The problem with pooled funds

What is a pooled fund?

A pooled fund is simply a fund where investors’ money is combined and invested by a fund manager. Essentially anything other than individual assets will be in pooled funds – all your well-known managed funds, ETFs, and LICs – both actively managed and index-tracking funds – are pooled. Pooling is an easy way to diversify into hundreds or even thousands of securities in a single investment.

How pooling affects capital gains

Unfortunately, since the entire fund is a single pool of assets, if there are more units sold than purchased, the fund will have to sell some assets, and this triggers capital gains for all investors of the fund. So even if you don’t sell any units, you still realise gains.

Something to note is that this does not occur with ETFs due to their unique structure. Instead, capital gains are deferred until you sell your ETF shares yourself. The reason for this is explained in the first section (“Managed funds vs ETFs”) of the following article: How is VDHG tax-inefficient?

Important note: when the underlying fund sells assets (e.g. rebalancing, or when stocks fall out of the index), you will still realise those capital gains in both ETF and non-ETF pooled funds. What this article is talking about is whether you realise gains when other investors sell their units.

In plain English, pooled funds (with the exception of ETFs) pay tax at the fund level and therefore are taxed gradually in small amounts each year, whereas, with ETFs, you don’t realise those gains until you actually sell.

Generally, you want to defer paying capital gains for as long as possible so that additional money can be earning money and compounding for potentially another 30 years or more. More importantly, you’re likely to be on a lower or zero marginal tax rate in retirement meaning less (or no) tax would be payable.

Examples

One example is during the coronavirus market downturn VGAD (the ETF) had no mid-year distribution (due to currency hedging), yet the managed fund version had a distribution due to other investors selling their units. This is even despite the two funds having the same base fund because they’re two different pools of money and are managed according to the fund structure.

Here are a couple of threads where people are complaining about the managed fund version of Vanguard’s funds which are pooled (as opposed to the equivalent ETFs which were not).

How it affects your super

Pooled funds in super pay tax along the way just as they do outside super, and while it’s taxed at a lower tax rate in super than outside super, it’s still taxed (15% for short term capital gains and 10% for long term capital gains).

However, in super, once you meet a condition of release and move funds to an account-based pension (i.e. when of retirement age), money in your account-based pension is tax-free and therefore, if you instead held ETFs in super and built-up those capital gains instead using pooled funds that separate out capital gains along the way, all those embedded capital gains don’t need to ever be paid – provided you don’t need to sell when converting to pension phase.

Take a moment to think about that – those capital gains you accrued for potentially decades during accumulation don’t ever need to be paid. So, in super, regular (pooled) funds misses out on effectively having your capital gains tax bill wiped entirely.

Most super funds are pooled, including the passively managed Index funds at Australian Retirement Trust (ART), HostPlus, Aware, Rest, and QSuper, which are regularly mentioned on investing forums as the go-to passive investing option for passive investors due to their very low fees for indexing options.

But wait, there is more.

These gains from the pooling, while not insignificant, don’t make up the majority of your total capital gains. What if there is a way to wipe the majority of your capital gains from decades of capital growth?

Capital gains tax of pooled funds: outside vs. inside super

As explained above, in pooled funds both inside and outside super, when the fund sells assets (due to investors owning the units selling), the whole pool must realise capital gains, even for individuals that did not sell any of their units. However, there’s still a difference between pooled funds inside and outside super due to the fact that outside super the units are taxed individually while in super the fund itself pays all of the tax.

This means that with pooled funds outside super, most of the capital gains are still paid by the individual. These are payable when you sell (but are lower by the amount of capital gains you have had to pay along the way as a result of others selling).

This is as opposed to pooled funds in super (which is essentially all super funds that aren’t direct investment options or wrap accounts), where all capital gains are paid by the fund and there are is no more to pay. As a result, you pay no capital gains tax when switching from pooled super funds (because it has already been taken out).

Tax provisioning in pooled super funds

To avoid the problem of capital gains building up in pooled super funds and being unfairly distributed, capital gains are provisioned. Provisioning means that if there is $100m in assets in a fund and it grew by $10m, members’ balances will total only $108.5m with the other $1.5m showing as segregated and available to pay any tax liability of members redeeming (selling) their units in that pool.

This $1.5m is an accounting record, so it is still sitting there in the pool of funds earning returns and those returns will be attributed to members, but the $1.5m that has been provisioned does not show as being attributed to the members. This is why you can switch funds in super without paying any capital gains (it has already been accounted for).

Here’s the important bit — as mentioned above, when you reach the age where you convert your super to an account-based pension (where zero tax is paid from then on), converting from a pooled fund is considered a redemption (selling and rebuying) and you are effectively paying out capital gains from decades of superannuation earnings (which have been provisioned). This is in contrast to individually taxed investments in super (and which allow in-specie transfer to an account-based pension), where all your decades of capital gains would never need to be paid. Yes, you read that right.

What can you do about it?

Individually taxed structures for your superannuation avoid this problem as they meet both of the following requirements.

  1. Allows investing in ETFs directly, which results in being individually taxed; and
  2. Allows converting to pension phase without the need to sell down and realise gains.

Individually taxed structures include:

  • SMSFs
  • Wrap platforms
  • Direct investment options (in public super funds).

The trade-off between them is cost, complexity, and flexibility.

An SMSF is a private super fund that you manage yourself. The plus with an SMSF is that you have complete control and therefore flexibility over your investments. However, the complexity is high and typically requires someone to manage it, which means the cost is high. The cost is fixed, so at low balances, it is a high percentage of your assets, often making the cost outweigh the benefits, but can become more cost-effective for higher balances.

The cost also depends on whether you use an accountant and/or adviser for $5,000-$7,000 per year or whether you use a low-cost SMSF provider like ESuperFund, StakeSMSF, icareSMSF etc., which are closer to $1,500 per year. I would be wary of an adviser or accountant recommending an SMSF where they or any entity related to the company they work for is doing the administration of it because of the high potential conflict of interest in their recommendation.

With a low cost provider and with both partners of a couple holding their assets within the SMSF, the cost can become very affordable. $1,500 p.a. on a combined $1m of super is a low 0.15%. Conversely, an adviser/accountant managing your SMSF for $5,000 on a $500k balance is 1% p.a., which is a large hit to your returns each year considering historical real returns have been about 6% p.a. But note that $1,500 p.a. on a combined balance of $300,000 is still 0.5%, and then there is the investment fee of probably another 0.15%-0.20%, so the cost of a low-cost SMSF provider is still very high even at this balance. A $500,000 balance would come to about 0.50% including investment fees, which is still rather high.

Wrap platforms are simpler with the platform taking care of the administration. However, they have percentage based fees that grow with your balance, which is great for low balances but is not good once your balance gets to a significant amount. And you are forced to realise a lot of capital gains if you want to leave later, defeating the purpose. Also, many advisers recommend wrap platforms for reasons that are against your best interest.

The last option is direct investment options in public super funds. The fund again, takes care of the administration, and many super funds charge a fixed and percentage-based fee, but a couple of the bigger ones only charge a fixed fee of a couple of hundred dollars a year and no percentage-based fee. This article from ETFWatch lists a number of super funds which offer direct investment options that allow you to invest in ETFs.
Which super funds allow you to invest in ETFs & LICs? – ETF Watch

We’ll go through some of these in more detail, but there are some commonalities among direct investment options.

First and foremost, additional costs over regular pooled investments in public super funds:

  1. An additional fixed cost of $168+ p.a. (depending on the fund manager) for using their direct investment option and, other than HostPlus & AusSuper, their regular management fee is also partly based on your balance. For instance, Legal Super is 0.29% which would be a no-go for me.
  2. Brokerage is payable and slightly on the high side.
  3. The ETFs own management fees are payable.

Due to these costs, it appears to be better to use something cheaper such as ART’s low-cost index funds for low balances to avoid the fact that fixed costs are a higher proportion on small balances which eat away at your compounding. However, at a certain point, the improved capital gains tax treatment outweighs these costs, at least in super funds with little or no admin fees tied to your balance.

Besides the higher fixed costs, there is a requirement in all these direct investment options to hold at least 20% of your assets (with a fixed minimum of $2,000-$10,000 depending on the fund manager) outside the direct investment options. This appears to be required by all funds that offer a direct investment option. While I haven’t checked all providers, the HostPlus PDS says that in pension phase, the minimum withdrawal comes from this 20% pool, and I imagine their ongoing fees and insurance premiums and any other costs come from this pool.

The HostPlus PDS says that –

Should your other investment options fall below their required amounts, you will be required to transfer cash from your Choiceplus account. This may require us to sell some of your Choiceplus shares or ETFs and LICs or break a term deposit. We will make every endeavour to contact you prior to selling any of your holdings in Choiceplus.

It makes sense that they would want a portion available in either cash or their pooled funds which are easily accessible to use for paying fees, insurance, as well as an income stream when in pension phase so that they can avoid trading shares in your direct options without the owner’s permission except as a last resort. In fact, HostPlus ChoicePlus requires 1.5x the minimum pension amount to be available in their pooled options to draw from which means at age 60 (4% pension minimum), you would need 1.5x that amount.

You also need to check their ETF options. Some of them are a little restrictive. For instance, Cbus self-managed doesn’t appear to offer many ETFs, including missing VGS, although they offer the SPDR equivalent WXOZ which has an MER of 0.40, which is close enough, although coupled with their 0.15% admin fee (on top of their fixed fees), the total cost doesn’t seem appealing.

There are a couple more downsides that you may come across (with both HostPlus ChoicePlus and AustralianSuper Member Direct), which concern moving from your accumulation account in retirement to an account-based pension or a TTR pension account:

  1. If you have over the TBC (Transfer Balance Cap – the amount you can move to an account based pension), you are required to sell down and realise any capital gains for that amount over the TBC before moving to an account-based pension in specie. This means you can not continue to earn money on delayed tax of that additional amount since you can no longer delay the tax on that. So if you are likely to exceed the TBC, this is an important consideration. Although, I suppose you could potentially use both of them and split it up.
  2. These typically don’t support keeping direct investments in a Transfer To Retirement (TTR) account, which means you can not use several superannuation strategies if you continue working from age 60 to 65 without losing a significant amount of the benefits of this article.
  3. As with other individually taxed superannuation structures, you are required to realise (i.e., pay out) capital gains to leave. 30+ years is a long time to be locked into one provider and risk having to sell down realising CGT if they change the rules. ING Living Super was an example of that where they used to be an excellent option until they added 0.5% admin fee.

So for larger balances, or even accounts that will have large balances in the not too distant future, it is worth considering an SMSF from the start of when you are considering using direct investment options.

Some direct investment options

HostPlus ChoicePlus

  • Allows you to purchase ETFs directly, making it individually taxed.
  • Allows you to transfer your ChoicePlus held ETFs from your super to your pension account without the need to sell down and realise gains.
  • They have the lowest fees with fixed costs of $168 p.a. for the direct investment option on top of the regular admin fee of $78 p.a.
    Unlike most other direct investment options, there’s no percent-of-assets fee, so once you reach an amount of assets worth using this direct option, your costs as a percentage of assets fall as your balance grows.
  • Brokerage fees also apply. As well as the ETFs own management fees.
  • As with all other options we looked at, you are required to retain 20% of your assets (with a minimum of $2,000) outside ChoicePlus in cash or pooled investment options.
  • An important aspect to be aware of is whether there are low-cost index options in their pooled funds for the remaining 20%, and HostPlus does have low-cost index options for Australian, international, and international currency-hedged funds.
  • As with some (but not all) direct investment options, there is a limit on how much you can invest in any single security. With ChoicePlus the max 20-50% in any single security. It should also be noted that this percentage is across your combined balance in their direct investment option and outside their direct investment option, therefore you could have one of their low-cost indexes outside ChoicePlus and 4 funds inside.

AustralianSuper member direct

  • Allows you to purchase ETFs directly, making it individually taxed.
  • Allows you to transfer your member direct ETFs from your super to your pension account without the need to sell down and realise gains.
  • Their fees are higher than ChoicePlus, currently $180 p.a. for the direct investment option on top of the other admin fee of $78 p.a. The higher fixed fee affects lower balances.
  • Brokerage fees also apply. As well as the ETFs own management fees.
  • As with all other options we looked at, you are required to retain 20% of your assets (with a minimum of $5,000) outside the member direct investments in cash or pooled investment options.
  • Unlike HostPlus, there aren’t low-cost index options in their pooled funds for the remaining 20%, except for their index-balanced option which has a substantial helping of defensive assets (cash/bonds).
  • The one advantage I can see for AustralianSuper member direct over ChoicePlus is that there’s no limit on how much you can have in any of these broad market index-tracking ETFs: VAS, VGS, VGAD, VTS, VEU.

Cost comparisons

To make a comparison, I need to use some assumptions, so please keep in mind that these figures may not be the same as for you.

In the following table, I’m using the following assumptions:

  • Brokerage every 2 months for purchases below $5,000
  • A portfolio of ETFs with a management expense ratio of 0.20%
  • The total cost for varying amounts is for the portion in the direct investment option and excludes the portion required outside in pooled funds besides fixed fees.

Fund Direct investment fee Brokerage cost Other fund admin fees Total cost for $100k Total cost for $200k Total cost for $300k Total cost for $500k Total cost for $1m
HostPlus ChoicePlus $168 p.a. up to 13k: $13.00 $78 p.a. $524 (0.52%) $724 (0.36%) $924 (0.31%) $1,324 (0.26%) $2,324 (0.23%)
AustralianSuper member direct $180 p.a. up to 13k: $13.00 $52 p.a. + (0.1% up to $350) p.a. $610 (0.61%) $910 (0.46%) $1,210 (0.40%) $1,660 (0.33%) $2,660 (0.27%)
Pooled options for comparison purposes
Australian Retirement Trust (ART)
$0 $0 $78 p.a + 0.10% of balance up to $800 $298 (0.30%) $518 (0.26%) $738 (0.25%) $1,178 (0.24%) $2,078 (0.21%)
HostPlus
$0 $0 $78 p.a $132 (0.13%) $186 (0.09%) $240 (0.08%) $348 (0.07%) $618 (0.06%)

** In the last 2 rows, I’ve added ART and HostPlus pooled options as a comparison using the asset allocation as per Ma15’s whirlpool thread Recreating Vanguard diversified funds at SunSuper (now ART) where the investment fee is 0.12% and for HostPlus I will use a similar allocation of 40% IFM Australian Shares (0.03%), 20% international index hedged (0.07%), 40% international index unhedged (0.07%) for a total investment fee of 0.054%

Show calculations

TL;DR (summary)

Your balance in a public superfund that is shown when you login is the amount less what has been “provisioned” (set aside) for tax.

The purpose of this is that if someone leaves an investment option (changes to another investment option, or rolls over to another superfund), that they are not leaving the remaining people in the fund to pay their capital gains tax liability from selling.

Until you sell, the provisioned tax is still in the fund earning money, but you don’t see the amount — you only see the amount less the provisioning.

So say you have $500,000 of which $30,000 is unrealised capital gains tax payable if sold, let’s take a look at the two different situations when you move to pension phase:

  1. Public super fund — you only see $470,000 when you login; furthermore, it is considered selling and rebuying when your $470,000 (after tax within the fund) is moved to a pension fund that will then hold $470,000. This is because the same investment option (e.g., Australian shares) in an accumulation account and a pension account are different funds because each is subject to different rates of tax and tax is paid at the fund level. So while you never see the tax taken out (because you are shown the after-tax amount when you log in to your accumulation account), it is lost as it is ‘sold’ from the accumulation fund (incurring tax) before it is moved to your pension account.
  2. Individually taxed options — you see $500,000, and $30,000 of it is unrealised capital gains tax; when you move from an accumulation account to a pension account, it is not considered selling down, so no tax is paid on the transfer, and you get $500,000 in your pension account; furthermore, as you are now in pension mode, no tax is paid, and the capital gains tax accrued from all those years never needs to be paid.

Some public superfunds offer a Retirement Booster to help with this, but these are fairly new and so there is not much history or transparency, and it’s unclear how these are calculated for each member. As it is relatively new, often times the amount is very small relative to your actual CGT liability, and in other cases, they have a very low cap. For instance, ART has a maximum of $9,500, TelstraSuper has a maximum of $8,000, QSuper has paid an average bonus of $2,000, and AustralianSuper has paid an average of $2,000.

Final thoughts

There are significant savings to be had by using individually taxed structures due to having decades of capital gains tax wiped upon conversion to pension in those options, however, the current offerings have higher fixed costs which cost more than those savings at lower balances. I would typically use a rule of thumb to require a total cost (including everything) of no more than about 0.35% before moving to an individually taxed structure. Up to the crossing point, low cost pooled index options in funds like ART, HostPlus, Aware, and Rest appear to make more sense.

** Please note that as I learn more, I plan to update this article, so if you have any information that I can include for others (and that can be explained to someone with little or no prior understanding of this), please hit the contact button at the top right and let me know.

** I first read about this issue here: AustralianSuper member direct – PropertyChat. When I initially read it, I only understood that it was about tax inefficiency but not what the actual problem was. Once I understood it, I decided to turn this into a post for others. A big thank you to HockeyMonkey for looking through a number of the PDSs, and Zennon Damant for help with the grammar.

** This is an interesting thread discussing it further, where the poster did some rough calculations:
Effects of CGT-provision-drag and possible return in super funds : AusFinance