $1 million life insurance policy. The old codger has since raided all the cash value out of the policy to fund his medical treatments and early retirement. Indeed, because of his age the cost of insurance is now rapidly increasing meaning that the old codger will either have to put more money into the policy or it will expire anyway. His problem is that he doesn't have any more money to put into the policy unless he borrows against the equity in his home or something, which he really doesn't want to do.
Keep in mind that by this time the old codger has forgotten what he bought the life insurance for initially, which was both for tax-free growth and to leave something for his kids. Because it no longer has cash value for him to access, and because he has forgotten that it will pay out a large amount of money to his kids if he keeps it up, it to him is a wasting asset that he would love to get rid of. The life insurance has basically become a "What have you done for me lately" sort of investment, and thus emotionally the old codger is much more willing to hold it than, say, stock in IBM which hasn't paid him much in the way of dividends but still has dramatically appreciated in value.
A quick glance at your handy pocket guide to Actuarial Tables & Life Expectancies reveals that the old codger is supposed to die, on average, within five years. So, you go to the old codger and say, "Hey, I'm willing to buy your life insurance policy from you for $500,000 paid immediately." From your viewpoint, this is a good investment. If he cashes it in by 70 as predicted, then you get paid $1 million on the policy, meaning that you've made $500,000 over 5 years (less any premiums you have to pay to keep the policy up). In round numbers, this is a $100,000 per year pre-tax profit on your original $500,000 investment. That 20% annual pretax return doesn't look too shabby against current interest rates, and the insurance company is arguably much more solvent than any bank. Gosh, even if the old codger lives to 75, it's still not a bad investment, since then you're still making 10% per year. And the odds of the old codger living past 75 (and giving your corporate bond like rates) are somewhat offset by your hope that he will cash it in before 70 meaning that you made a wonderfully nice profit.
As an aside, most of the investors in life settlements are large financial firms and hedge funds who are looking for something that has at least the safety of high-grade corporate bonds, but with a high return (since bond yields are still intolerably low). These firms buy many, many life settlements and pool them together. While these firms can not, of course, predict when a particular old codger will finally kick the bucket, they can employ the Law of Large Numbers to get a pretty good actuarial feel for when most of the policies will pay, thus allowing them to calculate their expected yield for the pool - and sell slices of the pool to investors looking for safe, higher yielding investments.
Who Loses With Life Settlements?
From the old codger's viewpoint, it is a great deal for him too. Since he couldn't afford to make current payments to keep the policy up anyway, in his mind the value of the policy was a precisely calculated "$0". And here you come along and give him $500,000 hard cash for it. Sucker!
Wait, you say, how can this "win win" situation be? Not everybody can be a winner in a transaction, right?
Absolutely right. In this situation there is a loser, and a big loser too. It is the old codger's kids. Had the old codger kept the policy alive, his kids would have been big winners at his death - just like the investors will be, and even more so since unlike the investors the kids will not have to pay income taxes when the policy pays off.
In other words, if this transaction makes so much sense for the investors, it makes even more sense for the old codger's kids. Basically, the old codger is giving up a very valuable future asset for basically pennies now - it is simply not a good trade. However, few of the life insurance salesmen tell their clients to engage in life settlements really work to advise their clients that it is a bad trade to settle their life insurance policy instead of keeping it alive.
To an extent, the insurance company is also a loser. The reason has to do with what is called a policy "lapse", meaning that the insurance company receives premiums but does not have to pay out on the policy. Anytime a policyholder doesn't keep a policy up, there is a lapse. Suppose the old codger did not sell his policy to the investor, but simply let it lapse. In that case, the insurance company would have collected premiums from the old codger for years, but in the end never paid out any death benefits to the old codger's estate.
Policy lapses are sweet money for life insurance companies, and do impact their profitability. A life insurance company can make a bunch of bad underwriting bets but still be profitable if lapse rates are high enough. Indeed, there are some industry analysts who suggest that some life insurance companies are only profitable because of their lapse rates.
Life settlements can theoretically work to reduce lapse rates, because the investors who buy the policy will always contribute just enough money to keep it paid up until it pays off. If enough people hear about life settlements and sell their policies before they lapse, the lapse rates would go to zero and the life insurance companies would be forced to raise rates. This would make life insurance less competitive against other investments, and probably lead to lower sales.
But if you think that any of this causes the life insurance companies to worry, you're wrong. Life insurance companies know that any loss of sales due to higher premium rates will probably be more than offset by the greater sales due to people who start buying life insurance policies as investments with the thought of later selling the policies to fund retirements. Life insurance companies had always been somewhat embarrassed by lapse rates anyway, since they tended to indicate that policies had been improperly sold in the first place. Also, life insurance actuaries already assume that a certain number of policyholder's will have health declines, and thus will hold their policies until their death. From an actuary's standpoint, the concept of life settlements in causing losses to the insurance companies isn't nearly as onerous as the insurance agents try to paint it out to be when making a sale.
Finally, the life settlements markets are limited to a relatively small part of the market since they are only for people over 65 and who have had a dramatic health change. This group probably represents less than 0.5% of all life insurance policies, so life settlements probably are not going to impact life insurance profitability that much. It is, however, an argument that life insurance agents falsely use to try to portray the insurance companies as the big losers, and not the kids of those who are selling their policies.
Problems with Life Settlements
The point is that a life settlement is only a good deal for folks who have no beneficiaries or estate needs of any kind. If you take into both family and charitable aspirations, this is a very small market. If an old codger has heirs that he wants to benefit, or any other estate needs, then life settlements are not a suitable strategy. Instead, the old codger should do anything he can to keep the policy going, just like the investors would do if they got it.
So, there are several significant problems with the life settlements market, and all of this discussion is just my way of meandering around to give you some background on life settlements so that we can discuss those problems.
The first problem is that some bad guys in the life settlement market cannot leave well enough alone. Because there simply are not enough seniors who are situated like the old codger, i.e., have a large life insurance policy that they cannot afford to keep up, these bad guys look to basically "grow" future life settlements by arranging slick-sounding deals to encourage people who don't even have much life insurance yet to buy life insurance with the idea that later they will sell it. With these arrangements, known as SOLI (short for "Stranger-Owned Life Insurance") life insurance truly does become a pure investment with the policies grown like so many fields of corporate bonds awaiting future harvest.
SOLI is a hot topic product right now among many life insurance agents who cater to wealthy people, since they can be pitched that they can get a very high level of insurance for two years (thus allowing the policy to mature past the noncontestability period), and then also make a tidy profit up front just for engaging in the transaction. If they don't have the money on hand to buy the life insurance policy up front, that's still no problemo as the investors will loan them the money, subject to taking the policy after the two years in repayment of the loan. This means basically Free Money (!!!) for those who allow life insurance policies to be bought on their lives.
The problem here is that this is precisely the sort of thing which can - and should - draw Congress' attention to allowing life insurance to grow tax-free. Why these life insurance policies are allowed a tax-free build-up is anybody's guess, since they really are a pure investment that have little to do with protecting the family from the insured's death. Indeed, because of insurable interest requirements for the initial issuance of the policy, most of the people who are approached to engage in this type of transaction already have a large enough estate that they don't need these policies to protect their families, and indeed are almost immediately cashing out of them. In these situations, the life insurance really is no different than a corporate bond, and there really is no sensible reason that they should be taxed much differently.
What is happening is a recognition that wealthy people have a hidden asset, which is their insurability. The bum at the bus station can't qualify for $5 million in life insurance, but many affluent and nearly affluent Americans can. If somebody has an estate worth $5 million, then they have an insurable interest of at least that. So why not take that unused asset and make some money off of it, right?
Whether buying a lot of insurance makes financial sense for a person depends on a lot of factors, including their age, health, and what the internal rate of return will be. But when it does make sense, wealthy people should be taking advantage of their large insurable interest by purchasing as much life insurance as they can reasonably afford so as to either pay estate taxes or to further grow their estate (income tax free) for their children.
Most wealthy people will not do this, of course, because they generally don't like life insurance no matter how much financial sense that it makes. What SOLI does is to turn this dislike of life insurance on its head so that wealthy people think that it is cool that they are not only making money but also selling a policy they never really wanted to these crazy investors.
But in reality it is the wealthy folks who are stupid, and the investors who are smart. On a $10 million policy, a wealthy person might get $500,000 for selling their policy, but the investor will get $10 million on their death, less this $500,000 and any agent commissions, plus maybe a couple of million in keeping the policy going until the wealthy person kicks the bucket - at which time they might make $6 or $8 million in pure profits. You decide who is smart and who is stupid.
If the wealthy people were really smart, they would simply buy as much life insurance as they could and hold it until their deaths. If they didn't have the cash on hand to buy it, they could always use the services of many lenders who are willing to finance the premiums with the loans being paid out of the policy proceeds at death. These days, many lenders are even willing to make these loans on a non-recourse basis, meaning that the policyholder is not even personally liable for the loan (the policy is used as security for the loan until the loan is paid off at death). But as discussed above, wealthy people let their dislike of life insurance (or maybe of life insurance salesmen) get in their way of what would be a really good investment for their families.
The Hidden Suitability Issue
This leads us to the most significant problem involving life settlements, which is suitability. Usually, the issue of suitability relates to the agent selling a senior something which they don't need. Here, the suitability issues relates to the agent incorrectly advising the senior to sell something that the senior should be holding.
In many ways, it really is no different than if the senior held a Certificate of Deposit that would pay $10 million in ten years, and the agent came and convinced them to unload the CD now for only $1 million. What the agent might argue is that the senior was cash-tight, and needed the $1 million now for cancer therapy. In that very limited case, the agent's advice might be correct. But how about if the senior didn't even need the $1 million because the senior had other cash available? In the latter case, the senior would not be deemed to be suitable for the sale of the CD.
In fact, in NZ the Securities Commission does not consider life settlements to be securities, subject to firm supervision. If life settlements are securities then that raises a wide variety of issues, including suitability and whether the life settlement sold must be accompanied by an offering memorandum or prospectus just like any other security. Certainly, all of this opens the door for securities litigation whenever a life settlement is sold - and perhaps most likely against the agent who acts as a de facto securities broker in encouraging the senior to sell.
One must also wonder whether so-called "senior abuse" statutes might come into play where seniors are being encouraged to sell their policies when they have the ability to continue to fund them.
What goes on in a lot of these cases is that the insurance agent who is encouraging the senior to sell his life insurance policy by way of a life settlement is then also encouraging the senior to "replace" their life insurance needs with a new policy. While this puts the insurance agent into a wonderful double commission situation where they are making money both selling the old policy and buying the new one, it usually makes little sense. The reason is that the insurance costs of the new policy will almost always be higher than that of the old policy, simply because the senior is now older and more importantly, much less healthy than when he bought the original policy, so he will be in a higher "risk" class.
In other words, the insurance agent is telling their senior to sell a perfectly good policy and replace it with a crappy one. This is usually bad advice, since if the senior was really smart he would put enough money into his old policy to keep it alive, and then use whatever remaining excess liquidity that he has to buy as much more life insurance as he can afford and the underwriters will let him buy.
The Insurable Interest Problem
As egregious as the life insurance agent's conduct sounds, many of them are starting to tell their seniors that they can repeat this process "every two years" which leads to the next problem, that of insurable interest.
The concept of insurable interest means that you have something worth insuring. In addition to other things, this keeps people with nothing to lose from buying a lot of life insurance and then suddenly being found dead. The concept of insurable interests is why the bum at the bus depot can't buy $5 million in life insurance, but the person with a $5 million estate whose heirs will need the money to pay, can.
The problem with insurable interest is that even though it grows with the wealth of the policyholder, it is still finite. Just as one cannot buy $5 million in life insurance on the bum at the bus depot, one cannot buy $50 million in life insurance on somebody who only has a $5 million estate. Yet, that is exactly what is happening with many of the life settlement deals where a portion of the money is being used to buy new policies.
What goes on to avoid the insurable interest issue is tantamount to fraud, as the insurance agents who fill out the applications either fail to disclose the existence of other insurance, or they inflate the value of the senior's wealth. While in the past the life insurance companies have not paid much attention to the issue, they are now redrafting their forms to pick up these instances of multiple sales of life insurance to a single senior.
A significant risk for wealthy people who engage in these transactions is that their estate could lose - big. If a life insurance company later decides to challenge the insurable interest issue and wins, it means that the life insurance policy held by the investors has become valueless, and the investors will then sue the estate of the person for fraud and seek damages equal to what they would have made had the policy stood up. Of course, this means the face value of the life insurance policy is much larger than the pittance that the wealthy person originally made by selling it.
The investors need not be much concerned about the insurable interest problems because for them it is a "heads I win, tails you lose" scenario. If the policy survives an insurable interest challenge, the investors get the face value death benefit from the life insurance company and go away fat and happy.
But if the policy doesn't survive an insurable interest challenge, then the investors get to sue the helpless (because dead people can't testify in their defense) estate for the fraud of the wealthy person who sold them the now "bogus" life insurance policy, and they can collect the face value of the life insurance policy from the estate. From the investors' view, this is of course another excellent advantage to dealing only with wealthy people.
Who Ends Up Owning Your Life?
So where do all these life settlements end up? Most of them end up in pools owned by large financial institutions and hedge funds. The firms monetize the policies and sell interests in the pools to the investors, which are usually even larger investment or pension funds. That is what happens most of the time.
Although having your life insurance ultimately purchased by a mobster is probably a longshot, it may not be worth the anguish to later find out that your life insurance policy that had been initially purchased by a Cayman hedge fund has since been sold to an obscure company in Colombia. With life settlements, there simply is no guarantee who will end up owning the policy, and that might disturb some.
Indeed, the historical background of the insurable interest laws goes back to what were known as the "death pools" of Victorian England. Then, bettors would speculate on when a particular person would die, and later started taking life insurance out on their lives without them knowing about it or giving their permission. When later the "accidental" death rates of such persons started to rise, the English Parliament basically forbid SOLI by requiring that the purchaser of a life insurance policy have a recognizable interest in the person being insured. By waiting the two years before buying the policy, the investors in life settlements skirt these rules but the underlying concerns are still there.
US Congress and Life Insurance
Some of the life insurance companies are concerned about life settlements. This concern has nothing to do with lapse rates or death pools, and everything to do with Congress. Their concern is that if Congress realizes that life insurance policies are really just investments, Congress will start taxing them the same way as other investments.
Life insurance has a huge tax advantage over most other investments insofar as its value is allowed to build up tax deferred no income or capital gains taxes are due when the life insurance policy pays off at death. This special treatment is due to the historical use of life insurance to take care of families after the death of the breadwinner, but today it makes little sense where many life insurance policies are just ordinary investments with only the thinnest sliver of death benefit being given to get the tax-free buildup.
Congress, which is once again running huge deficits, has been eyeing the cash buildup in life insurance policies and wondering exactly why that buildup is not taxed. Some in the life insurance industry are concerned that this whole life settlements business may precipitate the taxing of this buildup.
Some Final Thoughts
So what do you do if you have already been talked into a life settlement and then were talked into buying replacement insurance? You should talk with a Solicitor to determine whether the original sale made sense, and whether your life insurance agent fully explained to you that it might have made more financial sense to continue to fund the policy than to sell it. You should also talk to your Solicitor about whether your life insurance agent explained to you that the cost of insurance might be higher with a replacement policy because you have aged. And if you are being approached to do this transaction, you should find a Solicitor who is knowledgeable about it to help you to review whether it is right for you.
Life settlements are now being pitched as "free money" for wealthy people, but in reality they should only be used by people who no longer have the liquidity to keep their policies in effect. For everybody else, the sale of the policy is probably unsuitable and the advice to sell it will often be wrong. Those considering entering into a transaction to "grow" a life insurance policy for later sale should consider their risks of later liability to investors if the policy is successfully challenged, and demand indemnification and hold harmless agreements from the investors. Also, they should carefully consider who might end up holding their policies, and perhaps attempt to limit the investors in their policies to strictly institutional investors.
In the meantime, seniors should be wary of deals that offer them quick profits for simply allowing life insurance to be placed on their lives. They should not allow themselves to be rushed into such arrangements, but instead should take the time to carefully analyze what it is they are doing, and whether they would be better off simply buying the life insurance themselves and holding it, instead of committing themselves to selling it off after two years.
Insurance agents and financial planners should also be wary of these deals, and the potential for later being subject to discipline for advocating an arrangement which was unsuitable for their clients and subjected them to lost opportunity when their client later discovers that he would have been better off holding on to the life insurance as his estate's own best investment. Particularly where replacement insurance will be used, insurance agents and planners should be very careful that they explain that the true cost of insurance for the new policy will likely be higher than if their client had simply continued to fund the original policy. It is not too difficult to envision lawsuits after the death of the senior where the family finds out that the senior had a huge amount of life insurance, but they were not beneficiaries.
What does a credit rating mean ?
Have you ever seen a bank, insurance company, finance company or financial institution advertising their ‘credit rating’? Given the plethora of information and all the different types of ratings, it’s hardly surprising many people are confused about what they actually mean (it’s certainly not as easy as ABC!)
However, with several finance company failures recently, it has never been more important to understand it all. So, let us try to explain.
Put simply, a credit rating is an objective, independent assessment of an institution’s ability to meet its financial commitments (which might include interest payments and the repayment of your investment capital). Effectively it tells you how financially secure the company is (and therefore the likelihood of you getting your money back when you invest it).
This is important for three reasons:
1. Almost every investment carries risk, and credit ratings allow you to gauge the level of that risk.
2. You can work out whether you are comfortable with the given level of risk.
3. We can then work out what sort of return would be appropriate for the investment.
This is often reflected in the margin that the investment provides over and above the ‘risk-free’ rate.
For example, let’s say you can invest into New Zealand Government bonds (which have the highest possible credit rating of AAA from Standard & Poor’s) at 7.5% p.a. before tax (effectively, this is the risk-free rate). And let’s say you are thinking of investing in a company like South Canterbury Finance, which is rated BBB- and is offering say 9% p.a. before tax.
Through the credit rating, the investor/adviser is able to assess whether the extra 1.5% offered by South Canterbury (over the risk-free rate) is sufficient return for the extra risk - because BBB- is a lower rating than AAA.
And how do you quantify the extra level of risk?
The best way to do this is to look at what the credit rating means in terms of the probability of default (i.e. the risk that the company will be unable to pay interest and/or principal). This is shown in the following table from S&P.
|Rating Category||Estimated Probability of Default Over an Average 1 Year Period|
|00.00% - 00.01%
00.01% - 00.02%
00.05% - 00.10%
00.20% - 00.40%
00.60% - 01.60%
03.00% - 11.00%
25.00% - 30.00%
So, as you can see, over a 12-month period, the investments that are rated AAA have a risk of defaulting of between 0.00% and 0.01% (or a one in 20,000 chance).
Meanwhile, a company like South Canterbury (BBB-) has a somewhat higher risk of default (a one in 3,333 chance). However, the risk tends to increase exponentially once you get to a rating of ‘single B’ and below.
Generally companies rated below BBB- are considered to be ‘sub investment grade’, which basically means they carry a higher degree of risk. It does not mean that you should never invest in these securities, but it is important that the return is commensurably higher in order to justify the extra risk.
So what should you do ?
1. Contact us for advice.
2. Invest in fixed interest investments with a minimum of investment grade rating (BBB or better).
3. Make sure you are being rewarded for the risk you are prepared to take.
4. Talk to us Contact Us about investment management platforms which can report on all of your investments and take care of all the tax work for you.
How do the tax changes work and how do they affect you ?
There has been a huge amount of attention on the changes to legislation regarding the taxation of investment income. Much discussion has focused on the changes being a ‘tax grab’ by the government. In reality, the changes have substantially leveled the playing field and in many cases, they mean you will be paying less in tax.
Do the new rules apply to you ?
The new rules apply principally to international equities. Investments in New Zealand and certain Australian shares are excluded. All other international investments will be subject to a new Fair Dividend Rate (FDR) tax calculation, unless your investments qualify under the following exemptions/thresholds:
• The total cost of all your offshore shares is NZ$50,000 or less (or $100,000 for a couple). Please note this threshold does not apply to trusts. If you are unsure as to how to calculate the cost, please call us for a two-page guide.
• Investments in Australian-resident companies (which are listed on an approved index and maintain a franking credit account).
• Australian Unit Trusts (AUTs) that provide a Resident Withholding Tax (RWT) facility and meet certain other criteria. If you have AUTs, we can talk this through with you.
• There are certain other exemptions including GPG, New Zealand Investment Trust and venture capital companies.
• Investments in New Zealand tax resident unit trusts are excluded from your personal KOR calculation (even if they invest in international shares).
How does the Fair Dividend Rate Work ?
If your investment in international equities does not qualify for an exemption as outlined above, you will be taxed each year on a maximum of 5% of the opening market value of your offshore shares.
If the total gain (dividends and capital gains) on your offshore share portfolio is less than 5%, tax is payable on the lower amount, with no tax payable if the shares make a loss.
Value of Qualifying international shares As at 1 April 2007
Value of Qualifying international shares As at 31 March 2008
Tax Paable for a 19.5% tax payer
The most you will ever pay in tax for international equities is whatever your marginal tax rate of 5% of the opening market value. There is a Quick Sale Adjustment (QSA) if you buy and sell shares during the year.
So why is this positive ?
1. Any gains you receive over 5% are effectively tax free (in the first example this is $20,000).
2. If you are an individual or family trust investor and you make a loss, you will not pay any tax (although you can't carry the loss forward).
3. In most cases, you will have certainty of your overall tax liability at the start of the year.
4. Overseas dividends are no longer taxable by themselves unless an exemption applies.
5. Previously, if these investments were held in a non-grey list country, your entire gain would have been taxable.
What about managed funds ?
The tax changes have really enhanced the appeal of certain managed funds. These funds are the ones which are going to register as Portfolio Investment Entities (PIEs). The PIE will pay tax on behalf of the investor based on the Fair Dividend Rate (FDR) at their marginal rate, capped at 33% (i.e. either at 19.5% or 33%).
So 39% taxpayers will generally have an additional tax saving. In addition, managed funds which register as PIEs (some will continue to be taxed as they are currently) will take care of all the taxation work for you (if you are an individual or a family trust who elects to have tax deducted at 33%.
PIEs which invest into Australasian equities (New Zealand equities and qualifying Australian equities) will have no capital gains tax and will only be taxed on dividends.
The changes effectively mean there may no longer be a tax advantage in investing into direct equities over using a managed fund and PIEs provide an excellent tax effective method of investing going forward.
So what should you do ?
1. Contact us for advice.
2. Invest in managed funds likely to become PIEs (we can help you recognise which ones will fall into this camp).
3. Make sure your fund managers have your correct marginal tax rate.
4. Talk to us Contact Us about investment management platforms which can report on all of your investments and take care of all the tax work for you.
Are we getting richer ?
The result of a recent survey into the net wealth of New Zealanders provides some interesting reading. The survey has revealed:
Household net worth increased 14.7% during 2005
Liabilities increased by 15% over the same period
The increase in net worth was driven primarily by a strong price appreciation in the housing market.
While ostensibly the survey is extremely encouraging, if you dig a little deeper there are actually some areas that are cause for real concern. For example, although total net worth (assets less liabilities) increased by nearly 15%, financial net worth (excluding non-monetary assets such as property) only increased by around 5% over the year. This tells us that the increase has been driven almost solely by capital gains in the housing market.*
Why is this a concern?
Most people who own a house, also live in it. Therefore, in most cases, a property is not an income-producing asset. So although it feels good to have an increase in the value of your house, unless you sell or downsize, the increase in value is of little tangible financial benefit.
It creates a ‘wealth effect’ whereby people feel rich and then in some cases begin to make poor financial decisions based on the fact they feel more wealthy. Evidence of this is found in the fact that overall debt has increased by 15% over the year (so in real terms, there is no net gain).
Real financial savings in financial investments such as term deposits, managed funds, etc. show little sign of any growth. There is nothing fundamentally wrong with property as an asset class. However, the danger lies in people making ill-advised decisions because they feel they are better off, when in pure financial terms they actually are not. If you would like to discuss your own financial position with a view to increasing your financial net worth, we would be glad to help you.
Asset rich cash poor ?
When you are retired and your only source of income is NZ Superannuation you don’t have a lot of spare cash available for paying the escalating power bills, car repairs, appliance repairs let alone a annual holiday or buying birthday or Christmas presents for the grandchildren. Often retired folk have poured all their savings into paying of the house and becoming debt free, which leaves them with a house which has been escalating in value and no spare cash.
There are several options the retiree can consider to enhance their cash position.
All solutions could work, however each option needs to be carefully considered, hopefully with consultation with your professional Advisers and the support of your family.
Downsizing works best when it involves a move to a nearby, cheaper area. However it can be a wrench moving further away from friends and family who may in the case of illness be providing much needed support. If you happen to own a large family home in Wellington moving to a smaller unit in a cheaper suburb may release substantial equity and give you the cash to make life easier.
Some retirees may be reluctant to sell the large family home because they want to leave the house as an inheritance to their children. In this case the children may want to protect their inheritance by providing Mum & Dad with an ongoing weekly income. Two or three children getting together and providing Mum & Dad with an extra $50 a week can sometimes make all the difference.
Most banks would not entertain lending Mum & Dad money if Mum & Dad’s only source of income is NZ Superannuation. In this case the children may want to protect their inheritance by servicing the mortgage for Mum & Dad.
Another option is for the children to lend Mum & Dad the money secured by a mortgage over the family home. When Mum & Dad pass on, the estate settles the mortgage.
Reverse Annuity Mortgage
Over the last several years there has been huge growth in the popularity of the reverse annuity mortgage. This involves Mum & Dad agreeing to mortgage their house for an unknown final amount, in exchange for a monthly payment, of say, $1,000, tax free.
The annuity is not repaid until Mum & Dad pass on, at which time the amount paid out, plus interest, compounded monthly, gets taken from the proceeds of the final sale of the house. The power of compounding interest means the debt doubles every 8 years, at an annual interest rate of 9%. If Mum & Dad receive around $1,000 per month for 10 years, the estate would be charged $120,000 of capital, and around another $90,000 of interest at today rate of 9%.
This method quickly spends the children’s inheritance, but doesn’t matter if there are no children or the children are wealthy in their own right.
Home Equity Release Mortgage
Similar to the reverse annuity mortgage in regard to the compounding effect, but Mum & Dad receive a lump sum of say $100,000 instead of the monthly payment. The amounts Mum & Dad can borrow are very much dependant on their age and the house value. This type of loan doubles the debt about every seven years. So if Mum & Dad are around 80 years of age, by the time they are 90 years of age the debt is around $245,000.
Both the reverse annuity mortgage and the home equity release are sold on the basis that if historical house inflation continues there will be some value remaining for the children’s inheritance.
Deferred Settlement Loans
A company agrees to buy Mum & Dad’s house, with the settlement date deferred for up to 10 years. To qualify Mum & Dad have to be over 60 years of age and the house is worth at least $300,000and another long list of ongoing requirements as to maintenance and insurance cover. The company essentially buys the house, but will not take ownership for up to 10 years.
In this case the company pays the seller $30,000 and then pays $10,000 per annum for each year till the sale occurs. On the original sale date the house is valued, by the vendor (Mum & Dad) and the company and a sale price set at the halfway point of the two valuations.
When possession date comes, the house is valued again and the company then pays the original sale price, half of the capital gain that has occurred minus the money paid out (say $120,000 - $30,000 plus nine years of $10,000). So say the original price was $300,000, the price agreed after 10 years was $400,000, then the pay out will be $300,000, plus $50,000 minus $120,000. That is $230,000.
Mum & Dad do not have to move out of the house after 10 years. They have the right to rent the house indefinitely, at market rentals, which they pay out of the income from the $230,000. The result is the company has bought a house, sacrificing interest on $120,000 in return for half of a capital gain.
Payment for Guarantee
The children wish to buy a residential investment property through a company. They use Mum & Dad’s house as security for borrowing the funds. Essentially Mum & Dad receive a monthly guarantee fee from the children for the time they use Mum & Dad’s house as security. The major pitfall is if the residential property investment goes sour the lender may force a mortgagee sale of Mum & Dads house to get their money back.
The true value of seeking advice
“”more people obtain advice from friends and relatives (36%) than from a
specialist investment advisor (21%)”””
A survey released recently by the ANZ and the Retirement Commission has uncovered some fascinating findings regarding those who have sought financial advice. The survey was New Zealand’s first-ever financial knowledge survey targeted at New Zealand adults only.
The Ministry of Economic Development supported a section of the survey focused on understanding behavior in relation to superannuation, life insurance, shares and other securities products.
A summary of the results:
Financial knowledge in general was reasonable, but there were some significant gaps
There was a strong correlation between financial knowledge and socio-economic situation
Very few people have a documented financial plan
85% of those who had sought advice about superannuation or life insurance found it very useful or useful, and 94% of those who sought advice from an independent financial adviser on these same products found it useful or very useful
54% of respondents thought fixed interest would offer the best returns over an 18 year period
Only 20% of respondents currently held share investments
30% of respondents could not cope financially for three months if they had a major loss of income
Regarding NZ Superannuation - 35% incorrectly believed it was income tested and 28% thought it was asset tested
36% of respondents had received advice about superannuation, life insurance and shares from friends or relatives
Some people think it is all right to divulge their internet banking password to bank staff.
The key things that these results tend to underline is that the public has a degree of financial knowledge, but the lack of understanding of key areas like retirement savings, risk and investment understanding is disturbing.
Of major concern is that more people obtained advice from friends and relatives (36%) than from a specialist investment advisor (21%).
The percentage of people obtaining advice about superannuation and life insurance from a professional (insurance company agent or advisor) was slightly higher (38%). However, specialist investment advisors were the primary source of advice for collective investment schemes and debt securities (56%).
The key things that these results tend to underline is that the public has a degree of financial knowledge, but the lack of understanding of key areas like retirement savings, risk and investment understanding is a major concern.
Please Contact Us you will benefit from a initial free consultation.
Prudent trustee decision making - more than just a rubber stamp
We believe that with the massive proliferation of trusts in recent years, it is timely to provide a reminder about the importance of the Prudent Person Rule contained in the 1956 Trustee Act (and more specifically in amendments to the Act in 1988).
One of the key tenets of the amendments to the Act in 1988 was the replacement of the long list of authorized investments with an ‘open door’ policy, which allowed trustees to invest in any form of investment, subject to “the care, diligence and skill that a person of business would exercise in managing the affairs of others”. This duty of care is known as the Prudent person Rule.
In summary the Prudent Person Rule means that trustees making investment decisions may need to exercise the same level of scrutiny as professional investment managers. Some trustees do not follow anywhere near this level of detail in their decision-making process, and are often there purely to ‘rubber stamp’ decisions, rather than thoroughly investigate what is in the best interest of beneficiaries.
Some important things you as a trustee need to consider in regards to the trust’s investment decisions are outlined below:
1. The value of the investments are protected against inflation.
2. The investments are diversified to protect capital and minimize risk.
3. The likely amount of income. Will this meet beneficiary needs?
4. The likelihood of capital gain or loss and how this fits with the risk propensity of the beneficiaries.
5. The duration of the trust.
6. Taxation liability.
7. Managing the cash flow needs of the beneficiaries in accordance with the Trust Deed.
A common mistake trustees make is placing all their investments into fixed income investments. This may seem like a sound investment strategy and the allocation could be appropriate for the beneficiaries, however:
1. The Act requires trustees to protect the real (i.e. after inflation) value of the trust.
If the trust is distributing the income produced from these investments, the real value is actually being eroded.
2. It conflicts with current mainstream investment theory, which
emphasizes the importance of diversification across asset classes.
3. It is usually the result of trustees failing to understand the risk
characteristics specific to the trust. For example, when assessing
the degree of risk the trust is prepared to accept, it should be the
trustees’ assessment of the beneficiaries’ risk propensity, not their
own comfort with risk.
4. It may mean the trust underperforms a similar investment strategy with
a balanced asset allocation over a period. Certainly, if you had placed
an entire portfolio into fixed income investments in late 2002 as a result
of the downturn in international equities, you would have
underperformed a diversified strategy over the past three years. It is
important that the trust makes investment decisions based on long
term, proven investment theory, rather than responding to fluctuations
in the market.
The importance of this is highlighted by the often quoted, but nonetheless important, Mulligan case (1998) in which the husband left a life interest in his estate to his widow.
The trustees (including the widow) invested solely in fixed interest investments from 1965 to 1990.
During that time the value of the trust property fell from $108,000 to $102,000. If instead, the real value of the estate had been maintained it would have been worth $1.368 million at the time of the trial in May 1996.
The court found that the trustees knew the effect inflation was having on thereal value of the assets and that they should have diversified into growth assets. It was not a balanced approach and the court held the trustees negligent.
From an application perspective, the Prudent Person Rule is not concerned so much with the results of investment decisions, but how those decisions were arrived at. Any action may be judged based on whether the defendant has met a standard, commensurate with a professional fund manager.
In doing this the court will ask three questions:
1. Was the investment decision consistent with the prevailing academic
consensus at the time on portfolio theory, investment management
and the basic rules of prudent investment ?
2. Was the investment decision consistent with the rules, standards and
procedures laid down by relevant professional bodies ?
3. Was the advice based on researched, quality information ? As you
can see, there is a lot involved and if trustees are not prepared to
analyze all of these issues, either they should not become trustees
or they should employ a professional trustee to assist in this process.
The risk of not taking it seriously is likely to be larger than you think.