*Pic: Clint Eastwood in the film, The Good, the Bad and the Ugly ...
First published July 12
Today, I’m going to tell you that you’ve been lied to. By some of Australia’s biggest insurance companies, no less.
But first, I want you to picture this: It’s the year 2037. Tony Abbott’s still being a pest. Your little kids, well, they aren’t so little anymore.
And they’ve sat you down for ‘the talk’.
Which goes something like this ...
‘Please tell us you didn’t put our money into an investment bond’
You see kids these days are as sharp as a tack. Older people, the generation with all the money, tend to trust what they read in the newspaper, or rubbish advice they get on the internet. Like the idea investment bonds are somehow a good thing.
So I’ll get this off my chest early - investment bonds are crap. Actually, they’re seriously crap.
Despite that five-star rating crapometer rating, they’re still being flogged in the media as a great way to save for kids.
Here’s the typical conversation I’ve had recently when talk turns to bonds:
At that point, we usually start arguing. That’s because most parents are drip-fed bullshit about bonds being Good Things.
And the insurance companies lap it up because they’re making squillions from well-meaning, but misinformed mums and dads.
Bill and Ben, Flowerpot Men
Let’s talk about two good mates who own a flowerpot business. We’ll call them Bill and Ben.
Business is good, and they want to put aside some money for the kids.
Bill reads something in the newspaper about how investment bonds are great because you don’t pay capital gains tax and after 10 years, they’re tax-free. Se he puts $10K into a bond for his kids.
Ben does some sums, and instead of an investment bond he puts $10K into an Australian shares fund in his name.
Every year, Bill gets a statement telling me how his bond is going.
Every year, Ben gets a tax bill, because the dividends from his fund are assessable in his name, and he gets slugged the top marginal tax rate of 47%.
So Bill’s ahead, right? Actually, no.
After 10 years, let’s see what the spreadsheet spits out.
Trigger Warning - Numbers Ahead
In 2027, Bill’s investment bond will be worth $16,538. He can withdraw that tax-free.
Ben? His investment is worth ... $20,135.
Some of you are shouting at your screen ‘but that’s before Capital Gains Tax,’ and you’d be right.
If Ben sold his investment and paid tax at his marginal rate of 47%, he’d still have $17,749, or about 7% more than Bill.
But he doesn’t have to sell his investment. He can leave it, compounding away nicely.
After 20 years, Ben’s got a tidy $40,626 for his kids, or $33,424 after paying CGT.
Bill’s way back in the potting shed somewhere. His investment bond’s only worth $27,353.
Okay, I’ve made some assumptions here, and any pencilheads reading can email me if they want a detailed breakdown. But here’s the guts of it: I’ve assumed both Bill and Ben invest in an Aussie share ETF, with 5% growth and 3% fully franked dividends, and they’re identical except Bill’s is held inside a bond. The bond has a management fee of 1%, and pays an effective internal tax rate of 23%.
But Wait, There’s More
You might not be earning $180K plus and paying 47% tax. If you’re an average Jo/Joe, you’ve probably got a marginal tax rate of 34.5%.
If that’s you, after 20 years you’ll have far more than either Bill or Ben. In fact you’ll have $44,882, or $38,862 after tax.
Let’s get our Alan Kohler on, and remember, I’m talking after-tax returns here.
That’s Bill’s bond in the red. Way behind Ben, and even further behind the average parent saving for the future of the rugrats.
How can this be? Two reasons. First, investment bonds charge a management fee - typically around 1%, but often a lot higher. So for identical investments, you’re way behind as soon as you begin.
Second - and it’s back to tax - investment bonds pay tax on your capital gains every single year. So rather than leave your gains to compound, every year you’re sending some of your savings off to the ATO.
The Naked Investor Guarantee
I know some of you will think this is a crock. So here’s my offer: The first person who can show that someone with a passive sharemarket investment is better off in a bond held for the long term than by holding it personally, I’ll give them a present. A bottle of French champagne for starters, plus $200 to put into an investment bond of your choice.
I reckon my money’s safe and I’ll be drinking the bubbles, not you. Here’s why.
The Insurance Industry’s Dirty Little Secret
A while back I sent my spreadsheet and assumptions to the head of one of the biggest sellers of investment bonds in Australia.
He got his beancounters to check my numbers. Reluctantly, he agreed that I was right and his marketing was, shall we say, dodgy.
Then he begged me not to publish this.
So if you’ve got an investment bond, you might like to show this to the person who sold it to you, with a ‘please explain’. If you’re thinking about investing in one, please think again. Anyone can run these numbers on a spreadsheet, probably your kids these days. So do your own sums.
The Naked Takeaway
This was meant to be about the good, the bad and the ugly of investing for kids. Well I’ve given you the bad, and I’ve run out of space.
So on Sunday I’ll deliver you the ugly, and then make you happy with the gold standard of saving for kids. Nearly all Australia’s politicians do it this way, so it must be okay ...
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