Aussie Firebug

Financial Independence Retire Early

In case ya missed it, earlier this year I published what turned out to be my most controversial article of all time (and it’s not even close). The Curious Case of Franking Credits and the FIRE Community of course.

The thing is, I actually really don’t like talking about politicians and what they say and plan to do at all. That piece was never meant to be political but after reflecting for some time now, it was always going to be that way due to the nature of the subject matter.

So why the hell would I ever go near it again?

Because even though I don’t like those 🤡, politicians do affect us in the journey to FIRE and I need to set the scene first in order to talk about how we come to the conclusion at the end and where we’re heading moving forward.

And the beauty of having your own blog is you get to write and publish whatever you want. I create content from my point of view and never claimed my writing was balanced. This site isn’t the ABC or some neutral FIRE outlet. I presented facts in that article with my opinion which I understand everyone isn’t going to agree with.

However, that topic was interesting to me (and a bunch of others) so if I’m offending you or you don’t like what I’m writing, maybe you should follow another FIRE blogger ✌

 

Franking Refunds Survived…For Now

Like Steven Bradbury before him, ScoMo and the Coalition skated past the ALP for a come from behind victory and with it, the franking credit refunds will remain for the foreseeable future.

This was a hot topic amongst the FIRE community and now that the election has passed, it seems like things should proceed as per normal right?

I mean, franking credit refunds didn’t get the chop so fully franked dividends are safe to retire on yeah…?

Well… about that

Whilst I think that the result of the election speaks volumes to where the majority of Australians priorities lie, I strongly believe that a lot of the policies the ALP were trying to win votes on will not be touched for a very, very long time. They were aggressive with their tax reforms, franking credit refunds being one of the smaller changes (CGT and trust distributions being a lot bigger).

This was supposedly the unlosable election for the ALP. Every poll in the country had them winning by a landslide. Sportbet even paid out on them winning two days early to the tune of 1.3M 😮

For them to lose in the fashion they did, especially after all the shit the Coalition has done during its previous term tells me that the majority of Australians did not agree with the policies they were proposing.

And it’s my opinion that aggressive tax reforms played a huge part!

Now I’m definitely not an expert on this subject and don’t know for sure (no one really does) but I doubt we will see such aggressive policies proposed by any party for some time. I’d almost bank on it that scraping franking credit refunds will not even be thought about in the next election. They’ll go after something else, that’s a given. But it won’t be the same policies that contributed to them losing the election this year.

Sidebar: I’m not here to talk about the policies or politics so for the love of God don’t @ me in the comments about it.

But that’s enough about the election.

Again, I really don’t like politicians in general and try to avoid talking about them as much as possible. I only bring them up because it’s important to set the scene for the decisions we’re making in regards to investing for financial independence which is what this blog is all about.

Which brings me back to the point about the franking credit refunds.

Whilst I truly don’t think any political party will go near them for a very long time. I also learnt something very valuable from that campaign policy.

The legislation risk associated with franking credits in general.

I was completely naive in thinking the government would not pull the rug out from underneath us and the refunds would be here to stay.

What a fool I am!

I’m just thankful we’re still in the accumulation phase and have a chance to mitigate this risk a bit moving forward (more on this below).

But wouldn’t it have absolutely sucked if you’d worked your whole life and built up a retirement fund utilizing franking credit refunds only for the government to turn around and change the rules on you!

The refunds are safe for now. But I plan to be retired for 50+ years. That’s a long time for people to forget what happened in 2019 and if I were a betting man, I’d wager that sooner or later, franking credit refunds will be back on the chopping block!

 

Are Aussie Shares Worth It Without Franking Credits?

The thing about franking credits for those who are chasing FIRE in Australia is that without the refund, they are worth a hell of a lot less and in some cases, will mean that you don’t receive any benefit from the franking credits at all.

Let me give you an example.

Mrs FB and I know that to fund our current lifestyle in Australia, we spend around $48K over the course of 12 months.

We plan to own a house one day, so if we remove our rent and add on a bit to cover rates, maintenance on the property, insurance etc, we get to around ~$42K at a guess.

The plan before the election was for us to split our dividend income 50-50 and pay ourselves the $18,200 (tax-free income threshold) each from Aussie franked dividends. Let’s assume that the dividends are fully franked.

We each would receive $18,200 in cash throughout the year plus $7,800 in franking credits each. This means that the ATO would look at us having a taxable income of $26,000 for that year (dividend plus the FC).

Here’s the math behind the grossed-up dividend.

Dividend % Franking Franking Credit Tax Before FC Tax After FC Grossed up dividend
$18,200 100% $7,800.00 $1,482 -$6,318 $24,518.00

The franking credits soaked up the owed tax of $1,482. This will still happen if the refunds were ever removed.

But more importantly, the franking credits refunded us $6,318!

Because we, as the shareholder, have already pre-paid tax @ 30% that was removed from the dividend before it hit our accounts. It’s only fair that this is recorded (the franking credit) and the ATO is aware of us pre-paying the tax so we can be refunded later if we paid too much tax for that year which in this example, we did.

This was always the intention of imputation credits. Not to only stop double taxation (which consequently it also does), but to ensure that income is taxed once by those obliged to pay it.

So the end result is around $24.5K each to fund our life after retirement.

That’s almost $50K! More than enough for us to live comfortably forever whilst factoring in inflation.

But if we remove the refund. We only end up with $36K between us.

That’s a whopping $13,036 dollars difference and means we need to head back to work. 

Or let me put it to you another way. You’re losing 28% of your return 💸

 

Tipping Point

I was on the fence for a long time before moving towards an Aussie dividend approach with Strategy 3.

A lot of people out there don’t realise that a major part of the dividend approach for me was not about total return. In fact, I even mentioned it in Strategy 3 that if I were to guess, I’d wager that Strategy 3 would slightly delay my FIRE date because of the less efficient tax method of income (dividends are less efficient vs capital gains) and less diversification.

We moved to Strategy 3 predominately because of the psychological aspect of receiving income that was not affected as greatly by human emotion (share prices) and is more anchored to business fundamentals (income of a profitable business that is passed to the shareholder via a dividend).

There have been great Australian based articles written that objectively looks at retiring on dividends vs capital growth and I constantly receive messages that link to studies showing superior returns for an internationally diversified low-cost ETF portfolio.

Guys, I’m a die-hard FIRE fanatic,

I’ve come across most of these theories and articles before! What’s missing here is the human element. We’re not investing robots. I’m not too fussed between minor differences in returns and place great value in simplicity and sleep at night factor.

I thought the trade-off of less international diversification and a slightly delayed FIRE date was worth retiring on dividends vs dividends + capital gains.

But everyone has their tipping point.

Without the franking credit refund, Aussie shares just don’t cut the mustard IMO.

The difference is just not worth it for us. But everyone’s circumstances are different.

For instance, those looking to retire on FATFIRE will not be as greatly affected by this change since they will have more of an income to soak up those credits.

And many people have rightly suggested to me that there are a lot of alternative strategies to generate unfranked income such as REITs, Bonds, P2P lending etc.

These are viable alternatives for some, but we want to continue investing in companies for now.

 

Mitigating Risks

Let me be quite clear.

I’m still a massive fan of the dividend approach.

But placing such an enormous amount of faith that politicians won’t change the rules around franking credits over the next 50 years just doesn’t seem logical to me.

I want to mitigate the legislation risk of a potential franking credit refund axing as much as possible but at the same time, continue our overarching investment philosophy of investing in great companies.

We want to reduce our portfolios franked dividends and take advantage of a more diversified portfolio again. Which means…

I kept the international part of our portfolio when we decided to focus on Aussie shares. And when the very real news of potential changes in franking refunds was mentioned, I felt such a huge sigh of relief knowing we still had some international exposure. I guess this just goes to show the power of international diversification. If one country stuffs something up, there’s plenty more out there so you’re covered… doesn’t really work if you’re all in on the one country though 😅

Given that I don’t think franking credits refunds will be there over the next 50 years (no refund for us basically means no credits at all). I would like to receive some income from international companies along the way. It’s not going to be as good as the Aussie yield, but it helps the situation and my sleep at night factor.

Also, with the help of capital gains, an internationally diversified portfolio according to almost every major study done of the subject, will reduce risk, volatility and increase safer withdrawal rates!

 

To LIC or Not To LIC?

This one’s quite straightforward. A LIC has to pay a fully franked dividend. An ETF does not. VAS, for example, has a franking % of around 70-80 % which means that part of the income is not franked.

As I detailed in my ETFs vs LICS article, they are so similar that we are basically splitting hairs when comparing the two. As such, the greater legislation risk associated with LICs to me has shifted my favour towards ETFs.

I want to make myself clear again. I’m still a fan of LICs. I love the dividends they produce and the two companies I’m invested in (Milton and AFIC) have goals that align with my own (to grow their income over time).

It’s just that A200/VAS are so incredibly similar but have the key difference in utilizing a trust structure and not a company. The legislation risk has tipped the scales in favour of ETFs for me moving forward.

This is purely a tax minimisation decision. It has nothing to do with changing the overarching investment principles (investing in great companies) or a shift away from Aussie dividends.

The FI Explorer wrote a great piece on a sceptical view of LICs which some of you out there have emailed me about. I agree with what is written in that article, always have. I never invested in LICs expecting a superior return. What I go back to is the mental aspect of investing. A lot of people who retiree will feel more comfortable living on a relatively stable smooth flow of dividends vs more volatility but a slightly higher return.

 

Strategy 2.5

Okie Dokie.

So here she is. The new…ish strategy moving forward.

It’s called 2.5 because it’s extremely similar to strategy 2 just with a few tweaks. It’s almost like we’re going back to strategy 2 and I didn’t think enough has changed to honour it with strategy 4.

Change 1

Firstly, with the addition of buying more international shares back in the plan, we will move back to a ‘split’ approach.

Our splits have changed slightly from strategy 2 with more of an emphasis on Aussie shares as the dividends are still attractive regardless of franking credits refunds.

We will be looking to maintain a split of

60% A200/VAS/LICs (Aussie)

20% IVV/VTS (US)

20% VEU (world ex US)

We’ll keep our two LICs in the portfolio but won’t buy any more units moving forward.

The plan when buying new shares is a lot easier than looking at when LICs are trading at a premium or not.

Before we buy each month, we will look at the current splits in the portfolio and purchase the shares which have the lowest targeted weighting.

For example, this is what our portfolio currently looks like.

So next time we buy, it will be to ‘top-up’ the lowest split, which in this case will be World ex US or VEU. The splits are all out of wack because we focussed on Aussie equities during the last 12 months. Ideally, you want to be as close to your splits as much as possible. When your portfolio reaches a certain point however, the market movements will be so great that you might find it hard to maintain your splits even by buying the lowest weighting split. But this will be a good problem to have since your portfolio at that stage will be in the 7 figures.

Something really cool about this strategy is that you’re always buying the split that is down. If one split booms but the others don’t, you won’t be purchasing more of that booming split.

Change 2

The second change we will be making is switching from VTS to IVV.

iShares Core S&P 500 ETF is extremely similar to VTS with a few differences but no major ones we’re concerned about. VTS is more diversified and 0.01% cheaper but is not domiciled in Australia and does not offer DRP. This means that we need to fill in the W-8BEN-E form every three years or so.

The W-8BEN-E form is literally 10 minutes of your time every 3 years and is often overblown in terms of effort, but nonetheless, the two funds are so similar that it’s worth saving the extra admin plus having the DRP option available which I’ve been looking to use as of late.

Here are their 10-year returns to just show how similar they are.

Change 3

The third part of the plan is a hybrid approach between relying only on dividends vs dividends and selling parts of the portfolio. IVV and VEU don’t pay a lot of dividends, but they still pay them.

IVV has returned 3.27% over the last decade and VEU has done 2.85%. Not great, but still cash flowing into the account. And more importantly, those dividends are unfranked income!

We will aim to not touch the portfolio and use the dividends from both Aussie and international shares to live on. If it’s a bad year, however, we will look to sell-off some units to cover the shortfall.

I’ve already gone into why selling parts of the portfolio is perfectly ok if you allow for it to recover in strategy 2. In fact, from a rational market point of view, there’s really little difference between selling units for income and having the company pay you via a dividend. In theory, both should have the exact same consequences. But markets are not rational so they vary to some degree and is a prime reason why we like the dividend approach more.

How It Works

Let’s look at how the newly allocated portfolio would have done during the last 12 months. Here, I have created a dummy portfolio with all trades done exactly one year ago with the total of the portfolio’s value being a cool $1M which is what we’re aiming for.

Aussie equities (I had to use VAS to go back far enough) @ 60%
US (IVV) @ 20%
World ex US (VEU) @ 20%

$46,809 worth of dividends ain’t bad and is more than of FI number of ~$42K!

Bumping up the weighting of Aussie shares to 60% (it was 40% for strategy 2), plus the lower dividend payments of our international shares have actually generated enough income for us to live off during the last 12 months.

But this was a particularly good year for Aussie shares and it won’t be this good all the time. We will save any extra income during those good years to create a cash buffer in preparation for the bad ones that will no doubt come.

If it’s a particularly bad year for dividends, we will look at selling off some units to cover our expenses.

The other thing is that the likelihood of us not earning any money in retirement is extremely low. I’ve covered this in what retire early means to us in the context of FIRE.

I’m extremely confident that the dividends from a $1M portfolio that is weighted to 60% Aussie shares plus any additional income will be more than enough for us.

Selling off units is there as an option but I don’t think we’ll need it tbh!

Time will tell.

To summarise strategy 2.5

  1. An internationally diversified portfolio consisting of 60% Aussie shares and 40% international
  2. Buying IVV instead of VTS moving forward for DRP and Australian domiciled.
  3. Buying Aussie ETFs and not LICs due to risks associated with franking credits. ETFs don’t pay fully franked dividends and are impacted slightly less in the event of legislation passing.

 

 

Stop Changing Strategies Dude!

This is you

“Man, you flip flop more than my thongs! Stick to one strategy mate and stay the course. If the axing of the franking credit refund caused you to change strategies, you were never in it for the right reasons.”

And this is me

“Yo! The overarching strategy of investing in great companies has never changed. There was definitely a major difference between strategy 1 and strategy 2. But the fundamentals from strategy 2 to 3 and now to 2.5 are exactly the same”

The thing is, investing in great companies should always be the number 1 goal. All this other shit comes later.

The issue with picking the good companies from the duds is that it’s really hard to do. Which is why index investing is so cool.

The tweaks between our strategies are really fine-tuning our portfolio to meet our specific needs in the following areas:

  1. Mindset/sleep at night factor
  2. Simplicity
  3. Tax minimisation
  4. Mitigating legislation risk (something I hadn’t considered before)

I think everyone should be a bit flexible with how they invest to a certain degree. Picking one strategy and literally not changing anything during your whole life seems unlikely. Franking credit refunds are a great example of this.

And what’s to say the government won’t impose some stupid tax on other asset classes or something else within our life?

It would be ridiculous to suggest that if the government turned around and started taxing Aussie shares an additional 30% that everyone should just ‘stay the course’ and not look at alternative methods.

Everyone has their tipping point when enough is enough. And even though the refund remains, for now, I’m looking at protecting against this potential rule change without drastically upheaving everything.

I think strategy 2.5 is a nice balance between everything that’s important to us in an investing strategy.

 

Conclusion

I’m still learning as I go.

Judging by some of the emails I get, you’d think that I’m some sort of investing guru which couldn’t be further from the truth.

This years election taught me a valuable lesson that I hadn’t considered as much as I should have before.

The legislation risks for investing in general but particularly the very real possibility of no more franking credit refunds one day.

For us and I assume a lot of people chasing FIRE, franking credits without the refund in retirement won’t be worth the concentration risk or the ~4% yield (still pretty good) when you consider that you’re losing up to 30% of your return due to the additional tax that you otherwise wouldn’t be paying had you invested in something other than franked dividends.

Although not completely, Strategy 2.5 mitigates this potential change by re-introducing international shares back in the portfolio which reduces our reliance on Aussie dividends. It also makes other small changes as mentioned above.

When we made the shift away from property to focus on shares, the number 1 goal was to invest in great companies. None of this other stuff is as important as that. Index investing means we don’t have to research which companies are going to be good or bad. It filters that stuff out for us.

Because we don’t have to worry about choosing the good companies from the bad, we can instead spend our time to tweak our strategies so they align with what’s most important to us.

Mrs FB and I optimise the portfolio to improve these areas:

  1. Mindset/sleep at night factor
  2. Simplicity
  3. Tax minimisation
  4. Mitigating legislation risk (new)

Strategy 2.5 improves on all of these areas whilst not uprooting our investing fundamentals which is what any good tweak should do!

That’s it for now.

Let me know what you think in the comment section below 🤙

 

Spark that 🔥

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