GPs are the highest earning occupation group in Australia.The Australian Bureau of Statistics estimates the average full time adult earns about $73,000 a year. That’s not a lot, and many earn much less: income statistics tend to be skewed up by a relatively small number of (much) higher income earners. Lots of people can earn more than $73,000 above than the average, but no one can earn more than $73,000 below it.
We do not know any GPs who only earn $73,000 for a full working week. Registrars start on more than this, and with overtime often ears twice this much in their first year. Averages are deceptive, and exceptions occur, but a realistic range of average incomes for Australian GPs looks like this (source: McMasters Accounting):
|Metropolitan GP, non- owner||$A220,000||$A180,000 to $A360,000|
|Metropolitan GP, owner||$A275,000||$A220,000 to $A500,000|
|Rural GP, non-owner||$A300,000||$A270,000 to $A450,000|
|Rural GP, owner||$A400,000||$A350,000 to $A700,000|
|Cardiologist||$A450,000||$A400,000 to $A600,000|
|Dermatologist||$A400,000||$A400,000 to $A600,000|
|Psychiatrists||$A350,000||$A300,000 to $A500,000|
|Paediatricians||$A300,000||$A250,000 to $A400,000|
|Ophthalmologist||$A400,000||$A350,000 to $A700,000|
|Anaesthetist||$A400,000||$A350,000 to $A700,000|
|Surgeon||$A400,000||$A300,000 to $A700,000|
|Obstetrician||$A400,000||$A300,000 to $A700,000|
|(Based on a fifty plus hour week)|
These incomes are competitive internationally: Australian doctors including GPs are amongst the highest paid in the world. These figures are also competitive with other professions: medicine is the highest paid occupation in Australia.
To give context, 2014 research from Melbourne University says only 1% of the population report taxable incomes of more than $211,000 a year, and those in the top 1% average $400,000 a year.
In summary, almost all GPs are in the top 1% of income earners. Medicine is the highest paid occupational group in Australia, with virtually every doctor working a normal week easily in the top 1% of the income population.
Given how hard you worked to qualify, this should come as good news!
Many GPs choose to work less than a full working week to accommodate their preferred family lifestyle. Older GPs might cut back consciously to do other things while they still can. Many other GPs, often overseas trained GPs, are keen to set up their financial future and choose to work much more than a full working week.The medical profession is flexible. It accommodates all choices. GPs can typically control the number of hours worked each week and there is no minimum or maximum hours, or sessions (a session typically running for between three and four hours depending on the practice).
Throughout this book we return again and again to the characteristics of a GP’s income. Let’s look at them in more detail here.Height. GPs have high incomes, much higher than almost all other occupations. The average 40-year-old GP makes $200,000 to $300,000 a year. This is 3-4 times the national average of about $70,000 for a 50-year-old male and up to ten times the average for a 50 year-old female.
Stability. GPs do not face unemployment. There is a shortage and most GPs can choose their working hours and conditions in a way non-doctors only dream about. This is not to say GPs have it easy: general practice is stressful and grueling. But most GPs can control their hours and are not compelled to work by the fear of never working again.
Scalability. Most GPs can increase their incomes whenever they want to. Most have found the patient rate and weekly time commitment that best suits them. But one or both can often be increased on demand. For example, a GP facing a short term cash flow strain can arrange to work Saturdays, and increase income by as much as $2,000 a week, or more than $100,000 a year. Or see an extra half a patient per hour, for ten hours a day, to increase daily income by says $250, or $1,250 a week, or more than $60,000 a year. GP incomes are very scalable.
Length. Most men are retired by age 58 and most women are retired by age 50, even though they do not want to be. Age discrimination and youth bias do not apply to GPs. GPs routinely keep working productively and happily into their sixties and seventies, probably cutting the hours back a bit, but only to the extent that suits them. This means the GP’s income has a greater longevity then most, perhaps as much as an extra fifteen or even twenty years on average.
Throughout this book we will repeatedly stress how the height, stability, scalability and longevity of the GP’s income creates great financial planning opportunities for GPs at all stages of their careers.
The GP’s working life should be paced and spaced to enhance their prospects of working enjoyably into their seventies, maximising economic potential and contribution to society, while making sure there is plenty of time and opportunity for things other than work.
Balance is the thing that is needed. A medical career is a marathon, not a sprint. And the course is a hilly one, at that. Medicine is hard yakka. Balance is needed to maintain your own wellbeing.
Balance is is achieved by control. That is why wealth is so important: wealth confers control. It is much easier to pace yourself if you do not have to sprint just to get by. Accumulating further wealth away from your practice allows for balance.
It just takes time.
Financial planning and GPs
Most financial planning books start out with a predictable list of ‘do’s and ‘don’ts. There is nothing wrong with these lists; they make good sense and, coupled with their wholesome and happy examples, even make good reading. In fact we recommend you read them: most contain at least one gem that can make a real difference to your financial fortunes.
For example, Paul Clitheroe in his classic book “Making Money” (Penguin 2011) provides “ten steps to financial security”. They are:
- Have a plan
- Budget and take control of your money
- Save little and save often
- Avoid punting and silly risks
- Don’t plan to save cash
- Plan to own your own home debt-free
- Super is good – invest in it
- Minimise tax
- Protect your assets
- Take advice if you need it
These are excellent rules, and they echo through this book, adjusted to the circumstances of GPs. If GPs follow these rules there is every chance they will end up wealthy. We basically say the same thing: take advice on setting a long term plan to invest regularly in safe growth assets, minimising tax and maximising superannuation and other asset protective strategies.
That said, the classical authors do often make one substantial mistake. They seriously overstate the case for investing via managed funds. This is a theme we will return to later in this book, but for now let us simply quote Clancy Yeates from the Sydney Morning Herald of May 20 2013:
Here’s something many fund managers would prefer wasn’t discussed: most of them are probably failing to create long-term value.
Despite the billions the industry soaks up every year, statistics show that after fees, most funds underperform over the long term.
Take the latest figures from Mercer comparing big funds’ returns with the ASX 200. Before fees, the typical fund has posted returns of 7.4 per cent in the three years to March, which is a tad better than the index returns of 7.2 per cent.
But this advantage is wiped out once annual fees – which are typically between 1 per cent and 2.5 per cent of assets under management – are taken into account. It’s a similar story for returns over the last year, while over five years pre-fee returns from the typical fund are ahead of the index by a fairly skinny 1.2 per cent a year.
This is why we recommend GPs stay in control of their investments and avoid managed funds (and the institutional financial ‘planners’ who promote them). GPs should invest directly in property, shares and index funds to minimise costs, avoid conflicts of interest, minimise risks and achieve higher net returns.
The rules for successful investing by doctors aim to maximise investment returns and minimise risk – in all its many forms. So, we augment Paul Clitheroe’s general purpose advice with four doctor-specific rules of our own (OK: the first two apply to everyone else as well).The rules are:
- Never trust anyone with your money.
- Anyone who is dogmatic is probably a salesperson.
- The best investment is your practice.
- The next best investment is your home.
Following these four rules may mean you miss out on one or two good investments. But you will also miss out on many more bad investments, and on balance you will do much better. The math is in your favor.
Let’s look at each of these four rules in turn.
There are many ways to lose money. They include fraud, stupidity, bad luck and bad judgment. One popular method involves trusting others with your money.Trusting others with your money is a precursor to misfortune. If you trust someone often enough your trust will eventually be betrayed. Financial institutions are no exceptions.
Even those who are household names will not protect you. For example, recently CBA clients have suffered at the hands of rogue advisers who threw out the rule-book and rampaged through their clients’ funds, all the while being feted internally and even promoted by the CBA because they were bringing the money in. This matter escalated to a Senate Enquiry and there were even calls for Royal Commission.
The CBA formally apologised to the 400,000 customers in July 2014 but refused to end “sales targets’ for its ‘advisory’ staff. Think about that: if a person has a ‘sales target’ how could they be ‘an adviser?’ Sales people have sales targets. Advisers have happy clients.
Don’t expect the watchdog to protect you: it took nearly three years for ASIC to start investigating the CBA. It took a Senate Enquiry and the threat of a Royal Commission for any real results to be achieved.
It’s not just the CBA. Most of the big financial institutions have been subject to enforceable undertakings from ASIC. These mostly relate to churning, ie recommending product switches from an option that pays the institution less to one that pays the institution more. These ‘switches’ were not in the clients’ best interests. They were in the institution’s best interests.
This is dishonest. Unfortunately, ASIC simply does not have the resources to stamp out dishonesty in the funds industry. But individuals can avoid it themselves. The simplest way to avoid dishonesty is to not create situations where it can occur. You do this by staying in control of your own money: not trusting anyone with money is a basic principle of successful investing.
This does not mean a GP should not use advisers. Some of the best investors use advisers and use them well. They understand we all need coaching sometimes, and one person cannot know everything. But successful investors do not allow the coach to play for them. Successful investors make decisions themselves, stay in control and eliminate unnecessary middle-men.
Many commentators thought we would see the end of conflicted advice when the new Future of Financial Advice (“FOFA”) rules were announced. These rules started on 1 July 2013 with a ‘best interests’ rule and a rule against conflicted remuneration. Many of the original announcements have now been watered down, and although most commissions are banned, ‘commission-like’ payments abound, still.
In early 2014 the new Liberal government announced further changes to allow unqualified bank officers to be paid commissions on products provided they do not provide “personal advice,” that is, do not consider the personal circumstances of the client. It’s hard to see any logic other than a free kick to the banks at the expense of consumer protection.
There are thousands of investments out there, and it is impossible for anyone to know for sure which will be the best. Yet some “advisers’” refuse to admit any asset class other than the one they earn a living from has any merit. This includes financial planners who refuse to acknowledge that residential property has some attractions, stockbrokers who tell GPs to only buy shares, and real estate agents who insist that shares are always second best to property – particularly the properties they have listed for sale.So, just as you should avoid giving over control of your money, so you should avoid any ‘adviser’ who thinks that there is only one way to make money from investing.
If you are doctor, then the best investment available to you has nothing to do with the share market or the property market. The best way for you to make money is by owning a medical practice. No other investment performs as well. It does not matter whether you start from scratch or buy an established practice, operate on your own or team up with a group, are in the inner city, the suburbs, the country or a remote rural area. You will always be busy and have a never-ending stream of paying patients. Your practice will be your best investment.One can often see a GP buy a practice, or part of a practice, for less than $100,000, and almost immediately earn $100,000 or even more extra cash every year. This is the best rate of return they will ever earn. And it is safe and secure, and likely to last as long as they do.
This is the key to creating wealth: derive spare cash that can then be systematically invested in other investments like your home, other property and shares. Own these assets in ‘safe havens,’ such as super funds, trusts and companies to protect them from professional and commercial risks.
The most profitable practices are those that are, or are close to being, portfolio investments. Portfolio investment is where the owner is not actively engaged in the practice, apart from overseeing it via several key performance indicators, a structured reporting program and regular site visits (if the GP is not working from that site himself or herself).
In particular, the successful owner GP is happy for most patients to be seen by other GPs and instead focuses on providing quality services to those GPs.
That said, few practices become true hands off investments. Medical life is not like that. Successful owner GPs delegate as many functions as possible to colleagues, the practice manager and other staff. But few stop seeing paying patients altogether. They love what they do and can’t imagine doing anything else.
Successful practices are successful for a reason: it’s almost always the people involved.
In a following chapter we will describe in detail why homes are such great investments. In summary, many of the factors that make homes such great investments are financial – things like there being no capital gains tax payable when a family home is sold at a profit. But there are also many of these ‘success factors’ which are non-financial. Things like having a really nice place to live. Try as you might, you simply cannot live in a share portfolio!So, great economics combined with enhanced lifestyle means that a quality family home should be a priority for every doctor.
80% of ‘financial planners’ operate under the auspices of an institutional owner. That institution makes most of its money selling managed funds and life insurance.Unsurprisingly, about 80% of financial plans are therefore a waste of time and money. They only deal with managed funds and insurance products. They do not deal with the really important assets, ie the practice, the home, other property, direct shares and so on. They rarely deal with real financial strategies based on long term coordinated plans to maximise financial outcomes and happiness amongst the wider family and across the generations.
To be blunt, they just flog second-rate managed funds to GPs.
Most GPs are surprised to hear most financial planners are actually not allowed to recommend investments other than managed funds. Why? Simple: they do not generate income for the institutional owner. That is why you never see a financial plan prepared by an institutional financial adviser that discusses the GP’s income, their practice, their property, direct shares, investment property, etc. The institution does not sell them, so the adviser does not recommend them.
Even worse, these financial plans also ignore things like asset protection. The risk of patient litigation should not be overstated. But nor should it be ignored.
Most financial plans also under-estimate the income security of a doctor. Conventional financial planning theory says that a person aged 55 is due to retire soon and therefore should be moving to a more conservative investment profile. This is a problem for all people, as many people can expect to live at least another thirty years once they reach the age of 55. How would your current finances (or those of your parents) look if all of your assets today were still valued in 1987 prices?
But it is a particular problem for a doctor, who can look forward to another ten or fifteen years of above average income, even if they begin to cut their hours back and work part time over that period. Indeed, there may be more work than ever for these doctors. With a high proportion of GPs over the age of 55, the Health Work Force initiative estimated that Australia will face a massive shortage of doctors by 2025 when a large number of GPs are set to retire. ‘Forced retirement’ on anything other than medical grounds is simply not going to happen.
A financial plan for a GP should:
- Be based on individual circumstances including age, income, wealth, health, marital status, number of dependants, preferred work life balance, career ambitions, risk return preferences, financial goals and overall personality.
- Reflect the high stable and long income stream faced by most GPs at all ages;
- Be written by a financial planner, not a para-planner, with a range of experiences and expertise suited to the task. The writer should be familiar with the GP’s particular circumstances. The plan should not be written by a computer, should be personal and should address the GP’s individual needs.
- Be based on a data collection process pitched to GPs, and allow for subjective assessment of responses, with further questions from the adviser to discover what drives the GP and where their financial aspirations lie: it may not be about making more money. It may be about making more time, living better or longer.
- Consider residential property, both as a home and an investment,
- For practice owners, consider ways to develop that practice, including things like engaging more GPs, engaging allied health professionals, improving efficiency, increasing prices, controlling costs, and growing patient numbers.
- Consider direct shares (or index funds as a close proxy).
- Include sound tax planning developed specifically for GPs so that after-tax income is maximised, allowing a maximum amount of cash for investment.
- Include sound asset protection strategies, such as family trusts and self-managed super funds, as vehicles for holding wealth.
- Address at least ten years, and preferably twenty years, and ideally include the next generation, while still detailing what needs to be done now.
- Be specific, particularly for the earlier years. The plan needs to say who, what and when so everyone knows what they have to do and why they are doing it.
Having said all of that, the best plan in the world will not create wealth unless the GP has the conviction and the discipline to start it, follow it and finish it. Successful investing is a long-term process involving decades and even generations, not mere years, let alone quarters or months. This (very) long-term perspective must be kept in mind at all times and is the key to really understanding investment theory.
Successful financial planning and investing is well within the abilities of most GPs. Simple low-risk strategies over time produce good results and create financial security.What is the point of being wealthy? If you are to become wealthy, you have to understand why you want to be wealthy. There are many reasons for accumulating wealth. Most GPs will become wealthy by operating efficient practices: the market rewards good medicine and good patient outcomes. The practice income is first re-invested in the practice and then, once the practice is at optimal efficiency, invested in more passive investments, ideally the home, and then other property, direct shares and index funds owned in SMSFs, companies and trusts.
GPs are good investors, but they need independent advice and objective information. All GPs should:
- work with an adviser who is not controlled by a financial institution, who provides objective advice and can act in the GP’s best interests;
- maximise their income and tax profiles by developing their practices as businesses;
- consume less than they earn, and invest the excess in a mix of diverse asset classes, skewed to producing non-taxable unrealised capital gains;
- use spouses, family trusts, companies and SMSFS to protect investments and achieve better after tax rates of return;
- invest in a well located good quality home;
- prefer direct investments to indirect investments;
- carefully use debt to maximise after-tax growth;
- emphasis cash flow positive investments to increase net cash flow and decrease risk;
- stay in control of their wealth at all times; and
- avoid investing in anything that pays anyone a commission or something that looks like a commission, such as asset based fees.
Chapter 02 – Financial Planning for Younger GPs
Younger GPs are interesting economic propositions. Just out of training, they usually have high incomes but low assets relative to their age peers in other occupational groups. The 30-year-old accountant or computer programmer probably has a higher income and more assets. And if the GP is married with kids the gap may be even greater.
The gap is greater again if the GP’s training included a year or two overseas. Boston or London are great life experiences, and should not be missed. But expect the credit card to take a hiding, and the asset accumulations to be put on hold while life is experienced.
But as the young GP finishes training this is all about to change…
Young GPs without dependants usually have after tax cash flow above their living costs. The excess cash has to be invested somewhere. Young GPs with dependants usually have more claims on their cash flow but still tend to have excess cash that needs to be invested somewhere. (This phenomenon tends to disappear as the kids get older and morph into private school students with teenagers’ lifestyle tastes. More about this below in the chapter on middle-age.)Three investments should get particular attention from young GPs. These are buying into a private practice, the family home and superannuation.
The first big decision is whether, when and to what extent the young GP should own a practice or work for someone else. Generally, owning a practice is financially more rewarding so most GPs will be better off owning a practice as soon as possible once they complete their training and feel comfortable with their experience and expertise.That said, every person is different and many younger GPs prefer to hold off on buying a practice while they hone their skills and make decisions about the type and location of any practice that they may one day own.
Buying and paying for a family home will usually be a top priority for young GPs. Our advice is almost always “buy as much home as the bank will lend you, and then pay it off as fast as you can”. The reasons for this include:
- home prices have increased significantly over the last two decades. History shows consistent returns (including rent) of more than 9% a year. The population is growing faster than ever and the experts agree houses will cost a lot more in 2037 than 2017, particularly in the major capital cities. It makes sense for younger GPs to buy as much house as they can as soon as they can;
- interest on a home loan is not tax deductible. This means paying off the home loan early earns the equivalent of 10% pa or more and is effectively, capital guaranteed. It is unlikely any other investment will come close to this sort of return;
- use an interest offset account rather than paying off the home loan directly. This allows equity to be transferred to a new home down the track, and the old home kept as a negatively geared investment;
- increasing equity in the home, by paying off the home loan and from price increases, lifts the GP’s ability to acquire other investments including, for example, a practice or rental property. Using the home as security for investment loans minimizes interest costs and is a great way to expand the GP’s asset base; and
- the home generates non-cash income: the ambience of a pleasant place and the peace of mind of knowing that you have somewhere to live are significant benefits even though they cannot be measured in dollar terms.
The family home is discussed in detail later in this book.
Super is a vexed question for young GPs. Some say the rules are forever changing and retirement is too far away, so super should be left for now and the cash instead used for other things. Others say that you cannot start too early and that the power of compound interest demands a maximum effort as early as possible.We say have a bet each way. Make super contributions up to the aged based limit for a person under age 35, often for a spouse too (provided they are a genuine employee) and at the same time pay off the home loan and, possibly, get started on a negative gearing strategy for other investments.
Being a member of the highest paid profession in Australia certainly helps here! Most young GPs can afford to do it all. Especially in the years before parenthood themselves, when they can still live like a student while they earn like a… well, a doctor.
It’s amazing how many young, and not so young, GPs are married to another GP or other high-income earner.This presents a special case, financially speaking. Even with just one GP the household income is statistically high, but with two GPs the household income is sky high. Combined incomes well above $400,000 a year are not unusual. Add in an almost unique stability and longevity, and you have a mini-economic powerhouse on your hands.
Quite often each spouse works part-time, say 80%. This allows child-care roles to be shared and external child-care costs to be minimized. This augurs well for household harmony since both mum and dad can get the work and family balance they really want.
This augurs well for economic harmony too. Twice the number of GPs means twice the income, but not twice the living costs. This more than doubles the potential savings. Often all the second income, or more, is saved and invested: this is something we recommend: live on one income (or less) and save all of the other income (or more). You will be wealthy before you know it.
Being married to another GP also reduces risk. It’s a form of diversification (which is an entirely romantic way of looking at things, isn’t it?). If things go wrong for one GP its unlikely things will also go wrong for the other GP. So, overall, risk is minimised. This is especially relevant to debt management: the height, stability, scalability and longevity of the GP’s income, plus the natural hedge of having another GP as a spouse, means greater tolerance and capacity for debt based strategies.
Being married to another GP (or other high income earner) does not change the basic concepts and goals for younger GPs. It just makes them easier to achieve: the idea should still be to own a home debt free as soon as possible, get started on super and perhaps add a few rental properties to the portfolio.
Perhaps the home should be bigger, and better located, the super more ambitious and the rental properties more numerous. As a general proposition, the two-GP household can take on more debt than a one-GP household, and those that do tend to reap the benefits with larger capital gains over time. And the un-taxed unrealised gains coupled with the immediate tax deduction for interest and other holding costs drags down the average rate of tax on all income. This in turn creates more space for future investments, setting the stage nicely for what comes next.
Does our advice differ for a solo GP? Well, in short, no, it doesn’t. The idea is the same, although the home is more likely to be a groovy city town house than an outer suburban ranch, with all mod cons including sand pit and swings. There are some differences in how assets will be owned, as well. But the differences are more in scale than in type.
One gender issue merits specific reference. This is the tendency for female GPs to be under- superannuated. This tendency is repeated in pretty much every profession or occupation group. Women have less super. This is al the more problematic because super is arguably more important for women. After all, women live longer, and have greater retirement needs.Historically, women (including GPs) have been under-represented in the superstakes. They have lower incomes and spend less time in the paid workforce. This means less super at retirement.
While there is no doctor-specific data (at least that we have been able to find), the OECD estimates that Australian men are in the paid workforce for 38 years before retirement, which is almost twice the women’s equivalent of 20 years. There are also significant differences in pay rates (in 2012 women were paid on average only 82.4% of male salaries). This pay difference appears in general practice too: female GPs obviously face the same prices and costs that male GPs face, but the reality is they have lower incomes, and the statistics show the average female GP sees fewer patients per hour than her male counterparts.
The Australian Bureau of Statistics (ABS) says 49% of women expect super to be their main retirement income, compared to 56% of men; 18% of women expect to rely on their partner’s income, compared to just 4% for men; and 27% of women expect the old age pension to be their only retire income, whereas it’s just 25% for men.
The federal government has tried to balance the gender super bias with special rules for spouse contributions, contribution transfers and co-contributions. These have not had a significant effect to date.
It is critical that younger female GPs do not repeat the mistakes of their predecessors. Their super contributions should start as early as possible and be as big as possible, ideally the maximum allowed each year.
The earlier the super snowball starts, the faster it rolls and the bigger it gets. That’s the magic of compound interest.
Chapter 03 – Financial planning in the middle age (peak cost) years
First, the good news: a GP’s middle years, say from age 35 to age 55, are typified by high incomes.Alas, they are also typified by even higher living costs! Indeed, these are “the peak-cost years”.
Sometimes the peak-cost years make it simply too hard to do any significant investing. Family goals come first and this is fine. The kids are kids for such a short time that it is foolhardy to sacrifice the desired family lifestyle for investing. There is plenty of time to get the investments going later once the kids are off mum and dad’s hands. After all, GPs retire much later than everyone else, anyway.
It can seem that no matter how hard the GP works and how much cash comes in, the cash goes out faster. Cash consumption exceeds disposable cash income at all levels of disposable cash income. There are a virtually infinite number of claims on the family budget. The money just goes. Sometimes it seems investing is just a pipe dream, just another thing that might happen one day – if the kids let you.
Some GPs, probably less than a third, invest significantly during the peak-cost years. They tend to be those who have invested well in the earlier years, and, in particular, those who bought homes and paid off their home loans as soon as possible. This has freed up a lot of their cash flow such that they can meet the significant expense of raising teenagers while still having (even a little) left over.
But most GPs are not able to do much fresh investing in the peak-cost years.
In summary, there is not enough money.
Take a typical male GP called, say, Fred, age 43. Fred bought into the practice last year for $120,000 and the practice premises for $150,000, using debt secured against their home (value $1,200,000 with $600,000 of remaining home loan).
Total assets are $2,000,000 with $970,000 of loans.
These will be good investments, but they will struggle with the loans for years to come.
Fred’s wife Wilma works four days a week and the combined before tax family income, including rents, is $350,000 a year. This is divided between Fred $270,000 and Wilma $80,000 (both including super and car fringe benefits). Fred’s after tax income is about $195,000 and Wilma’s after tax income is about $65,000. This means the family has about $260,000 cash available to it.
Fred and Wilma have three kids. The eldest two are in their secondary years at a private school, and the youngest one is at a state public school.
Let’s look at the family’s annual cash payments budget:
|Home loan principal and interest payments on $600,000||$60,000|
|Investment loan principal payments on $270,000||$30,000|
|School fees and related costs||$50,000|
|Entertainment and holidays||$15,000|
|Rates, repairs and maintenance and so on||$5,000|
|Total Cash Costs||$286,000|
You do not need to be a CPA to see the problem. Cash costs of $286,000 are greater than available cash of $260,000. There is a shortfall of more than $26,000 cash each year, or about $500 cash a week.
This shortfall may surprise you, but it is normal for most middle-aged GPs with families.
The solution is to work harder and longer and/or spend less. But this does not really help: new costs present and what’s saved somewhere is quickly spent elsewhere.
The real problem is that it costs at least $250,000 cash a year to live a normal slightly upper middle class) lifestyle, pay off the home loan and pay some extra into super.
Cash costs tend to exceed cash income at all levels of cash income. This is a normal problem. So is the stress that comes with it.
GPs who invested well earlier avoid this problem, and the stress that comes with it.
Obviously if a GP has followed our advice and bought as much home as possible as early as possible, got the tax planning right, developed their practice as a business (and enjoyed at least an extra $100,000 a year every year) and started to invest excess cash in other investments then their financial prospects are better in these peak cost years.
In fact, some GPs invest so well earlier they are insulated from the financial rigors of family responsibilities, and go on adding to their net wealth each year. All the good family stuff is enjoyed while at the same time the family’s financial fortunes get better and better.
We often find ourselves explaining that the peak cost years are a normal financial phenomena and that do not last forever. GPs do not need to do anything drastic. The peak cost years will pass. There will be plenty of time to build wealth later. The family’s immediate priorities should prevail.The key is to:
- own a home in a fashionable suburb, or soon to be fashionable suburb, that rise in value at a rate greater than the average home;
- keep up the super contributions, ideally at the maximum allowed each year, so that you are in the top 1% of savers;
- look after your health; and
- enjoy yourself and your family lifestyle.
The growth in the home’s value and the super accounts are creating a firm financial base, and you do not have to do much more, for now at least.
Ideally you will not borrow to pay for the peak cost years.But sometimes there is no choice. For example, what if Dr Fred in our example above had another child, and a fourth lot of school fees, and Wilma could not work for a salary: she was too busy maintaining the home, particularly with Dr Fred working such long hours?
This is, of course, a common presentation.
It can make sense to borrow to fund the peak cost years. The position can be graphed like this:
Fred and Wilma have about $2,000,000 in assets now, and about $1,000,000 in debt. If they don’t borrow any more and continue the expected debt repayment plan (green line) they will pay off their loans at age 68.
If Fred and Wilma decide to borrow to help pay their peak costs they move to the adjusted debt repayment plan (red line) and will pay off their loans at age 73.
Fred and Wilma can relax a bit financially, borrow to pay for school fees and family holidays, and still achieve their family goals, very confident that once the peak cost years pass there is plenty of time and opportunity to build the assets up.
Most men at Fred’s age of 43 have only 15 years left in the workforce. But Fred at age 43 can keep working on a high income for even another 30 years. Arguably, he has a life’s work ahead of him (if he wants it). The height, stability, scalability and longevity of Fred’s income make borrowing in the peak cost years a sensible financial strategy.
Up to one third of marriages end in divorce. It’s more for GPs, probably reflecting the stress and long hours away from home and hearth.It’s normal for a newly divorced GP around age 50 to be bereft of assets, worried about the future and feeling that, financially at least, being a GP is not all it was cracked up to be.
The good news is that if you are going to be relatively bereft of assets and worried about the future being a GP is great occupation to be in. Most fifty year olds face seriously uncertain financial futures. There is an age prejudice and a youth bias in many workplaces. Retrenchment is a real prospect and, for most workers, retrenchment means forced retirement, with no second chance to establish a firm financial base.
Not so for GPs.
There is a shortage of GPs and experienced GPs, divorced or not, can take their pick of practices and work almost wherever they want whenever they want. There is no age prejudice or youth bias in general practice.
So, the solution for a newly divorced GP, age circa 50, with few assets is simple. It boils down to:
- keep working. But do so at a pace and in a space you are comfortable with. The idea is to keep working as long as you can, but on a progressively reducing basis until, say, age 75 (or whatever age you – and your patients! – are comfortable with). That means you have 20 more years to build up wealth and that’s more than enough time;
- paying the maximum super contributions each year, ideally on a monthly basis using automatic Over two decades this will grow to be a very sizable sum, more than enough to get you through to a comfortable retirement;
- buying a It does not have to be a four bedroomed four-car garage mansion. Think small. A three bedroom townhouse is all you need, and this comes at up to half the price of a larger house;
- using a GP friendly lender so you can borrow more than otherwise, and then pay off that expensive non-deductible loan as fast as you can (using an interest offset account). Rapid non-deductible debt reduction is the key to getting ahead at all ages, and age 50 is no exception;
- having appropriate income protection insurance in place, but do not over-insure;
- potentially investing in a medical practice: most owners make an extra $100,000 or more a year, and this is the safest and least risky way for a GP to build up new wealth;
- tax planning, including making sure you get the best structure for your
Over the years we have seen countless GPs down on their luck at age 50 achieve financial success by age 60. Once again, it’s all down to the characteristics of a GP’s income. Its height, stability, scalability and longevity mean, GPs recover financially from divorce a lot faster than most people.
It’s part of being a GP. It is the payback for all the hard work you have done so far.
Chapter 04 – Financial Planning for, ahem, senior GPs
Here is some advice on retiring that you have probably given others yourself. When it comes to retirement, the best way is to “start early and never finish”. Most GPs warm to this idea once it is explained. So let us explain it.Once the peak-costs years have passed and the kids are off mum and dad’s hands, attention focuses on the next phase of life and, morbidly, mortality. This often happens at around age 55, or perhaps a little later, as the kids finish their education and (finally!) become financially independent.
Mum and dad can spend money on themselves for the first time in perhaps 30 years.
By age 55 most GPs have accumulated a reasonable amount of wealth, even if it is tied up in the family home and super, or maybe the practice’s goodwill and/or premises. The 55 year-old GP is probably at their professional peak: years of experience grounded in extensive training and professional development mean most patient presentations are handled competently. This converts to a high level of employability: most 55 year old GPs can get as much work as they want anywhere in Australia. Provided health is ticked off, there is no reason why this is going to change for at least another fifteen years, or even more.
So, with a reasonable amount of wealth, a guaranteed high income, a full waiting room stretching inexhaustibly into the future, but only so many days left on earth, the rational GP often makes a smart decision. They cut back the working hours and spend more time on other things, like travel, sport, exercise, reading and further learning.
Obviously the more wealth a GP has, the more they can do this. But even GPs who have not accumulated that much wealth can cut back their working hours confident that they are not condemning themselves to an impecunious old age. With careful health management the working years can be spread out and blended with early retirement so the GP gets the best of both worlds.
We often suggest the 55-year old GP to cut back to four days a week for 10 months of the year. Over the years this trend continues so by age 70 the GP is working say four sessions a week for eight months of the year.
The other days are spent at the beach house or some other place where work cannot interrupt life, and the other months are spent somewhere warm or cool, depending on your preference.
This retirement strategy has numerous advantages:
- the GP (and usually a long suffering spouse) can enjoy the time out while still (relatively) young and healthy. Travel gets hard after about age 70, so why not go now at age 60 while you can still enjoy yourself?
- tax-planning strategies remain effective, particularly if a spouse has stopped working and is not getting any income;
- a longer working life creates a triple whammy that radically improves the economics of retirement. More particularly:
- the GP continues to add to their capital base, usually through continuing super contributions and possibly other forms of saving;
- the draw down and consumption of capital is deferred, compared to earlier retirement; and
- a longer working life means a shorter (fully) retired life, which means the capital does not have to last as long compared to earlier retirement;
- medical work has a high social utility, so working longer is fundamentally good;
- medical work is good for GP’s sense of personal wellbeing. GPs are happier and healthier when they work longer; and most importantly,
- spouses cannot stand the retired GP hanging around all day with nothing to do. This is serious: (typically) the husband’s retirement can be a flash point in the marriage, and often causes great stress for all concerned.
It’s a paradox that, from an economic point of view, the GP who starts to retire early will probably end up earning more than the GP who does not. The tortoise beats the hare, particularly if the hare has a heart attack from too much work.
But there is a further paradox: if the tortoise does not beat the hare, then being a tortoise makes even more sense. If the heart attack was coming no matter what, then the GP will hardly rue that he or she took more time off before it happened.
So, starting to retire early can lengthen your life. And if retiring early does not extend your life, then it makes even more sense to do it!
So, retiring early is a good idea. But how do you do it?Investing early and well means the GP can retire early and well. If things are done properly then as the kids come off the GP’s financial hands the investment income starts to exceed the practice income. This is a great position to be in, particularly if the income consists largely of unrealized, and hence un-taxed, capital gains.
Interestingly, most GPs continue to practice even at this point. But thankfully they work sensibly, and take more holidays and long weekends. There is a huge difference between the 55-year old driving to work because she wants to, and the 55-year old driving to work because she has to. One is much happier than the other. One enjoys the drive much more than the other.
The major problem relates to the costs of general practice. Many costs do not fall when the GP does fewer sessions. Many costs, for example, rent, some wages, depreciation of equipment and so on, stay the same regardless of how many sessions are completed each week. These costs are called “fixed costs”. This is because they are fixed irrespective of how many sessions are completed each week. A common mistake is to assume that this is not so.
A GP completing, say, 10 sessions a week and making $240,000 a year may reason that his income will fall to, say, $140,000 a year if he cuts back to 5 sessions a week. Sadly this is not so. More probably, because fixed costs stay the same, profit falls by more than this, say down to $70,000, if not less. The high fixed costs mean that any drop in the sessions worked each week will produce a more than proportionate drop in profit.
Something has to change. The GP has to stop practising solo or in a group practice where costs are shared equally irrespective of the number of sessions. This can happen in a number of ways but they all get back to the same theme: the GP has to make changes to a practice structure where all costs (or virtually all costs) are variable costs not fixed costs. As that name suggests, variable costs are those that are only incurred when a fee is generated. Once all or most of the costs are variable, then cutting the number of sessions by half will reduce profit proportionately (in the above, example, by half, say from $140,000 pa to $70,000 pa).
There are a number of ways of doing this but they all get back to the same idea. A GP should leave their own practice and join another practice as an assistant on the standard fee split of, say, 40% to the host practice and 60% to the GP. One thing that can work here is if the owner GP sells the practice to another GP and then stays on as an assistant. From the patient’s point of view, nothing changes.
In some cases the purchaser can ‘sweeten’ the deal by getting a better than market fee split, say 30% to the host practice and 70% to the GP. The extra 10 percentage points are really a form of goodwill, an extra payment recognising the GP’s contribution over the years. Remember, good GPs are in short supply. Having an established local GP join the practice without cannibalizing the patient base is great for profit. Even 30% of the extra billings is well above the cost of the extra GP, so it’s a guaranteed profit.
Patients win too: their GP is still there and has made sure other good GPs are there to take over as they finally retire completely.
Sometimes, though, if there are no buyers, the older GP simply shuts the doors and walks away. Patients cope.
GPs who part-own a group practice might not move away from the practice. These GPs may instead re-negotiate their co-ownership agreements to facilitate the older GP reducing their hours and retiring gradually over time.
Chapter 05 – Investing in your practice (a doctor’s number one investment!)
A young GP will often ask what should I do? Buy a home or buy a practice?
The best answer is usually “buy a practice and generate extra cash flow. And then use the extra cash flow to buy a better home.”
The best investments for GPs are their practices and their homes, usually in that order.
Most GPs who become truly wealthy do so by owning practices. They work on the practice and turn it into a business. They spend less then they earn, save the difference, then invest in other areas, first the home and then other assets, to build up a significant and diversified asset base.
Ultimately the investments become the major source of cash, income and wealth. But the practice is the engine room: this is where it all starts. The practice deserves special prominence in any discussion about GPs’ investments. It should be investment number 1.
The practice produces the best returns with the lowest risk. Goodwill values are low and this means returns are high. It is not unusual to see rates of return of more than 50%, and even 100% or more in some cases.If a GP borrows $100,000 and starts to earn an extra $50,000 a year profit, above their time reward, that is a 50% return on the GP’s investment. And it is very low risk. The bottom will not fall out of the market. Indeed, if the economy turns down, then a typical GP is likely to become even more busy.
After a few decades this increased cash flow compounds out to a very large difference, millions of dollars of difference in the net wealth position of owner GPs compared to non-owner GPs.
Most GPs, no matter what their age and circumstances, should consider owning their own practice. The only real exception is GPs who, for whatever reason, are not able to work full- time. A good example is older GPs downsizing into retirement. Common sense says they work for someone else. Another good example is (generally) female GPs contemplating kids and family. (Once again, generally) most expect to be the primary care giver and many are happy to put owning a practice on the back burner for a year or ten until circumstances change.
There are numerous ways to set up a practice, and what suits one practice may not suit another.Some practices bulk-bill and still have good profitability. This is achieved through high patient numbers and fiercely controlled costs. Other practices privately bill patients, work on a strict appointment system, perhaps even closing their patient lists, and deliberately spend more on staff and other costs to improve efficiency and profits.
Some practices are ideally located in prime real estate next to large shopping centres, where the pedestrian traffic generates a constant supply of potential patients. Other practices are in industrial areas or CBD business areas, providing occupational health services to nearby industrial and office complexes and relying only on reputation for patients to come in.
Good GPs usually make good profits. So what features distinguish profitable practices?
Anecdotally, more GPs are moving from bulk-billing to private billing. It is really just a change in emphasis since most will still bulk-bill some patients.
Our typical advice is to not bulk-bill patients unless they are genuinely in need. Patients are only in genuine need if there is no income earner in the household and they do not own a home.
A patient, even a pensioner, is not in genuine financial need if they own their home, drive a car, smoke or have a job, and should be billed as such. If this means the patient does not come back to the practice, then so be it. Ultimately, it just means that they do not value the GP’s services. Price is a filter that sifts out the patients who really do not want to be there.
Price rises rarely lead to a drop in patient numbers.
Most GPs are good at controlling costs. Some control them too well and do not spend enough on their practices. Don’t be shy about spending money to improve patient services. Carefully calculate the effect on profit of the proposed cost and, if it will go up, proceed.
A simple example is constructing a new consulting room. The new room costs $150,000. If it generates an extra $3,000 a month in net management fees, this translates to a 24% pa return on investment. This is more than the 5% pa interest charge, so the decision is “proceed” (and perhaps to ask what happens if two extra rooms are added!)
Other examples abound. Fresh water dispensers, children’s play areas, up-to-date magazines, pleasant music, health information and quality reception staff all cost a bit extra, but help bring in patients and encourage patients to pay a little more to see you.
With the shortage of GPs it’s too simplistic to say ’employ more GPs’. Nevertheless, the more profitable practices tend to have two or more non-owner GPs. Registrars are good too. Overall billings are higher and fixed costs are spread over more GPs, so the extra GP contributes to profit.
Extra GPs are the most profitable additions to a practice. But if this is not possible consider other health professionals too. Make sure they pay an appropriate management fee to be part of your patient eco-system.
The nicest profit is one made for you by someone else.
The practice’s tax profile will also improve. A realistic top tax rate is 30% if the practice satisfies the ATO’s views on what is a business. This paves the way for more investment and faster debt reduction, since more pre-tax profit is available as after-tax cash.
The most profitable practices are in areas where there is less competition.
There is less competition in less fashionable areas, particularly rural and semi-rural areas. Obviously, family and social preferences are important, but a GP starting a practice should at least consider these low or no competition areas.
Less fashionable areas have lower wages and rent costs. Goodwill may not be much but goodwill is normally not much anyway. Profits will be good and should be redirected from the practice structure to investment trusts and companies to other new investments, which will in turn generate more profit and net cash flow, leading to even more investments.
Buying a practice could be the best investment for a GP.A mark of a good practice is a demonstrable ability to produce an above average return for its owners. Prospective buyers will be prepared to pay a premium over the value of the practice’s tangible assets to receive that above average rate of return.
This premium is called “goodwill”. Goodwill is an intangible asset: it does not have a physical presence and will differ in amount and nature from practice to practice.
Goodwill values have been low for years. Low values skew the “to buy or start” decision in favour of “Buy”.
Starting a new practice from scratch is a more daunting option. It takes time and creates stress. It has the advantage of not having to pay for goodwill and location, staff and premises are an open book, allowing decisions to be made autonomously.
Buying a practice has more certainty. It allows GPs to be confident that the patients will be there. This lowers risk and ensures there is a good income from day one. Often the GP will work in the practice before buying and will be familiar with it. They may have actively contributed to the growth of the practice, which may be reflected in negotiations of a discounted buy-in price. This is the best due diligence: real hands on experience in the practice. Know the patients, the other GPs and the staff. You learn what makes it tick, and can be confident it will be there for you once you own it.
There is no definite right or wrong: some GPs are better off starting their own practice, and some are better off buying an established practice.
Our advice tends to be “buy if at all possible”. Starting a practice from scratch in a brand new location can be done, but will incur higher risks than purchasing a perfectly good practice down the road for a minimal cost. It can take months for a new practice to get up and running, and the months will drag into years if town planning permissions are involved.
The advantages of buying an established practice include:
- Immediately busy;
- No long lead time setting up;
- Time saving relating to acquiring new assets;
- No need to hire a new team of staff members;
- There is an established customer base i.e. patients;
- There are reduced marketing requirements;
- There is an established reputation; and
- There is no need to launch extensive new opening campaigns. The disadvantages include:
- The reputation may not be as positive as you would like it to be; and
- The staff may have work habits you do not like.
The phrase “buying a practice” includes buying part of an existing practice. This can be an associate buying a right to practice, a partner buying a share of a partnership’s assets, or a shareholder buying shares in a practice company. It assumes the buyer will take over any rights to provide management services to the practice, which are commonly owned by a separate service trust, and this is included in the assets being sold with the practice.
Staff contracts and provisions
The buyer takes over the staff contracts. Normally staff liabilities, including sick leave, annual leave or long service leave, are deducted from the sale price on settlement.
A buyer should keep staff for the first period after the sale. They can be the real the goodwill of the practice, and staff continuity is important for practice systems and patient relationships.
If you are intending to change staff , the question of which staff to keep is an important one that should not be answered before buying the practice. Err on the side of caution and do not let staff go until you have a real handle on how the practice is performing.
Buyers need to know about any employee liabilities, such as annual leave, sick leave, and long service leave. If they exist the purchase price needs to be adjusted. For example, an employee who has thirteen years’ employment will probably become entitled to three months’ long service leave in two years time. An adjustment should be made on a pro-rata basis for long service entitlements.
Is the price right?
Negotiations are a dynamic, and backing intuition is usually the best thing to do. It is a good idea to get someone else to double-check the reasoning. This helps ensure decisions are not rushed. At the end of the day the buyer must be satisfied on the matter of price. It is perfectly acceptable to ask for time to think things through. Alternatively, where confidence is lacking, someone else could be appointed to negotiate the deal. Emotional indifference can be a wonderful asset in a negotiation, and can throw an objective perspective over the whole proposal.
Once a price is agreed, don’t look back. Negotiations are difficult, and in most cases it will never be known whether a better price could have been reached. Once the price is agreed, it is time to begin making the practice work.
Consider if part of the purchase price can be deferred for, say, a year. If this is done, and for any reason results are not what was expected, the door is open to withhold all or part of the final payment unless an appropriate adjustment is made.
Financing the practice
Medical specialist lenders will lend GPs money to buy practices at normal goodwill values. GPs should demand the best possible interest rates: this will usually be the home loan rate.
Council zoning permissions
A failure to check zoning permissions is a common mistake in a sale of business transaction.
Do not assume a practice is permitted on the site just because a practice is there now. Confirmation from the vendor and the council is strongly advised.
This should be a standard part of the due diligence process taken by any solicitor acting for the buyer GP.
Preparation of the sale of practice agreement
The vendor’s solicitor will prepare the sale of practice agreement.
The buyer’s solicitor checks the sale of practice agreement and related documents and advises the buyer whether they are in order to sign, or what changes are needed.
The solicitor’s role is not to “do the deal”. This is done by the GPs, perhaps with some back room coaching from the solicitor. The solicitor’s role is to document the deal agreed to by the GPs, and make sure the sale transaction proceeds smoothly in accordance with the deal.
It’s not a good idea to buy shares in an existing company. The reason is simple: there may be undisclosed debts and the buyer will end up being at least partly responsible for these debts, or the debts may even be so large the company becomes insolvent.
This happens more often than you might think. And if you buy shares in the company, you buy the company, warts and all.
It can be a good idea to transfer the assets from the old company to a new company, and then subscribe for fresh shares in the new company. Provided certain rules are observed the transfer is ignored for tax purposes. This prevents the shares being tainted by any latent liabilities not appearing on the balance sheet, or that current shareholders are not aware of.
Specialist tax advice is essential.
Sometimes the buyer assumes responsibility for certain vendor debts. For example, the practice may be one year into a five-year lease on computers that cost $30,000. The lease is at a competitive interest rate and is with a reputable financier. Taking over the lease can be a smart way to part pay for the practice. The sale price is reduced by the amount of the liability. Here this means $24,000, ie 4/5ths of $30,000, will be taken off the purchase price.
Restraint of trade clauses
A restraint of trade clause is an essential part of any agreement to purchase a practice. It helps make sure the patients stay and the buyers gets what they paid for.
If there is no restraint clause the seller GP can re-appear a month later almost literally next door. The seller GP may not be able to directly approach the patients; however, word would soon spread and the buyer GP will not get what they paid for.
The restraint clause should place a reasonable restriction on the vendor for each of:
- The type of activity restricted (i.e. medicine and, perhaps, health care generally), whether as a principal, a partner, an associate, an employee or otherwise;
- The geographic area restricted. A reasonable geographic restriction is usually not more than, say, between 2 and 3 kilometres from the practice premises; and
- The time period restricted. A reasonable time restriction is usually three years. This period could be longer if an unusually large amount is paid for goodwill.
Deferring part of the purchase price is a good way to add business efficacy to restraint of trade clauses. It gives the buyer GP bargaining power should anything go wrong.
The right to use the premises, whether as an owner or as a tenant, is a critical part of the purchase agreement. It would be a disaster to buy a practice only to find the landlord will not renew the lease, and there are no other suitable premises available.
Tenure can be provided to a buyer in a number of ways. These include:
- If the vendor leases the premises, transferring the vendor’s tenant rights to the buyer. The landlord’s consent is usually given without too much trouble; or
- If the vendor owns the premises, arranging for a fresh lease to be granted to the buyer for, say, five years with options to extend the lease, as required.
We recommend buyers retain an experienced solicitor to check the lease carefully before proceeding too far with buying the practice.
Warranties and Guarantees
It is a good idea for a buyer to obtain third party guarantees from the vendor. For example, if the vendor is a practice company a director’s guarantee is appropriate. A director’s guarantee means that a director is responsible for the actions of a company.
One common warranty says the vendor has disclosed all known relevant matters. If the vendor won’t agree to this clause, the buyer should probably walk away.
Notice to Patients
Appropriate written notice should be given to patients and this notice should stress the skills, experience and other attributes of the incoming GP.
If the new GP is buying into a partnership it can be a good idea for the retiring GP’s patients to be invited to see the remaining partners as well as the new GP. This should improve the retention rate for the partnership as a whole.
For a solo practice managing the patients is even more important. The buyer should insist on a phase-in phase-out arrangement where the vendor fades out of the practice over time. If this is done properly, the patients may virtually not notice the change.
Potential of the practice
The potential of the practice should be given a great deal of thought. A new face can be a breath of fresh air in a medical practice. A new coat of paint can help too. Many potential new patients may come once to see what it is like. Word of mouth is a strong form of advertising. Positive first impressions cannot be underestimated.
Market value is the price a willing but not anxious buyer, and a willing but not anxious seller, will agree on. This definition assumes the buyer and the seller each have the same information regarding the asset, and each of them have other alternatives that they may pursue if the sale is not completed. That is, it assumes both the buyer and the seller come to the table with equal knowledge and bargaining power.Goodwill exists when the expected future profits from a practice exceed the amount the GP can otherwise earn. Here a willing but not anxious buyer will be prepared to pay a premium to acquire a right to receive or to share in the practice’s profits. Typically this is where the practice has a special quality that cannot be easily replicated, which is not personal to the owner, and can be passed to a buyer with a reasonable level of certainty.
There is no complete list of the qualities that create goodwill, but they include:
- Efficient support staff that enjoy a friendly rapport with patients;
- Clean modern premises that are easily accessible, have adequate car parking space and, preferably, a play area for children, with some form of entertainment for adults, so patients find the ambient surroundings comfortable;
- Stable and personable assistants and associates, who have their own lists of patients, and who are able to operate at a maximum capacity, with minimal supervision and control (and who do not intend to, or who are contractually prevented from, setting up an opposition practice in the same locality);
- Established relationships with allied health care professionals, such as physiotherapists, pathologists and chemists, ensuring the practice can provide a broad range of medical and health services to its existing patients;
- Increasingly, a market niche or practice specialty that attracts a particular type of patient, as well as the general practice patient. Examples of this include skin cancer, geriatrics, sports medicine, a language expertise, and women’s medicine;
- Good location, both within a particular suburb and as to the choice of suburb or region itself, and the related issue of a practice’s physical presentation; and
- In some cases, specialist equipment, that has a high cost or market interest, creates a barrier to entry for a particular type of procedure or service.
Chapter 06 – Your next best investment: a family home
The Real Estate Institute of Australia (REIA) says that at December 1980 the median home price in Sydney was $76,000. By September 2016, the same body reported that the median home price in Sydney was $1,076,878. The story was much the same across the other major capital cities, although Melbourne and Sydney had ‘performed’ slightly more strongly across the period.
That’s a significant increase in value over three decades. The increases have been bigger in the better suburbs.
Home values don’t go up every year. But they do go up every decade. When you look at home values over the decades there is a significant upwards-sloping trend line. The GFC dampened home values in the final part of the 2000s. But the Real Estate Institute of Victoria reports that the median house price in Melbourne rose by 5% in the last three months of 2016 alone. That tends to be the way with property prices: flat years are interspersed with strong ones, meaning that growth is generally lumpy, but positive over time.
As good as these results are, many GPs have done even better. This is because GPs tend to buy better homes in better suburbs, and these homes appreciate faster than others. Some GPs have made fortunes just owning their homes.Consider the scene in a Vaucluse lounge room in 1997, when a young financial adviser could almost not believe the GP when she said her home was worth more than $1,000,000. It did not seem that big or that good a home. It just seemed like an average home. And it was. The average home was worth more than $1,000,000. Vaucluse was the first suburb in Australia to break this price barrier. Paul Keating lived around the corner. It was the place to be.
The GP was wealthy because she bought there ten years earlier for less than $500,000. She is even wealthier now: the median value for Vaucluse is now more than $4,000,000. That’s an excellent return on investment. Sure it’s taken three decades. But that’s how long property takes to generate real returns, and it’s how long good properties should be held for.
Most GPs don’t live in Vaucluse. But most GPs live in better suburbs that have experienced better price increases over the last thirty years. Most GPs have experienced significant tax- free capital gains as well as enjoying the amenity and lifestyle the home offers.
What are future home prices expected to be?
Fifty years is a long time. But it’s how long property should be held for – Dr Vaucluse is 60% of the way there already. Property is an intergenerational asset and over the decades and generations will produce excellent rates of return.
How excellent? Well, obviously precise predictions of future prices are not possible. There are too many variables in the equation. But let’s stick to the basics, and look at what is expected to happen to Australia’s population over the next fifty years, and try to make an educated guess about home prices from that.
The Australian Bureau of Statistics provides the following data:
|State||Population 2012||Population 2062||Increase %|
Population growth underpins property price growth. In 1997, Australia’s population was 18.5 million. In 2016, it was 24.3 million. That’s an increase of more than 30%.
Income levels will rise too. Inflation runs at roughly 3% a year, so a $1,000,000 home in 2017 will be worth at least $4,384,000 in 2067 if it does nothing more than keep up with inflation.
Much of Australia’s population growth is driven by immigration. More than 220,000 arrive each year, and most are well educated, reasonably well off, and very aspirational: they want to get ahead in the Lucky Country and they work very hard to do so. Of this 220,000, nearly half arrive just in Melbourne, keeping demand for Melbourne property, particularly the fashionable inner, eastern and bayside suburbs rising and rising each decade.
These aspirations are shared by older Australians too: just listen to talk back radio for a day to witness the energy and effort put in to buying and keeping a home. It’s an intrinsic part of the Australian culture and psyche, and there is a stigma attached to not owning a home.
Obviously the more fashionable suburbs will be in more demand. They are privileged locations and people will fight to get there.
Vaucluse in 2017 is probably still a very good buy. One day a GP will boast she bought Vaucluse for a song at just $4,200,000 way back in 2017.
The above anecdotes and tables seem to be a persuasive case for home ownership, particularly in the suburbs GPs like to live in.But not everyone agrees.
Phil Ruthven is a well-known economics and social commentator. He argues owning a home as an investment is irrational and unlikely to produce optimum investment results. He says home ownership is nice emotionally but most will be better off renting different homes that suit them at different times in their life and implementing a disciplined investment strategy based purely on rational grounds (perhaps – indeed probably – including one or more investment properties).
Mr Ruthven says this is particularly the case if the hidden costs of home ownership are considered, such as hours and dollars spent improving the home, rates and repairs, and stamp duty, legal fees and other transaction costs when we move every seven years.
There is something in what Mr Ruthven says. This is particularly if you move more than once every seven years or if your home is not in a good performing suburb.
In July 2014 the Reserve Bank released a report saying that house prices need to go up by more than 2.9% a year for buying to beat renting.
On balance, though, we do not offer the same advice as Mr Ruthven. Fundamentally, the great advantage of home ownership is forced savings. Apart from super, most people would not save a cent were it not for the forced saving of regular home loan repayments. Most GPs own homes in good performing suburbs for more than seven years (and as you know we recommend homes be owned for decades and even generations).
GPs are more likely to pay off the (expensive non-deductible home) loan fast and to implement a separate disciplined investment strategy. Once again, it’s the unusual height, stability, scalability and longevity of the GPs’ income coming into play: put simply, GPs can afford to buy better homes, pay them off quickly and keep them as investments when they up-grade to the next home.
This means homes work well as investments for GPs. And on balance we expect the Reserve Bank’s 2.9% price increase to be easily beaten by the better suburbs in most major capital cities: 2.9% is barely the inflation rate, and well below the historical rates of return actually generated in these markets.
Our approach to family homes
Nearly every meeting we have with a GP discusses the GP’s home.
Questions include: Should it be sold? Should it be kept? Should it be renovated? Should it be protected? Should it be left in a will? Should it be used as security for an investment loan? Should it be used as security for an adult child’s home loan?
For GPs who do not own homes some questions include: Should I rent or buy? Should I buy something small and affordable for now, pay it off fast and up-grade later? Or should I buy something more than I can afford now, and work harder than ever before? Should I invest in shares instead, buying a fixed amount every month rather than paying off a home loan? Should I buy a practice first?
There is some evidence that Australia’s historically high home ownership rates are falling. Home ownership rates have fallen from 71.4% to 69.5% since the 1990s, with Australian being one of only five OECD countries where home ownership rates fell during this period.
This does not seem like much of a drop, particularly as the population grew strongly during this period and home prices grew even more strongly. The level of home ownership, and aspiring home ownership, in the medical profession has certainly not dropped.
Owning a home, and variations on the theme, is a major point of interest amongst GPs of all ages, and the home remains the greatest store of wealth for most GPs. Super is catching up, and may be one day will overtake home ownership as the most valuable asset for many people. But I would not mind betting that as GP super balances grow average home value will grow even faster, due to a wealth effect between these two asset classes. That is, GPs (like many others) will be more willing to take on more loans to buy more home as their super balances rise. Basically, wealth derived from anywhere tends to get invested back into property.
What are the advantages of home ownership?
The advantages of home ownership can be as much psychological than financial. It’s all about the nesting instinct and territoriality: this is your home, and your home is your castle. Home ownership provides a sense of permanence and control that is important to overall psychological happiness.
Residential properties, and the loans used to buy them, are a great way to save.
Many people, GPs included, would not save a cent if it was not for the principal component of their home loan repayments. Later, when the home is paid off, home owners do not have to pay anything, while non-owners pay rent for the rest of their life.
The family home, including improvements, is usually free of capital gains tax. The principal place of residence is excluded from the CGT net by dint of social policy and political survival. Improvements to the home are CGT-free, so if a $100,000 improvement creates $150,000 of value, that extra $50,000 is tax-free.
For older people, the home is outside the assets and income test for the age pension. Pensions are usually not an issue for GPs. But sometimes they are.
Increasingly older GPs without significant investments are using reverse mortgages to access the equity in their home without having to sell it. Reverse mortgages turn homes into tax-free reservoirs of wealth. Individuals can smooth consumption over their expected lifespan by building up the reservoir during their working years and running it down in retirement.
The Australian Master Financial Planning Guide 2013-14 (Walters Kluwers) recognises other advantages as including:
- Provides security since the alternative, renting, may involve the owner selling the property;
- Avoids the stigma that some feel may attached to not owning a home;
- Lifestyle choice where wealth creation is not the primary objective;
- Paying off the home loan is a form of personal saving; and
- Freedom to make personal changes to the property.
What are the disadvantages of home ownership?
Property can be expensive to buy and hold. Acquisition costs include stamp duty (work on 5% of the cost), bank fees, solicitors’ fees and titles office costs. Holding costs include council and water rates interest, land tax, maintenance and repairs, and real estate agent’s fees. These can be significant and are often ignored when people calculate the gains made on their homes.
Critics also list the opportunity cost on foregone investments and a lack of diversification, which means higher risk. But historically neither has held true. Think of the numbers we discussed above. Any lack of diversification is to the homeowners’ advantage – who wants to diversify into a lower-earning asset class?
Critics say residential property is not a liquid asset. This is not a problem for GPs because they have high, stable, secure, scalable and long income streams, so cash flow is rarely a concern. It has been even less of a problem in the past 10 years because equity access loans (debt facilities linked to the value of the home) allow GPs to cash out some of the value of their home, whether for consumption, investment or business purposes. Illiquidity is not a problem for property owning GPs.
The Australian Master Financial Planning Guide 2013-14 (Walters Kluwers) recognises other potential disadvantages as including:
- Property prices can go down, as well as up;
- Demand for property may be lower in the future due to:
- Low inflation, which reduces the potential for high capital gains;
- Increasing unemployment rates;
- The global financial crisis and continued global financial instability;
- The high costs of buying and selling property, including legal fees and stamp duty;
- The opportunity cost on missing out on other better performing investments;
- Lack of diversification;
- Property not being suited to investment;
- Miss out on other tax concessions, even though homes are CGT free; and
- Homes are illiquid, ie hard to convert to cash.
So, what do we say to GPs?
We generally say GPs should own as much home as the bank will let them as soon as they can, and then pay off this loan as fast as they can. GPs who followed this advice have done well so far and it is unlikely this will change much over the coming decades.
We are not sure what will happen to home prices over the next five years. But we do know that well located homes in good suburbs will cost a lot more in 2034 than they do in 2014. GPs should be fattening their residential property portfolios and buying a home, or up-grading to a better home, is one way of doing this.
The advantages and disadvantages of home ownership set out above are all valid and relevant. We believe the advantages outweigh the disadvantages.
In particular, the strong population growth over the next few decades dominates our thinking and means home values will rise significantly in the popular suburbs, particularly Melbourne, Brisbane and Sydney. We therefore routinely recommend GPs buy good quality well located premises in these areas, with a holding period of two decades, both as homes and as investments.
Many GPs are too quick to sell their homes, particularly when upgrading to a new home.Homes have been incredibly good investments over the years. So usually it’s not long before the sale of the old home is regretted.
GPs should consider never selling their old home when they up-grade, and should instead retain it, rent it out and let time do the rest. The first few months, or even years, may be tight, but before long the value of the new home and the old home will rise and the decision will be validated.
As a helpful hint, use interest offset accounts as much as possible: you can withdraw your equity and transfer it to the new home, reducing non-deductible debt, while the old home becomes a negatively geared investment property.
What if your home is not expected to appreciate?
GPs in capital cities think home prices always go up. And in most capital cities they almost always do always go up, at least eventually.
But outside capital cities the position is more complex. In some places prices do not go up at all. In other places prices fall. That’s why we always recommend rural GPs own at least one residential property in a capital city. The historically poor performance of rural residential property and the expected price increases for major cities makes this a must for both investment and lifestyle reasons.
The experience of one rural GP illustrates the point. He bought a property in the Melbourne suburb of North Fitzroy in the early 1980s using 100% borrowed funds. The property was rented through an agency for about 10 years under a classic negative-gearing strategy. The tenant and tax deductions basically paid for the property, while its market value rose … and rose and rose.
The GP chose to pay off the investment loan as quickly as possible, which is always the way to go with any investment or business loan.
By the early 1990s, its value had doubled and the original debt was almost gone. The eldest of the GP’s three children came to study in Melbourne and moved into the house. It became a student house, with rooms rented on a monthly basis and a kitty for common costs.
The child used the money from the other students to cover her own living costs. This was in line with an ATO ruling that says board is an offset to a private, and hence non-deductible, cost, and is not assessable income.
The parents could not claim tax deductions for the property, since it was no longer producing rent. But this did not matter, as the interest cost was negligible and not worth worrying about. Interest rates were dropping too.
Over the next few years the other two children took up rooms in the house. This meant the board from the other students dropped off, but was offset by the savings in living costs and the convenience of having a Melbourne base. It meant the children could live together and the parents had a place to stay when they came to Melbourne for a weekend (which the kids were not always glad to see happening).
The children lived in the North Fitzroy home into their late twenties, and their parents visited every few weeks. Each of the children then bought their own home elsewhere in Melbourne (few people return to the country once they have moved to the city). The kids bought these homes much earlier than they otherwise might have – living rent free for years meant they had bigger deposits years earlier than otherwise.
The North Fitzroy purchase stood the test of time. Not only has it stacked up as an investment on its own, it has also offered definite lifestyle advantages. The children stayed together in a secure and pleasant house, and mum and dad visited whenever they wanted. This gave the children a real head start in buying their own homes, and saved them tens thousands of dollars.
The parents have now retired to Melbourne to be close to their grandchildren. They renovated the house, and had a readymade home bought at 1984 prices, not 2017 prices.
And its pre-capital gains tax to boot!
GPs should use interest offset accounts rather than paying off home loans directly.A young GP registrar had $400,000 in the bank. She wanted to buy a smaller home, but was aware that her needs may change in five years time when she expected to up-grade to a bigger home better suited to a young family.
The advice was to buy a town house that suited her now (ie high security, low maintenance) in North Sydney for $750,000, borrowing 100% and asking her father to guarantee the loan, and place her $400,000 in an offset account.
This meant she only paid interest on the net amount of $350,000, rather than paying non- deductible interest at 5% on $750,000 and being paid taxable interest at 3% on $400,000.
She saved a total of $12,800 a year cash after tax, calculated as follows:
|Without interest offset||With interest offset||Amount saved after-tax|
|Interest paid at 5%||$37,500||$17,500|
|Interest income at 3%||$12,000||Nil|
|Less tax at 40%||$4,800||$7,200||Nil||Nil|
But it gets better. In five years when she needs a bigger home better suited to a young family she can withdraw her $400,000, plus any extra amounts deposited into this account principal repayments, and use this to help pay for the new home. She then retains the old home as a geared property investment – and gets a tax deduction for all of the interest on the $750,000 loan.
In summary, we recommend GPs use interest offset accounts rather than directly pay off loans because this allows GPs to transfer the equity in their old home to the new home when they up- grade, and retain the old home as a geared property investment.
Homes for children
Investing over the decades and the generations mean children and even grandchildren are very much in our minds.
GPs with children over the age of 18 should encourage those children to buy their first home. A loan, or a bank guarantee, from mum and dad means the next generation can enter the property market much earlier than otherwise, and can buy properties at 2017 prices rather than 2037 prices. And if the children stay at home and rent the property the tenant and the tax benefits pay most of the costs, really accelerating the wealth creation process.
It’s a great way to create a permanent financial advantage for your children.
The only real down side is the risk that the property may fall in value and the parents become exposed under the guarantee. This is a manageable risk, and one most GPs are prepared to take on.
It’s never too early
A recent experience of a GP highlighted the effect of time on residential property investments, and the power of gearing to increase returns many times over.
The GP finished her medical training in the early 1990s. She did not earn much in the early days and took on an extra session each week in an outer-suburban practice. Her friends thought her a bit excessive and her parents thought her a workaholic. None understood her. University was gruelling, so why not kick up your heels a bit before the next phase of your life starts?
The pay was good and she easily saved an extra $500 a week. It was left intact in a separate bank account that she never touched.
Three years later she and her fiancé were looking to buy their first home. They checked their finances and found they had none – except for the $500 a week extra pay, which had grown to $75,000. This was just enough for a deposit on a nice townhouse in a fashionable beachside suburb. The loan was scary – $300,000. Even on two incomes, it seemed they would be working forever to pay for it. So all her income went to paying off the loan, and they lived on his salary. They had to beat this debt as soon as they could!
Time moved on and housing prices rose. So did her income. Soon the $300,000 debt was almost gone and the townhouse almost owned. Circumstances changed (they always do) and something bigger was needed. “Sell the town house,” the parents and friends urged, “buy yourself something bigger. Get a new car too.” But the GP had other ideas. Instead she kept the townhouse and plunged head first into another bucket of debt, borrowing $800,000 to buy a new home just around the corner, with a big yard for the kids.
She let the townhouse and used the rent to pay off the home loan. She paid her spare income on to the loan as well. Melbourne housing prices rose and the beachside areas became even more fashionable. The debt-equity mix was good, so she borrowed again and bought another property.
She never doubted her strategy would work – borrow against the existing properties, pay the rent and spare income to the bank, and let time do the rest.
The GP and her husband now have a portfolio worth more than $15 million. Each property is well tenanted and has excellent prospects. Cash flow is good. There is no financial stress.
So far she has never sold a property, which means she has never paid capital gains tax. This is despite enjoying millions in unrealised capital gains.
The big pay-off came in early 2014 when her husband was retrenched. Prospects for retrenched bank managers are not excellent, but in this case, rather than being a financial catastrophe, retrenchment was (almost) a welcome event. The husband now spends even more time working on the properties, sprucing them up, and identifying potential good buys. Sometimes you have to stop working to start making money,
This GP’s story is unusual. It’s also simple and straightforward. All she did was work hard, forgo some current consumption, borrow money, buy quality assets, pay off the loans and let time do the rest.
Now, at age 59, the GP has achieved financial security for herself, her children and even her grandchildren. That part time job was the best move she ever made.
Don’t invest in apartments. There is an over-supply, and the capital gain prospects just aren’t there. Sure, some will be OK. But most won’t be. It’s better to be safe than sorry.
On 2 April 2014 the Age newspaper quoted Robert Mellor, managing director of real estate researcher BIS Shrapnel, as saying there could be 2,000 apartments in excess to demand in Melbourne alone, and Louis Christopher, the managing director of property researcher SQM Research, as indicating that the Sydney apartment market was over-supplied too, with higher planning approvals, low rental yields and rising vacancy rates forcing values down.
Some apartment developers are offering up to 10% commission to financial planners to get them to flog their stuff. If an apartment needs a 10% commission to be sold you can be sure its not going to be a good investment.
Don’t invest in tourist accommodation either. There is an over-supply and the capital gain prospects just aren’t there either.
In 2011 a GP made the classic mistake of buying a Gold Coast apartment for $400,000 while on holidays. It seemed a good idea at the time. The rent was good, $30,000 a year, which meant the interest of $22,000 a year is more than covered. The problem is management fees of $15,000 a year and cleaning costs of $6,000 a year. Throw in rates and water and total outgoings are more
$45,000 a year. The cash shortfall is more than $15,000 a year.
The apartment is worth less now than it was in 2011, and brand new apartment blocks are springing up all the time. Any capital gain is decades away.
The share market has risen 20% since 2011.
Holding costs of $15,000 a year means the family’s week in Surfers each May costs more than $2,000 a day, and he has missed out on nearly $80,000 of capital gain.
That’s what we call an expensive holiday. Don’t ‘invest’ in holiday accommodation.
In summary, tourist accommodation is too risky. The Australian dollar has made overseas holidays cheaper and virtually killed in bound tourism. There are too many apartments and too few genuine buyers, and you are at the mercy of the apartment managers.
Chapter 07 – Your next next best investment: practice premises
Practice premises are usually excellent investments for GPs.
This is because of the symbiotic relationship with the practice: good premises, in the sense of a modern, pleasant, efficient, well laid out and well located building that GPs and staff enjoy working in and patients enjoy visiting, have a significant influence on profitability.
The extra profit is normally much more than the market rent.
For example, better premises may help attract and retain non-owner GPs and better staff, and appeal to patients, particularly patients who can pay higher prices. More GPs, more patients and higher prices mean more profit. It’s hard to measure accurately but a good guess puts the extra profit in the hundreds of thousands a year. It’s certainly much more than market rent will be if leased to an arms-length tenant. That is why we say it is usually better to own the building that your own practice operates out of rather than to own a building that is rented to someone else.
Extending and improving existing practice premises makes a lot of sense too. One practice had spare land and put in a new minimalist consulting room for about $200,000. A new GP joined and before long she had new billings of $400,000 a year. The practice charged a management fee of 30%, so it got $120,000 extra a year. There were not many extra costs, so that $120,000 was almost all profit.
There are not many investments where a GP can earn a low risk 30% per annum return, but that’s how much this investment created for this practice.
Practices that own their premises are more secure. They are not at the mercy of a landlord, and liable to be moved on at the end of the lease. They control their space and this adds to the security of the practice and everyone wins.
Practice premises are usually capital gains tax (“CGT”) free
Many GPs are surprised to learn that practice premises are usually CGT free. They are covered by the Federal Government’s small business tax concessions and, provided certain conditions are met, are usually CGT on ultimate sale (although specific advice should be sought before selling).
This makes practice premises a relatively more attractive proposition than a simple rental property. Two buildings may be virtually identical but if one is used as practice premises it’s after-tax net return will be greater than the other, purely because of this CGT concession.
The CGT concession is part of the Government’s strategy to encourage small business.
Co-ownership of surgery premises
Co-ownership of practices normally means co-ownership of the practice’s premises.
For example, four GPs may club together to buy a surgery costing $2 million. Each of the GPs puts in $200,000 of their own money (possibly borrowed from their bank against the security of their home) and then borrows the remaining $1,200,000 secured solely against the surgery and the four owners’ personal guarantees, limited to their share of the total debt.
The GPs then rent the surgery back to their practice entities. The net rents pay the interest and repay the principal. The repayment of principal and capital gains over time creates value for the GPs.
An advantage is that each of the four GP has been able to access an investment that may have been beyond each of them individually. Risk has also been diversified, particularly if more than one property is bought using this method. As a practical matter for asset protection, the GPs will probably not own the surgery personally but will use a trust-based structure or own their interest in the surgery through their spouses.
There are various ways of structuring the ownership of practice premises. Typically, some form of trust is used. Self-managed super funds can be great for this purpose. The specific structure depends on how many owners there are and whether and how they are related. The specific tax planning needs of each owner – both now and into the future – also affect the decision.We recommend you contact us to arrange expert legal advice before buying practice premises.
What about building surgery premises?
Building practice premises can be a good investment. Once again, the expected return on the investment comes in the form of higher practice profits, and these are usually much more than a market rent. For example, one client case involved three semi-rural GPs clubbing together and buying land in a unit trust, and then building a surgery. It cost more than expected, and took longer than expected. The high fit out costs and the cost of new plant and equipment surprised them too.
When the new practice was up and running, with nine consulting rooms 80% full every day, their return from the practice was over $450,000 each. This was, in their case, spread amongst their SMSFs (which owned the building through a geared unit trust) and their family trusts which owned their interest in the practice itself, via a hybrid trust.
Before the project started they each made about $200,000 a year working in someone else’s practice, without much tax planning. Once the project finished they each made about $450,000 a year in their own practice, with some excellent tax planning.
They could not have made the $450,000 without the new practice premises, so in a very real sense they each earned $250,000 on their one-third share of the practice premises. They put in $300,000 each and borrowed the rest, so it was an unbeatable investment. In practical terms, it was virtually risk free: they are great GPs and the success of their practice was never in doubt.
Two practical tips:
- remember you are a GP, not a builder. It makes sense to employ a project manager to manage the project, so that keep working as a GP; and
- you are a GP, not a practice manager. It makes sense to employ a practice manager three months before opening to handle the huge number of tasks connected to creating a brand new practice, and for you to stay working as a GP.
You are a much better GP than you are a project manager or a practice manager. Focus on what you do best (and most profitably) and pay someone to do the rest for you.
Should the GP have to sell on leaving the practice?
Some practices link the interest in the practice premises to the ownership of the practice. This means if a GP leaves the practice they, or more probably their family trust, have to sell the interest in the practice premises.
This approach can make sense and suits many practices. But there is no rule that says the practice and the property must be linked. Some practices treat them independently, so even a retired GP can still receive a share of the net rent and enjoy the appreciation in the practice premises’ value.
There is no right or wrong way to do these things. Linking is a good idea because it creates a commonality of interest and symmetry of ownership between the practice and the practice premises. This usually makes for a more harmonious life and takes away any concerns or arguments about what rent should be paid.
However, a GP who is interested in buying into a practice may not be interested in owning a share of the premises as well. With GPs in short supply, it is not wise to limit your options.
Should the GPs own the premises in the same proportions as the practice?
Ideally yes. This has a large number of advantages including simplicity, equality and fewer arguments about what is, or is not, market rent. But it is not necessary.
It’s not uncommon for one or more GPs in the group to be unable or unwilling to invest in the practice premises. Provided the tenant entity (ie, the practice) pays a market rent to the landlord entity (ie, the trust) there is no problem here.
Ideally the GPs will be able to agree on what is a market rent. If they can’t a valuation from a local real estate agent may help. Otherwise, a sworn valuation is needed, but these are costly and should be regarded as a last resort.
One advantage of symmetry of ownership is that it does not matter whether the rent is a bit high or a bit low: it’s from one pocket to another. Preferably the rent should be a bit high, and the excess paid back to the bank as extra principal repayments. This is OK from a tax point of view provided the rent is within the band of “arms-length” rents experienced for commercial property. Eight per cent of value is about as high as you should go unless there is clear evidence supporting a higher rent.
What if someone wants to leave?
The procedure for someone leaving should be set out in a unit-holders’ agreement. The procedure will typically be:
- Related party transfers are permitted without the consent of the other unit holders.
- However, transfers to non-related parties are only permitted if a procedure is followed. This procedure involves:
- offers to sell to the other unit holders at market value, in their proportions;
- If unit holders fall to take up the offer to buy, those units are then offered to the remaining unit holders in their proportions; and
- if after three months the offer is not accepted, the units can be sold to others.
If a GP is leaving it may be agreed that one of the other GPs will buy the units in the property trust. The fact that the unit holders’ agreement prescribes a contrary set procedure can be ignored if all the unitholders wish to do so. We always stress the prescribed procedure is a last resort, to be fallen back on if the owners cannot work out something better as circumstances arise.
Parties to an agreement are always free to change the agreement if they all agree to.
How are renovations dealt with?
Renovation issues are much the same as ownership issues. However, if equity has been built up (borrowings repaid and/or values increased) the bank may be prepared to lend 100% of the renovation cost. If this is not the case, the unit holders may have to contribute a further amount to create additional equity to allow borrowings for the renovation to proceed.
The bank may be persuaded that the renovation will increase value by more than the renovation cost. But banks normally take a conservative view and discount the value back.
The rent should be increased post-renovation to reflect the increased value. This will create cash flow for the trust that can be used to service the renovation debt.
What if the renovations cost more than the increase in value?
This happens often. Building costs are high and a renovation costing $300,000 may only add say $200,000 to value. This means net value falls by $100,000 even before the angst factor is considered. This may be a good reason not to renovate a building that you do not occupy, but when you occupy it the decision is more than just a financial analysis. The synergy between the practice and the premises has to be considered. When a GP and the staff spend such a large part of their waking time in the practice premises its amenity and aesthetics are important.
If four GPs spend $100,000 “too much” and “over-capitalise” the building, what does it matter if they each intend to spend at least 10 years working there? That adds up to about $50 a week each – a small price for being in better quality space, not to mention the effects on staff and patients.
GPs can invest in commercial property other than the practice premises.Commercial property is any property other than property used for residential purposes. This includes shopping centres and malls, shopping strip retail stores, farms, tourism assets, offices, factories, some sporting facilities and medical and dental surgeries. Defining commercial property as “any property other than property used for residential purposes” emphasises purpose over form, so a GP’s surgery in a converted residence is classed as commercial rather than residential property, even though it may still have a potential function as a residential property.
Commercial property covers a wide range of property types that have quite different risk/return characteristics and will follow different trends and cycles, further compounded by geographic factors. For example, rural land in South Australia will increase in price after a good grain cropping season at the same time as sugar cane plantations in Queensland are dropping in value.
Tourism assets, rural land and sporting facilities are generally not owned by GPs. This chapter will deal with offices, factories and shops, ranging from small local facilities to the huge CBD and industrial-zone complexes.
Returns from commercial property comprise rents and capital gains (or losses).
Commercial property rents are generally high relative to residential property rents, but capital gains tend to be less. Exceptions can occur, as can losses, but generally the capital gain is determined largely by the inflation rate, since this tends to determine rent increases.
If a property’s annual rent increases by 3% then, all things being equal, its value should increase by 3% too. But things are rarely equal, and this will be reflected in the change on yield. Value is an inverse function of yield, so falling yields mean higher values and rising yields mean lower values.
Yields are determined by a number of factors. Some apply to the general economy, some apply to the property’s location, some apply to the type of property and others apply to the particular property. The factors include:
- General economic conditions. Favourable GDP forecasts normally mean that businesses will need space.
- Local geographic/demographic conditions. For example, the new ring road in Melbourne led to higher values in surrounding suburbs due to increased accessibility.
- The property’s particulars, including lease length, the timing of rent reviews, whether the lease allows for automatic increase, and the financial strength of the tenant.
Why don’t more GPs invest directly in commercial property?
GPs have a strange reluctance to invest in commercial property other than the practice premises. Possible reasons include:
- a lack of knowledge. Most investment books and magazines barely discuss commercial property, and if they do it is to stress how risky it is;
- most financial planners are not qualified to advise on commercial property;
- high entry prices relative to residential property;
- low liquidity, although this is mitigated by line of credit loan facilities;
- relatively smaller re-sale markets; and
- high stamp duty and, often, land tax.
An example of a great buy
A GP buys a factory in Moorabbin, Victoria, for $2 million, including stamp duty and transaction costs. It is leased at $160,000, or 8% yield, for the next five years. The tenant pays all outgoings including land tax (on a single holding basis). The tenant is stable and has operated from the site for more than 20 years.
The GP borrowed 70% of the total cost of the property and contributed the remaining $600,000 as equity. The interest rate is 5%pa. The term of the loan is 10 years.
The figures look like this:
|Net rent||$ 90,000|
The net rent of $90,000 represents a return of 15% on the GP’s $600,000. If an unrealised capital gain arises each year of 3% (ie, about the inflation rate) this generates a further 10% return on the investment, taking the total return to about 20%pa.
Of this 20% return, 10% (the unrealised capital gain) is not taxed and about 3% is sheltered from tax by depreciation claims and building allowances. This makes the investment very tax-effective.
The investment is cash flow-positive. This means it generates more cash than it costs to hold it. This excess cash is paid back to the bank. The investment is so cash flow-positive it is also covering the principal repayments.
The big risk is something will happen to the tenant, or the tenant will not renew the lease at the end of the lease. This means a big part of due diligence is finding out about the tenant and forming a view of the property’s attraction to tenants if for any reason it became vacant. In this example, a valuer’s report gave comfort, indicating that historically the Moorabbin area had experienced only 3% vacancy rates, and the vacant properties tended to be the lower quality older properties. Local real estate agents confirmed this view.
Not all commercial properties behave this way. The more fashionable retail areas sell on much lower yields. These were as low as 5-7%, but recently have fallen as low as 3-4%.
What about dealing with estate agents?
Negotiating the actual purchase of commercial real estate can also be a treacherous process. It is a good idea to engage someone else to do the evaluation and purchase negotiations for you. It is a tad presumptuous to think that a novice property investor can out-negotiate a seasoned real estate agent. When a professional buyer gets involved the price usually falls and the process is smoothed.
It is a good idea to choose a bank that no GP has any other borrowings with. This way there is no risk of the GPs’ private affairs becoming tangled up with the practice premises.
You should generally choose the bank that offers the lowest interest rate. With commercial property lending, the concept of service does not really apply. Once the loan is in place and the property is settled there will be automatic repayments for the term of the loan.
Chapter 08 – Investing in shares
The shares referred to in this chapter are shares in public companies, which can be bought and sold on a share market. Private companies also have shares, but they are typically not purchased by doctors as investments, and so we do not discuss them in this chapter.The ownership of a company is divided into several portions. Each portion is called a share. Owning a share in a listed company entitles the owner to a proportional amount of any dividends paid from the ongoing profits of the company. A shareholder can also claim a proportional amount of any dividends paid on liquidation or other return of capital.
A shareholder does not own a portion of the underlying assets owned by the company. What the shareholder owns is a to dividends and any net capital if the company is wound up.
Owning shares gives the shareholder a right to receive a portion of the future profits of the company. When a company pays out some or all of its profit to shareholders, this is known as a dividend.The value of a share is determined by expectations of future dividends, including any dividends paid on liquidation. The expectations belong to millions of potential investors around Australia and overseas, are inherently subjective and are influenced by an almost infinite number of variables. The market place co-ordinates these expectations into a market price that is quoted constantly on the world’s stock exchanges.
WHY DO PEOPLE BUY SHARES?
People buy shares to make more money. This money comes from two sources, being capital gains and dividends. Capital gains occur when the share increases in value, and dividends occur when the company pays out profits to shareholders
A capital gain occurs when the market value of a share increases. If a share is bought for $1, and the market price goes up to $2, then the capital gain is $1.An unrealised capital gain occurs when the value of a share increases but the share holder does not sell the share.
Unrealised capital gains represent an increase in a person’s wealth and in this sense can be thought of as income. However, unrealised capital gains are not included in calculating income for tax purposes. This is a critical thought when investing in shares.
The benefit occurs when the share rises in value, not when it is sold. The act of selling the share just converts the rise in value to cash, and triggers a taxation computation (whether tax is ultimately paid depends on a number of other variables). But there is no tax charge just because a share goes up in value. If the share goes up in value the GP is better off, but does not face a tax bill at that time.
This is the key to investing for GPs: invest for tax-free capital gains.
A realised capital gain occurs when a share is sold at a price greater than the price it was bought for – it is sold for a profit. Usually, if a share has been held longer than 12 months only half of the capital gain is taxed. The other half is tax-free. If the share has been held for less than 12 months all the profit is taxed. So capital gains are taxed favourably under the Australian tax law.
This favourable capital gains tax profile is why GPs should invest in shares with the view to holding them for at least 12 months.
Dividends are payments that the company males to shareholders. Dividends can only be funded by profits – including retained profits from previous years. They may be franked (paid out of taxed profits) or unfranked (paid out of untaxed profits or capital reserves). Dividends can be in cash or property, or further share issues (bonus shares) paid by the company unilaterally or by agreement between the shareholder and the company under a dividend reinvestment scheme.
Until 1987 dividends were taxed as profits at the company level and again at the shareholder level when paid out. This meant that company profits were heavily taxed compared to those in other countries. If a company earned $1 of profit, the company paid tax of (say) 30 cents. That left 70 cents to be paid to the shareholder. The shareholder might then have a personal tax rate of 45%, meaning that he or she paid tax of 31 cents. This left just 39 cents of the original $1 – the tax office has effectively taken 61% of the company’s profit.This was distorting the market and discouraging people from investing in Australian companies, which in turn restricted Australia’s economic development.
The Federal Government changed to a dividend imputation system based on the UK and the Canadian systems in 1987. Under the dividend imputation system the company is required to specify the extent to which the dividend is franked, ie, paid out of profits that have been taxed in the hands of the company.
The shareholder includes the franking credit in assessable income. Taxable income is computed, taking into account the shareholder’s other income and allowable deductions, and tax is computed. A credit is allowed equal to the value of the franking credit included in the shareholder’s income. Any excess credit is paid as a tax refund.
The amount of tax paid on the company’s profit depends on the shareholders’ tax profile. Assume a company makes a $1,000 profit, pays $300 tax and pays a $700 dividend.
|Description||20% taxpayer||45% taxpayer|
|Amount included in assessable income||$1,000||$1,000|
|Amount of tax paid||$200||$450|
|Less franking credit||$300||$300|
|Net tax paid (refunded)||($100)||$150|
The same profit will be taxed at either 20% if derived by the 20% taxpayer or 45% if derived by the 45% taxpayer. The tax paid by the company is imputed to the ultimate individual shareholder, thereby providing a lower net amount to pay or even a refund to a person who pays tax at a marginal tax rate less than 30%. The final tax paid to the government on a company’s profit depends on the tax profile (the marginal tax rates) of its shareholders.
HOW DO YOU BUY SHARES?
Shares in listed companies are traded on stock exchanges and in nearly all cases can only be bought and sold through recognized stockbrokers (or occasionally through a direct-share placement by the company itself, or, more unusually, in an off-market transfer).
If a GP borrows to buy shares, this is known as gearing. The interest on loans used to buy shares will be tax deductible. This is so even if the dividends are less than the amount of the interest and no capital gains are realized (ie, taxed) during the year in question.For example, a GP buys a parcel of shares for $100,000, using $100,000 debt borrowed at 8% interest. At the end of the year the shares have increased in value to $130,000, but have only paid 3%, or $3,000, as an unfranked dividend. In this case, the whole of the $8,000 interest is deductible even though only $3,000 of the $33,000 total return (the dividend of $3,000 plus the unrealised capital gain of $30,000) is taxed. That is, the GP can claim a net tax loss of $5,000 ($8,000 less $3,000) and, assuming a tax rate of 47%, receive a tax refund of nearly $2,500, despite making $33,000 over the year.
If the share value does not increase as much or goes down in value then the addition in unrealized income will change accordingly.
This has the effect of dramatically lowering the average rate of tax paid on the GP’s income from the shares and on the GP’s total income. It is actually a form of negative gearing, which occurs whenever the holding costs of a geared asset exceed the taxable income (in this case dividends) derived by holding the asset.
In the long run most GPs who have borrowed to buy shares have done well. This is because the long-term average rate of return on shares is greater than the average long-term interest rate.
Nevertheless, care is needed and GPs contemplating gearing a share portfolio should consider:
- sticking with blue chip Australian shares that pay high and franked dividends;
- not gearing 100%, and perhaps not gearing more than 50%, of the portfolio; and
- taking a very long term view and realising that in the short term capital losses are possible and that gearing increases the amount of the GPs capital that is lost when capital losses occur.
CAPITAL PROTECTED LOANS
Some financial planners will recommend “capital protected gearing plans” where the lender guarantees the investor’s capital will be protected at say the end of five years. Sounds good but there is a catch: the excessively high interest rate. The interest rates on these loans are often well above the long term average return from Australian shares of about 9.8% (Source ASX 2013 Investment Report), which makes it extremely unlikely that you will win this ‘bet.’
DIVERSIFICATION AND RISK REDUCTION
Diversification, ie combining investments with a low positive or negative price correlation, reduces the overall risk in the portfolio. For example, if you hold shares in export companies and shares in import companies, the export companies will do better with a rising $A and the import companies will do better with a falling $A. Owning both export companies and import companies means you have diversified away (some of) the risk connected to exchange rate movements, and total risk is lower than otherwise.
(Of course, if you expect the $A to rise you might deliberately invest in export companies and deliberately not invest in import companies to create “up-side” risk. In this case you deliberately not diversify, to try to take advantage of the risk that the actual return is greater than the expected return.)
Studies show that holding as few as 15 shares effectively diversifies risk.
Taylor and Juchau in Financial Planning in Australia (LexisNexis 2013) provide a more technical explanation of how diversification reduces risk. They write:
The concepts of risk and return are fundamental concepts in finance. The return on the investment is the reward to the investor for taking on a certain level of risk. Risk is present if the investor is uncertain as to the outcome the investment will produce (ie the possibility of both positive and negative returns). Probability theory is a useful tool in determining the most likely return on an investment and the expected return.
The concept of diversification as we understand it today is based on modern portfolio theory which was developed by Harry Markowitz in the 1950s. Modern portfolio theory is based on mathematical-statistical model that looks at the risk return relationship that changes as additional assets are added to a portfolio. The theory revolves around expected returns, the risk associated with those returns (standard deviation), and the relationship that exists between returns (correlation) for both individual shares and portfolios.
Markowitz’s theory suggests that maximum risk reduction occurs when the assets in a portfolio are perfectly negatively correlated. That is, given certain environmental conditions (eg economic), the rate of return on assets will be in the opposite directions. This means the optimum correlation coefficient is -1. Hence the aim of the adviser in minimising risk would be to choose assets in the portfolio that are as close to perfectly negatively correlated as possible. Risk will be reduced to some extent if the correlation between the assets is less than +1 but the maximum reduction would occur when the correlation coefficient is -1. Hence we will seek to combine assets in a portfolio with negative correlations. Research indicates that combining up to 20 assets in a portfolio will maximise risk reduction. Each individual asset added after 20 has a minimal impact on the risk of the portfolio.
Diversification enables the investor to achieve higher expected returns simultaneously with lower risk.
This is, of course, why we recommend GPs invest in index funds. Index funds are highly diversified: they include literally hundreds of underlying shares, and therefore “enable the investor to achieve higher expected returns simultaneously with lower risk.”
The longer one’s time frame the less risky so called risky share investments and property investments seem to be. Looking back, one sees clear upward sloping trend-lines, even if they seemed rather random and chaotic month by month and even year by year. Time gives perspective and clarity, and allows real relationships to emerge and be recognised.
This is, of course why we further recommend that GPs hold index funds for decades, not years.
WHAT ARE “DERIVATIVES”?
Share derivatives are, as their name suggests, a generic tag for any investment that derives value from a contractual relationship with another asset, usually a share.
WHAT ARE THE MAIN TYPES OF DERIVATIVES?
Variations abound, but most derivatives fall into one of these three classifications:
- traditional options, being a right issued by a company on its own shares entitling the holder to acquire a number of shares at a fixed price on a given The options can be sold to other persons, but lose their value if they lapse, ie are not exercised. They will lose their value if the share price falls below the exercise price;
- exchange traded call and put options are similar to traditional options but are created by third parties not the underlying company. Call options entitle the owner to buy shares from the option writer. Put options entitle the owner to sell shares to the option writer. There is no obligation to sell or buy, so losses are limited to the cost of the option;
- warrants, which can be either:
- Trading warrants, being short term contracts based on a stock, currency or index; or
- Investment warrants, being long term contracts based on a stock, currency or index and which may include a loan, with the income from the stock applied to the interest and principal, ie instalment warrants;
- contracts for difference, ie a contract which allows the holder to speculate on changes in price of the underlying investment without owning the investment; and
- futures contracts are like exchange traded call and or put options but relate to commodity or financial instruments.
Over the years we have seen GPs become bankrupt playing the derivatives market. They may well have gone straight to the casino: it’s basically the same thing.
GPs should not invest in share derivatives. They are just too risky. Derivatives are “zero sum game” in that any gain made by one person is matched by an equal loss of another person so that overall there is no change in wealth. Poker and blackjack are zero sum games too. But share derivatives are even worse: they come with significant transaction costs so, on balance, eventually, the players always lose to the house. In this case the house is the financial institution that created the derivative, and the agency that sells it from one person to another, such as the ASX.
YOU GOTTA KNOW WHEN TO FOLD THEM
We know of one GP who received $500,000 from a sale to a corporate medicine group and promptly lost it within 6 months. This was despite paying tens of thousands to an options trading ‘trainer’ who promised that he could not lose. When he did lose he was told to “put in another $500,000”, which is the same as the card dealer saying “double or nothing”. Thankfully he did not do this. He realised what he was really doing, ie gambling, stopped doing it, and returned to medicine.
Are there any exceptions to this advice? Yes. One. If you are a prize-winning maths PhD working full time in the finance industry with the best minds and the most powerful computers in the world on your team then you could give it a crack. But remember there is still a less than 50% chance that you will win. Are you feeling lucky?
This is standing instructions to all Australian financial planners. For example, the authors of Australian Financial Planning Handbook 2012-13 (Thomson Reuters) write:
The derivatives markets for options and futures evolved from the physical markets to enable the transference of risk from particular investors to speculators who were willing to take that risk. … Advisers will normally assist clients to invest savings and capital at the higher end of the security spectrum avoiding speculative asset acquisition.
In other words, they think derivatives are too risky too.
GPs should invest long term in the share market, the property market or both. Short term buying and selling introduces extra transaction and taxation costs and, to be done well, needs to be treated like a full-time job. Long-term investing is something that happens alongside a job.Without this sort of commitment it is really just gambling.
The question “property or shares?” is one that most intelligent investors ask. The answer depends on who you talk to. Those with vested interests in the share market tend to prefer shares. Those with vested interests in the property market tend to prefer property.
GPs should invest in both shares and property. Over time they tend to do as well as each other, often performing differently, perhaps even oppositely, at any point in time.
Broadly speaking, the property market tend to perform in shorter, larger, sporadic bursts while the share market accumulates more incrementally (and with smaller steps backwards and forwards in the process).
When you smooth out the cycles, between 1992 and 2012 the share market rose by about 9.8% a year and the residential property market did about the same. Both markets have merit and GPs should invest in both to maximise long-term investment performance.
Chapter 09 – Risk Insurance for GPs
What happens to my family if I die or if I am ill or injured and cannot earn a living?
It’s a standard question in every financial planning meeting.
The answer differs depending on the GP’s stage in the life cycle and their other circumstances, but will usually involve a discussion of risk insurance, mainly life insurance and income protection insurances.A young unmarried GP without any financial dependants may not need any life insurance. No one suffers financially if they die. We often explain this by saying you should not be worried about the bus that hits you and kills you outright, but you should be worried about the bus that hits you and does not kill you outright, but leaves you unable to work as a GP.
The focus for these GPs should be on income continuance insurances and health trauma insurances, ie insurances for the living, rather than for the dead.
This changes when our client enters into a relationship with a potential spouse and there are prospects of one day having children. Someone will suffer financially if they die, ie the spouse or potential spouse and any children of the relationship. There is a real need for some serious sums insured. Each case is different but it is hard to see why the sum insured should ever be less than $1,000,000. It’s a psychologically nice amount: our client knows his or her spouse gets a tax free $1 million if they kick the bucket prematurely: usually this is more than enough to clear all debts and to allow a reasonable standard of living for the surviving family members.
The sum insured may of course need to be greater than $1,000,000 if the spouse or potential spouse does not have a high independent earning capacity, the children are younger or more numerous, and conversely the need for a large sum insured is reduced if the spouse or potential spouse has a high independent earning capacity, the children are older (and therefore closer to financial independence) or less numerous.
Our references to “potential spouse” may raise queries. Once a relationship goes beyond a mere casual acquaintance, life insurance should be in place. One of the first deaths we were involved in had a young electrician being electrocuted on the job. He never knew it, but he was well on the way to being a father: his girlfriend was pregnant, and gave birth to a beautiful bouncing baby boy eight months later. There was some life insurance but not nearly as much as there would have been had he known he was going to be a dad.
The cheapest form of life insurance is known as “renewable term life insurance”. More than 90% of life insurance contracts are set up this way. This is pure life insurance, without any bells and whistles and without any investment component. This is usually the best way to arrange a GP’s life insurance, particularly if the policy is owned by a super fund where all the premiums are tax deductible.
Under most renewable term life insurance policies the premium increases as the life insured gets older. This is largely because the risk of death is increasing too – unless you are male and in your 20s, in which case you become less likely to die each year.
There is often a case for reducing the sum insured as the GP gets older: hopefully the net wealth position is increasing, and the children are less dependant as each year passes by. In short, the economic consequences of death are less severe, so there is less need for insurance. The risk of a GP dying in an accident are actually quite low, and GPs are in a unique position to judge their own health and longevity prospects compared to the general population. Often the analysis leads to the conclusion that cutting back the life insurance makes a lot of sense. But it can depend on the GP’s own comfort zone and attitude to risk.
At each stage in the life journey the GP should objectively consider two issues: what is the statistical probability of premature death, and what are the economic consequences of premature death. These are two distinct issues. Once these issues are considered, an appropriate sum insured can be arranged. This probably means that the sum insured will rise and perhaps also fall as life circumstances change. The position should be reviewed on a regular basis, preferably once a year.
Are premiums tax-deductible?
If the GP owns the life insurance policy then usually there will be no tax relief for the cost of the premiums. But if the policy is owned by a super fund, including the GP’s own self managed super fund, the premium is tax deductible to the fund, and therefore in effect deductible to the GP. This means the after tax cost of the policy is almost halved.
It also means that any benefits paid are taxed in the super fund’s hands. However, as the premiums will certainly be paid and will be tax deductible at 48%, but the benefits will probably not be paid (ie the GP will probably not die prematurely), and even if they are will only be taxed at 15%, then it’s still a good idea to run the insurance through a super fund.
If the 15% tax on benefits is really a problem, then increase the sum insured by 17%. If you want your loved ones to receive $1 million and the benefit will be taxed, then insure for $1,170,000. 15% of $1,170,000 is $170,000, meaning that there will be $1 million left. The premium difference for the extra sum insured is not much, and it is of course deductible right now.
We routinely recommend life insurance be owned by super funds, to make the premium tax deductible, and that the sum insured be adjusted for any 15% tax charge.
Some GPs need life insurance (by which we mean insurance that pays someone if you die). Some do not. Each case is different and the need for insurance is a question of fact, driven by the GP’s individual circumstances.
- one GP, aged 28, may not need any life insurance, because he or she has no dependants and no one is financially prejudiced by his or her premature death;
- a second GP, aged 28, may need $300,000 of life insurance because her mother is an aged pensioner and there will be no one to look after her mum if the GP dies prematurely; and
- a third GP, aged 28, may need $1,000,000 of life insurance because he is married with a dependant wife, two young kids and a third on the way.
What is life insurance?
Wikipedia answers this question as well as anyone else, and it says:
Life insurance or life assurance is a contract between the policy owner and the insurer, where the insurer agrees to pay a designated beneficiary a sum of money upon the occurrence of the insured individual’s or individuals’ death or other event, such as terminal illness or critical illness. In return, the policy owner agrees to pay a stipulated amount called a premium at regular intervals or in lump sums. There may be designs in some countries where bills and death expenses plus catering for after funeral expenses should be included in Policy Premium.
As with most insurance policies, life insurance is a contract between the insurer and the policy owner whereby a benefit is paid to the designated beneficiaries if an insured event occurs which is covered by the policy.
Life policies are contracts and their terms describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; for example claims relating to suicide, fraud, war, riot and civil commotion.
Life-based contracts tend to fall into two major categories:
- Protection policies – designed to provide a benefit in the event of specified event, typically a lump sum payment. A common form is term life cover, which applies for a specified term.
- Investment policies – where the main objective is to facilitate the growth of capital by regular or single premiums. These have become quite uncommon over recent years and are rarely taken up these days.
This is an American definition but it pretty much sums up the Australian situation too.
How much does life insurance cost?
The answer is it depends. The cheapest way to secure life insurance is through industry super funds such as Health Super and HESTA. These funds provide universal life cover to all members, without a medical examination and without medical disclosure.
For example, at age 28, a member automatically receives $166,200 of death cover and $166,200 of total and permanent disability cover for just $3.30 a week. The $3.30 is effectively tax deductible because it is paid out of your deductible contributions. This is remarkably cheap, and the simplest and easiest way to arrange life cover. The $166,200 will be sufficient for many GPs.
There are no commissions, which means we like industry fund life insurances.
But once you have kids $166,200 is nowhere near enough cover, if you love them.
Here you can consider:
- arranging extra life cover through your existing industry super fund, such as HESTA or First State Super. You can do this online and it is cheap and commission free;
- joining another industry fund. Most of the industry super funds provide similar cover. The covers are cumulative. Therefore, if a GP is a member of each of Health Super and HESTA, he or she will have twice this Some clients have as many as five industry fund memberships: a remarkably cheap and easy way to arrange a relatively large amount of life insurance without any medical examinations and without any medical non- disclosures; and/or
- arranging a separate life insurance policy directly with a life insurance company through a life insurance agent or
Once kids come into the equation we believe the total sum insured for a couple should be at least $1,000,000. And possibly a lot more, depending on your spouse’s occupation, your spouse’s insurance, the number of kids and your existing family financial profile including your parents’ financial profile.
Life insurance agents and brokers
Sometimes GPs cannot get an appropriate amount of life insurance through industry superannuation sources. Here the only alternative is a life insurance agent or broker.
The problem is commissions. Insurance agents and brokers are rewarded by commissions; initial commissions, bonus commissions, volume commissions and trailer commissions. This means the agent or broker will almost always try to sell you up. That is, increase the amount of life insurance above what you really need to maximise commission income.
To be forewarned is to be forearmed.
Be careful when dealing with insurance intermediaries: they are trying to maximise their commission income more than ensuring you have appropriate life insurance and are not over- insured.
Do not over-insure
Insurance is essentially a bet. You are betting you are going to die inside the agreed term, and the life office is betting that you will not. The life office will probably win the bet. Many GPs will need to make the bet: the consequences of losing are too high to ignore.
Do not bet too much. Make sure the sum insured is realistic and relevant to your dependants’ needs.
What is income protection insurance?
Income continuance or protection insurance involves the GP paying a premium to an insurer in return for the insurer agreeing to pay a set amount to the GP should they be unable to work for more than one month or some other agreed period.
The set amount is usually set as a monthly, fortnightly or weekly amount, and as a maximum tends to be about 70% of the GP’s usual income. Problems can be encountered proving the GP’s income, once super, related party salaries, negative gearing, service trusts and the rest of the tax planner’s armoury is taken into account. Usually communication between the GP’s accountant and the insurer, and an intelligent underwriter, will solve this problem: the larger income can be insured.
Assume a GP damages her back skiing and can’t walk for say three months. Once one month has passed she can claim a monthly amount of, say, $10,000 per month, or the equivalent of
$120,000 a year, under the contract, being 70% of her total reward from the practice. This is so even though her tax return only shows a taxable income of, say, $60,000.
Getting by for less than 3 months is not a big deal for most GPs. It’s getting by for 3 years, or even 3 decades that is our big worry. It’s that bus that does not kill you but causes mild brain damage that is the real concern here: your life expectancy is the same but your earnings fall to nothing. For this reason we usually recommend policies with a three month waiting period rather than a one month waiting period, as the premiums are significantly lower. A sound case can be made for running the risk that a GP is off for between one month and three months, but insuring the risk that the GP is off for more than three months. But it depends on the GP’s attitude to risk. The GP must be comfortable with the risk they run.
The number of financial dependants, whether they be children, parents or siblings, is relevant to the quantum of the sum insured, just as it is in the case of life insurance. But, unlike life cover, GP without any dependants will still need income protection insurance.
Why a 90 day waiting period?
More then one doctor has wanted to know a 90-day waiting period was recommended. They are usually 31 days into a disability and annoyed there is no cheque. Once it is explained that the longer waiting period means a greater benefit for the same premium, so although they lose in the first 90 days they make it up quickly after that, they tend to be quite accepting.
If you are really hit bad and off work for a year or two the 90-day waiting period is a much better option.
Sure, it means you are self-insured for the first 90 days. But that’s a risk most GPs can live with.
The policy documents need to be read carefully, and there is no substitute for an honest and competent adviser. For example, some policies are cancellable: each year the insurer can elect to cancel/not renew the policy if it wishes to. It can cancel the policy, for example, if the insured is in poor health! This is remarkable, if you think about it. Do not touch cancellable policies: only non-cancellable policies should be considered. And the payments must last to at least age 65: many of the cheaper policies stop all payments after two years. Not much good at all for a 35 year old GP with a dependant spouse, three young children with BCIBD, i.e. bus crash induced brain damage, or some other condition that means they can never work as a GP again.
Premiums are usually tax deductible, because they relate to the insured GP’s assessable income, which will include any benefits paid under the policy.
Dr Marcus Barnard developed trauma insurance in South Africa. Dr Barnard noticed his heart attack patients often made a satisfactory recovery health-wise, but were left devastated financially. He encouraged the South African insurance industry to create a new product, which pays benefits on the occurrence of specified health traumas.Trauma insurance was transplanted to Australia in the eighties and was originally limited to heart attack, cancer, strokes and by-pass surgery. It has grown to comprise a significant percentage of the total insurance market and the average contract extends to more than forty different health conditions, although some include as few as twenty. But nearly 70% of claims still involve heart attack, cancer, strokes or by-pass surgery.
Trauma insurance can be on a stand-alone basis or as part of a life insurance policy.
Read that fine print
We are half-hearted about trauma insurance. There is too much devil in the detail. Fourteen years ago, a client suffered a terrible stroke and after five days in hospital the machine was about to be turned off, along with our client. A last minute operation, against the odds, saved the day, and he is thankfully still with us, although there was a huge amount of rehabilitation and he is still under a specialist’s care. He never got his trauma benefits. The policy document was worded so that if he recovered sufficiently, no matter how long it took, the insurer could avoid the payment. It is hard to imagine a more traumatic health event. But it still was not traumatic enough for the insurer.
We have heard of similar problems elsewhere. Trauma is defined in unintelligible terms and different definitions are used in different contracts. GPs regularly tell us the contract definitions of various medical conditions are significantly narrower and more technical than those accepted by the medical profession. Hence our client had, according to his insurer, a non-traumatic near fatal stroke with permanent side effects, and no benefit payments.
Trauma insurance premiums are not tax deductible. This means they are relatively more expensive than income protection insurance premiums, which are normally tax deductible. Although there is a saving if a trauma occurs, as any benefits are tax-free. But with insurance premiums are certain, and benefits are not. So we prefer GPs to take out appropriate income protection insurance before they consider trauma cover.
Trauma insurance contracts can be held by self-managed super funds. But the preservation rules apply and it is highly likely that, unless the GP is 55 or older, most of the benefit will stay locked up in the fund. This is not the end of the world, but it is usually not what you would prefer.
On balance, we are not fans of trauma cover and usually counsel GPs against it, while thoroughly checking the life income protection boxes are ticked off.
Once again, if you do have trauma insurance you should make sure it’s commission free. Insurance commissions are huge: more than 25% of all premiums are paid back to the insurance salesman as a commission, unless you do something about it.
Property and business insurances tend to trigger fewer emotional reactions than personal insurances. The dollar and senses aspect of the analysis gets more priority. But the basic approach is the same as for personal insurances. The key steps to evaluating any insurance proposal are:
- identify the risk, ie what is the event you wish to insure against?
- ask what is the probability of that event occurring?
- ask what are the economic consequences of the insured event occurring?
- ask what is the proposed cost of insuring against that risk and those consequences? and
- decide if the cost is worth the benefit?
A cautious conservatism is required, particularly in the area of business insurances. We confess to thinking that many GPs are over-insured and that there are serious savings to be had by deleting unnecessary insurances wherever possible.
The insurance companies have come out with a whole range of insurances directed to the needs of the business sector. Many of these are actually applications or modifications of traditional insurance contracts rather than purpose specific insurance policies.
These insurances include key person insurance, split dollar insurance, business continuity insurance and similar contracts. We confess to not being too keen on these, for our GPs at least, and believe that most applications to GPs have been driven by the salesman’s thirsts for commission income rather than an objective assessment of risk. Thankfully these insurances have all but disappeared over the last ten years or so, and the abusive eighties and early nineties are just memories.
Our view is that most GPs’ needs will be more than satisfied by the traditional applications of personal risk insurances, particularly life insurance and income continuance insurance, and that separate so called business insurances just aren’t needed and are a waste of money.
Key person insurance
Key person insurance aims to indemnify a business (or more strictly its owners) against the loss of profit caused by the disablement or premature death of a key person. The normal examples of key persons provided in the text-books are the managing director with a wealth of knowledge and contacts in the relevant industry or the gun salesman who generates more than his fair share of all new sales.
Neither example is analogous to GPs, or at least commonly encountered GPs.
The big benefit claimed for key person insurance is that the premium is tax deductible. This is not relevant to GPs as their risk insurance premiums can be easily structured so that they are deductible. So even if a particular GP is a key person, the claimed benefit is superfluous.
GPs should not bother with key person insurance. The focus should instead be on whether there are adequate other risk insurances, ie life insurance and income continuance insurance.
Business expense insurance
This is a risk insurance contract aimed at covering the GP against the loss of profit connected to not being able to run his or her practice. So, if a GP was laid up with malaria for 6 months and had to continue to pay the costs of his or her practice whilst laid up, these costs would be recovered from the insurer.
This sounds great in theory but sadly turns out badly in practice.
This is because of the principle of loss mitigation. When a claim is made the insurers invoke this principal to basically require the GP to close his or her practice, i.e. shut the doors, put off the staff, cut off the electricity and, if possible, even terminate the lease, so that the insurers costs are mitigated, or better, eliminated. So that in the end the insurer only has to pay two or three months of costs. This is not big bikkies. And it is in sharp contrast to what the marketing documents said in the pre-sale stage, i.e. before the GP signed up.
Business expense insurance is not common amongst GPs, and we think this is a good thing. The risk it purports to address are much better covered by an income continuation policy with an appropriately large sum insured.
Each of the states and territories has compulsory basic third party cover insurance. This insurance is collected via the car registration processes. It protects the insured against claims by other persons for physical injury caused by the use of a car or other motor vehicle. The amount of the premium is set by the government and does not consider the individual driver’s circumstances or the value of his or her car. But obviously the population averages are considered when the actuaries do their thing and advise the government on what the premiums should be.
Occasionally we come across a driver who has not paid his or her car registration fees or is otherwise driving an unregistered car. Apart from being a breach of the law, this is also dangerous as the driver is not covered by compulsory third part motor vehicle insurance, nor any other insurances. If there is a serious accident the driver could be wiped out financially, not to think of the physical pain and suffering caused to the other driver and passengers. Happily the incidence of driving unregistered cars is not high amongst GPs. But it is a useful reminder of the importance of paying the registration fees on time.
After compulsory basic third party cover insurance there are a range of other car related insurances that can be considered. Cover differs from insurer to insurer and from contract to contract, so close attention to the fine print is always wise.
The major types of car insurance are:
- comprehensive insurance cover. This is the widest cover possible. It covers all damage to the car, usually based on market value but sometimes based on agreed values, and unlimited damage to third The amount of the premium depends on the driver’s circumstances and the value of the car;
- fire and theft This protects against the risk of financial loss due to, you guessed it, the car being burnt (rare) and the car being stolen (common) or both; and
- extended third party This protects against losses caused to third parties, ie other drivers and passengers, and does not cover losses to the driver, whether due to injury or due to fire or theft of the car.
GPs usually have higher dollar value cars, and hence there is a greater need for them to insure their cars than for most people. But the question of how much cover should be bought still needs to be thought through on a case by case, and car by car, basis.
For example a GP may decide that she has a lower than average risk of damage because she:
- only drives the car a short distance to the surgery each day and for local private travel, and does not otherwise use the car for long distance or frequent driving (example, from Melbourne to Surfers Paradise and back each school holidays) so that car use is well below the average of 15,000 kilometres per driver, and hence the basic risk faced by the GP is well below the average risk faced by a driver; and
- does not drive a car in the luxury car price bracket, for example, drives a second hand BMW costing $50,000, rather than a $150,000 Mercedes Benz;
a particular driver, whether it be the GP, a spouse or another family member, faces a below average qualitative risk, for example because he or she:
- does not speed and generally drives in a cautious and non-aggressive manner;
- does not drink and drive, even under the legal limits, and does not drive when extremely fatigued or otherwise drive when attention and response times are likely to be low;
- does not park the car in a suburb where there is a low risk of theft;
- uses a secure and lockable garage; and
- generally uses common sense to eliminate unnecessary risks connected to driving and owning a
The circumstances of both the car and the driver or more accurately, the drivers, should be considered before deciding on insurance for each car. It may be logical to have heavy insurance cover for the more expensive car that notches up the large kilometres, but only have low cover for the second car that only covers a few thousand kilometres a year around the local suburbs.
Car insurance costs are generally tax-deductible for a GP, to the extent that all car costs are deductible.
Chapter 10 – Super for GPs
Superannuation is a tax efficient financial planning tool that integrates tax planning with investment strategies to produce superior long-term results.Superannuation tax concessions aim to decrease reliance on welfare and increase economic independence in retirement. There are three main concessions. They are:
- deductions for contributions;
- low tax on income and capital gains in the accumulation phase; and
- no tax on income and capital gains in the pension phase.
This seems simple enough. And for most people they are a generous set of rules that, if acted on, almost guarantee a comfortable retirement and a significant legacy to the next generation.
When these rules are combined with the height, stability and longevity of a GP’s income, and the fact that most GPs are self -employed, they become an irresistibly powerful wealth creation strategy well beyond what can be achieved by most people. This is because:
- GPs have stable incomes, and strong borrowing ability, so locking money up in super to age 60 is not a significant risk;
- GPs have high incomes and can usually afford to pay the maximum contribution every year, from a young age on;
- GP spouses can usually afford to pay the maximum contribution every year too;
- GPs work much longer than most people, and hence pay the maximum contributions over a longer period;
- GPs are more likely to pay large non-concessional contributions, to build up the super benefits even faster;
- GPs are more likely to take advantage of the rules for gearing SMSFs, which are a powerful investment strategy;
- GPs are usually self-employed via practice entities, and this means they can borrow to pay deductible contributions, and the interest is tax deductible to the employer; and
- GPs are more able to integrate a sensible super strategy into their broader and more comprehensive financial
Just pay those super contributions every year
Super has existed for almost 30 years. This means there are now doctors who have accumulated more than $7,000,000 in super benefits just by paying the maximum amount to their SMSF every year for the last 25 years, ie from the time we first met, and invest the SMSF in share based index funds.
A simple, low cost, commission free strategy that any GP can implement.
They have not lived frugally. They have enjoyed themselves, put their children through a good education, travelled, socialised and generally had a great time.
At age 60 they are worth about $10,000,000, made up of a home worth $3,000,000 and the SMSF worth $7,000,000. They confess to being surprised at how easy it was. Just pay those super contributions every year, and pay off the home loan as fast as possible.
The $10,000,000 is invested tax-free. Realistically, it will grow by about $800,000 to $900,000 a year from here on. They are still working, and are still contributing the maximum amount every year. They expect to do this for at least another 10 years, and possibly another 15 years, and realistically the SMSF will be worth more than $30,000,000 by then.
The big payoff is peace of mind. They are financially secure, and it’s hard to see what can go wrong from here. The property and share market could both fall 50% and they would still be very well off (while everyone around them is ruined). They do not lose sleep worrying about their financial future. But they often stay up late planning their next overseas holiday.
This peace of mind extends to the next generation too. Each of their children will inherit a significant amount of wealth. Like most parents they do worry about their children. But unlike most parents they do not worry about whether their children will be able to earn a living. That’s not an issue.
This is why we implore every GP we meet to pay the maximum super contributions every year, ideally to a SMSF, and then invest in blue chip shares, property and index funds, with a 20 year time horizon and a “never sell” philosophy.
(Admittedly, a GP with $7 million in super has been able to take advantage of many generous super concessions that are not available today: for example, the old $100,000 contributions cap meant some years they paid $200,000 into super. Its fair to say $10,000,000 over 25 years is a tough target these days. Perhaps $5,000,000 over 30 years is more realistic. But you can see our point.)
Even if you do nothing else, pay the maximum super contributions every year. Just do this and you will end up wealthy. Maybe not super-rich. But certainly happy.
How can a GP best use the super rules?
Careful planning over the years, even the decades, leading up to age 60 is the key. GPs should start super planning as soon as possible.
Paying the maximum deductible contributions each year, for both yourself and your spouse, is a good start. Get your super balls rolling as early as you can and make a big effort to pay the maximum deductible contributions whenever possible.
What are the tax savings for deductible contributions?
The potential tax savings for deductible contributions depend on the GP’s age (which determines the amount that can be contributed) and marginal tax rate.
From 1 July 2014 the general cap on maximum concessional contribution is $30,000, and $35,000 for those over age 49 on 30 June 2014. The tax saving is shown here:
|Taxable Income||Marginal SMSF|
|Net Tax Saved|
on cap of $30,000
on cap of $35,000
|$37,001 to $80,000||32.5%||15%||17.5%||$5,250||$6,125|
|$80,000 to $180,000||37%||15%||22%||$6,600||$7,700|
|$180,001 and above||47%||15%||32%||$9,600||$11,200|
|* Does not include Medicare Levy or Deficit Reduction Levy|
Many GPs can employ and superannuate a spouse. This means these amounts are doubled.
The ATO view on GP’s employing spouses
The ATO accepts that a spouse who is a genuine employee can be superannuated up to the deductible contribution limit. This is so even where the amount is excessive relative to the market value of the work done by the employee spouse.
Special care is needed when the spouse is a director of a company. The ATO requires directors to be general law employees before contributions are deductible to the employer.
To make sure there are no problems we recommend a three-pronged approach:
- ensure the GP’s spouse is a genuine general law employee and does an appropriate amount of real work for the practice, and pay the spouse a market salary for this work, to evidence the employment relationship;
- ensure the spouse to be a director of a company; and
- create minutes of directors’ meetings recording that the spouse was under-rewarded in previous years.
If this is done there should be no problem in claiming a deduction for contributions paid for a GP’s employee spouse.
What are industry super funds?
Industry funds come from the ACTU accord with the Hawke government in 1983. The idea was simple: the government would legislate for mandatory employee contributions for the previously un-superannuated union members, and the unions would set up super funds to receive these contributions. (And the unions would not go on strike.)
These early union funds were not for profit and adopted a “members first” orientation which manifested in low costs and no commissions. Over time they grew, widened their membership criteria, and became more efficient, but never lost their members first orientation. This is why we recommend industry super funds to GPs who do not have enough super, or the inclination, for a SMSF.
Favourable features of industry funds include:
- they have very cheap life universal life insurance;
- extra life insurance can be arranged at low cost;
- they usually have 5-15 investment options, which will match most GP’s preferences;
- most funds are accumulation funds, at least for new members;
- they have low operating costs;
- they have never paid commissions;
- they are not for profit;
- they consistently earn higher net rates of return than retail funds run by large institutions; and
- some offer MySuper
GPs tend to be members of one of two main health industry funds, being HESTA and Health Super, which merged with fellow industry fund First State in 2011.
HESTA and First State are well regarded and are popular with GPs and their family members. Unless a GP wants to run a SMSF we rarely see any reason to switch out of HESTA or First State and we routinely recommend GPs become or remain members of these funds.
According to the Australian Prudential Authority report on Super fund-level Rates of Return at 30 June 2013 (issued 8 January 2014) industry super funds were the highest earning funds under its jurisdiction. This report can be accessed on www.apra.gov.au. Self-managed super funds were not included in this report.
Why GPs should use SMSFs
SMSFs suit most GPs.
Over the last 30 years we have seen SMSF clients record consistently better investment results, experience lower operation costs and enjoy greater control, information and protection compared to both retail super funds and industry super funds.
This is consistent with empirical studies showing SMSFs achieve better investment results and have lower costs than both retail super funds and industry super funds.
Any investment will do better in a SMSF than in some other part of a GPs’ financial structure.
Where the GP faces a marginal tax rate of 37% or 47% (which is virtually every GP) any investment will perform better in a SMSF. This is because:
- the tax deduction for contributions means up to 32% more cash is there for investment at the beginning of the investment’s life (ie 47%, the top tax rate, less 15%, being the SMSF tax rate);
- because more money is invested each year, investment earnings are greater. A head-start is created and this lasts for the life of the investment; and
- the SMSF’s income is taxed at no more 15% and realized capital gains are taxed at 10% (and sometimes 0%), so the after tax rate of return on the investment is always greater than for a 47% taxpayer, meaning there is faster compounding in a SMSF than outside of super.
This advantage is deliberate government policy. The old age pension is being replaced by a system of private pensions. It is a mathematical certainty that an investment in a SMSF will do better than and identical investment in a non-super environment.
A SMSF means you don’t have to wait for months after 30 June each year to find out how your investment is performing (or even what it is invested in). The information is always readily available. Most trustees can access information on virtually a daily basis.
The rapid growth in internet trading is increasing the amount of information. Most e-traders provide free portfolio tracking software, which means clients get immediate reports on the state of their portfolios at any time.
Cheap software packages make it even simpler for SMSFs to run their own investment portfolios with minimum effort and maximum fun.
Synergy with the GP’s other investment and business strategies
SMSFs can create synergies with the GP’s other investment and business activities. The SMSF’s investment strategy should be part of an overall investment strategy reflecting the GP’s attitudes and goals. The member’s will and estate planning should be considered as part of this strategy.
For example, it can make sense for a SMSF to only invest in Australian shares if the GP’s family trust is investing heavily in property. The overall portfolio is balanced and diversified, even if the SMSF invests solely in shares.
The 2013 ASX Report says Australian shares averaged 9.8% and Australian property averaged 9.5% in the two decades to December 2012. If a SMSF has a simple buy and hold strategy costs are very low.
It’s hard to see how a managed retail super fund with thousands of members of all ages, from all walks of life and with vastly different financial profiles can be as efficient as a SMSF.
One retail fund cannot be all things to all people. But one SMSF can be all things to one GP and her partner.
Tax free death benefits
In most cases eligible termination payments paid direct to a deceased GP’s dependants are tax-free in the dependant’s hands. This applies to all super funds, not just SMSFs. But as SMSFs are usually controlled by the deceased member’s nearest relatives there is more tax planning potential and certainly more control.
SMSF assets are protected from bankruptcy. This means a trustee in bankruptcy cannot access the benefits and the benefits are held for the member. Benefits paid out during a bankruptcy, say, on the member reaching a specified age, or before bankruptcy may not be protected.
(Keep perspective: few GPs go bankrupt, and we have never seen a GP go bankrupt from running a practice. It’s always bad investing, and abuse of debt.)
Capital gains tax efficiencies
SMSF investment income is taxed at 15% and capital gains are taxed at no more than 10%, provided the asset is held for more than 12 months while it is in accumulation phase. This gives SMSFs a significant advantage when it comes to deciding which entity should hold an asset that is expected to increase in value. But the tax benefits get even better once the SMSF starts to pay a pension to members: SMSF investment income becomes tax free.
Remember that capital gains are applied in the year the gain is realized, not in the year the gain accrues. Unrealised capital gains are not taxed. SMSFs allow GPs to eliminate CGT by controlling the timing of asset disposals. This means the realization of gains (and, in many cases, other income) can be deferred to a year when the SMSF pays nil tax, ie when the members are being paid pensions from the SMSF. With planning most capital gains can be derived tax-free using this method.
For example, a forty-year old GP may decide to roll $200,000 of her super benefits from HESTA to a new SMSF, borrow $400,000 and buy a property for $600,000. The $25,000 a year rent covers the interest on the loan. The SMSF will not sell the property until the GP is 60 and the SMSF is in pension mode. The whole of the capital gain from age 40 on will be CGT free. This is so even though most of it accrued while the SMSF was taxable.
Retirement planning for children
SMSFs can be used to obtain retirement benefits for spouses, children and even grand children. SMSFs are a sophisticated method of cross-generational wealth transmission.
SMSFs can choose to only hold investments they believe are ethical. Trustees can structure the SMSFs’ investment strategy so that no unconscionable investments are held, and socially advanced investments are emphasized.
It’s a pleasure: SMSFs as an enjoyable way to spend your time
Most GPs with SMSFs simply enjoy managing their own super. They are genuinely interested in investing. They enjoy learning about investment opportunities. They feel safe knowing exactly where their money is at all times and not being exposed to someone else’s bad investment decisions. They know most fund managers do not beat the market and they are
SMSFs do not have to take up a great deal of time. Some GPs get by with just a few hours a year. They only buy quality blue chip shares or other conservative investments, such as index funds, and never sell. This strategy has worked well over the last few decades and has the benefit of lower administration costs since there are fewer transactions to monitor.
Other GPs enjoy spending a few hours a week or in some cases even a few hours a day attending to their SMSF investments. They believe they can add to its performance by paying closer attention and investing. Older GPs who are retired from full time practice are more inclined to do this. With the low cost of e-trading, and the huge amount of information available on the Internet, we are seeing a new class of investor who works his or her SMSF hard to make extra profits.
Whether one method is better than the other is not clear. And it really depends on the ultimate choice of investments. But for many clients spending a few hours on their investments beats playing bowls. As Barbara Smith and Austin Donnelly said in “Do It Yourself Superannuation” under the heading “Psychological Benefits”:
Other benefits enjoyed by some trustee members are the interest and satisfaction from buying shares or property and watching market developments closely, particularly in relation to the share market. This process is an absorbing interest for some people.
Tax-deductible life insurance premiums
Life insurance premiums paid through a SMSF are tax deductible. This can almost halve the cost of the cover and is the cheapest way to arrange insurance. Often the tax benefit of deductible premiums more than covers the cost of running the SMSF.
Any insurance benefits paid will be included in the SMSF’s assessable income. Whether there is a tax charge or not will depend on the fund’s tax profile: the worst case is a tax charge of 15%, and the best case is a tax charge of 0%, which will apply if the SMSF is paying an allocated pension at the time of the member’s death.
Roll-over of taxable capital gains
Small businesses, including businesses in companies and trusts, can roll over taxable capital gains on the sale of their businesses into their SMSF. This rule acknowledges that businesses are often the main retirement asset for many people. Conditions apply and expert advice should always be obtained whenever a business is sold.
Goodwill values for general practices are quite low, and it’s rare to see a significant roll over.
An exception is a sale to a large corporate for say $500,000. Here the $500,000 is usually received CGT free, due to a combination of CGT exemptions, including an exemption for amounts rolled over to a super fund.
If a business is sold at a capital gain of $500,000 the CGT position will often be like this:
|Less 50% exemption||$250,000|
|Less Active asset exemption||$125,000|
|Amount rolled over||$125,000|
|– Amount taxed Reversibility||Nil|
If for any reason a GP decides a SMSF is not for them, it’s the easiest thing to reverse the decision. This can be done by paying an ETP, paying tax, and then reinvesting in a non-super environment or by rolling over to a managed super fund. This reversal is simple and cheap to complete, and the GP has not wasted thousands on entry fees and even more thousands on exit fees!
Other reasons for SMSFs are:
- increased information: you don’t have to wait for months after 30 June each year to find out how your investment is performing. The information is always at hand. Most trustees can access information on a daily basis;
- synergies with the member’s business activities (eg ownership of practice premises) or other investments. This means the SMSF’s investment strategy makes sense as part of an overall investment strategy. For example, it can make good sense for a SMSF to own the surgery and rent it back to the practice entity or service entity on an arms length rent;
- control over the fund. This may be the most important advantage. Control and security appeal to self-employed or professional people and GPs are no exceptions;
- tax-free death benefits. Benefits paid to a deceased member’s dependants are usually tax free in the dependant’s hands even if the member is not 60 years old;
- SMSF assets are protected from bankruptcy;
- control over the timing of income: capital gains and, in many cases, other types of income, can be deferred to a year when the SMSF pays nil tax;
- retirement benefits for spouses and SMSFs can be even used to create retirement funds for spouses and children. They can be used to help grand-children: SMSFs as a sophisticated method of cross-generational wealth creation and transmission is a growth area at the moment;
- tax-effective savings. The deduction for contributions and the low rate of tax (15%, 10% or nil %) means virtually any investment will do better in a super fund; and
- access to unrestricted non-preserved amounts at any time without having to retire, in the same way a member can access benefits held in an In some cases a SMSF can be used as a low tax rate (or even nil tax rate) bank account.
What about locking up my money?
GPs are sometimes concerned that super based strategies mean their money is locked up and unable to be accessed, or at least easily accessed. This is true. Supe rbenefits are generally locked up, or preserved, until normally at least age 55. But this is unlikely to be a problem for GPs. This is because:
- they have strong cash flow from their practices;
- they have significant borrowing ability, with or without security;
- they usually have sufficient life insurance and income insurance to cover adverse health events (with death as the ultimate adverse health event);
- super benefits can be paid at age 55 or earlier on death or serious illness; and
- many GPs will have other forms of investment that are not locked up and which are accessible, such as shares and properties in the name of a spouse or a family
How much does it cost to establish a SMSF?
It can cost less than $1,000 (plus GST) to set up a SMSF. This includes the trust deed, ATO registration, tax file number application, assistance with bank accounts and assorted other minor tasks connected to setting up the SMSF.
We have seen GPs charged as much as $8,000 to set up a SMSF.
It pays to shop around, and search the internet. Don’t be misled by an adviser saying they have a special quality deed or other document. SMSF documents are amazingly standardised (which is actually a good thing) and virtually all advisers source them from a small group of bulk suppliers, such as www.legaledocs.com.au, which sets up SMSFs for about $100.
The process for setting up a new SMSF
In most cases the accountant attends to these matters for the trustees, but technically they are still the responsibility of the trustees. This list is not in chronological order.
- Determine who will be the members and who will be the trustees.
- Execute a trust deed. A solicitor must prepare the deed. To execute the trust deed the trustees must sign and date the deed.
- The member completes a member’s application form.
- The employer contributes to the SMSF, the member contributes to the SMSF or existing benefits held in another fund are rolled over into the SMSF. The SMSF does not start until one of these three events has occurred (since without trust property there cannot be a trust).
- A tax file number request and an ABN application goes to the tax office.
- An application to register as a regulated fund is lodged with the ATO within 60 days.
- The trustees open a bank account in the name of the SMSF. This may be, for example, something like “Joe Smith as trustees of the Smith Super Fund.” The trustees will need to provide a signed copy of the deed and pass a “100” point identity check. A corporate trustee will also have to show a copy of its constitution and prove the identity of its directors.
- A register is created to record the minutes of meetings of the trustees. This is normally a ring binder that includes copies of the trust deed, and all other documents to run the SMSF and a copy of all trustee minutes and the accounts of the SMSF. But this register will also have a digital counterpart.
- An administration system is created to record the financial position of the SMSF and the details of member’s This need be nothing more than the correct completion of all cheque butts and the filing of all documents relating to the SMSF, eg the CHESS records for the purchases and sales of shares, and ideally include setting up on Banklink.
- The trustees provide members with certain information regarding the fund.
- The Trustee signs a statement saying they understand the duties of a SMSF trustee.
Retail super funds are large funds run by institutions for a profit.Retail super funds market their products through controlled financial planners. These financial planners are usually not allowed to recommend any other type of superfund to their clients and are strongly encouraged to only recommend in-house products.
Retail super funds have high operating and marketing costs and these are passed on to members. This means net investment returns are much less than otherwise.
GPs should generally roll out of retail super funds to industry funds or SMSFs depending on their circumstances and preferences, and recommend GPs do not use retail super funds.
Chapter 11 – Debt and GPs
Consumer debt is debt incurred on consumer products and services.Consumer debt is usually very expensive – some credit card debts charge up to 20% per annum – and is not tax deductible because it does not relate to assessable income.
We once met a GP with a credit card debt of more than $250,000. The interest bill was about $50,000 a year, and the GP had to earn nearly an extra $100,000 a year just to pay the interest: 20% non-deductible is the equivalent of nearly 38% deductible. That’s extremely expensive money and it’s impossible to get ahead with that sort of a millstone around your neck. Particularly if it means you have to work seven days a week every week just to make ends meet.
Happily most GPs know consumer debt is expensive and avoid it wherever possible. Encounters like this are very rare. Our GP ended up consolidating the loan on to his home loan, and effectively reducing the interest rate to a much more manageable 5% per annum. This was not hard to arrange: GPs are excellent credit risks, it’s due to the height, stability and longevity of their incomes, and a new bank was more than happy to do the deal.
Home loan debt is debt incurred on buying, maintaining or improving a home.Home loan debt is usually not that expensive, since the loan will be secured by mortgage over the home, and this means there is little risk for the lender. Rates are currently about 5%.
Home loan debt is not tax deductible: it is not incurred for the purpose of producing assessable income and it is inherently private and domestic in nature. This means a GP has to earn nearly $2.00 for every $1.00 of home loan interest, and 5% non-deductible is the equivalent of nearly 9.5% deductible. That’s still expensive money, and although not impossible, it’s hard to get ahead with that sort of a millstone around your neck.
GPs should pay off home loans as fast as possible. Paying off a 5% home loan is the same as earning about 9.5% capital guaranteed, adjusted for tax. That’s the best investment a GP will ever make (except for owning a practice).
Are there faster ways to pay off a home loan? Sometimes there are. For example, a GP setting up a new practice with $100,000 cash in the bank may choose to pay the $100,000 off the home loan and borrow to pay for the new practice. Get advice if not sure how these strategies work.
Interest offset accounts
Interest offset accounts are recommended for all GPs with home loans. Don’t pay off the home loan, and don’t put the money on deposit either: pay on to the interest offset account instead. There are two advantages:
- the GP does not get taxed on interest income, and instead pays less non-deductible interest (equivalent to 9.5% per annum); and
- the GP can withdraw their equity from the offset account when up-grading the home, and retain the old home as a geared residential property investment
Investment debt is different to consumer debt. Properly managed investment debt improves the GP’s overall economic returns and helps build long term wealth.Economic theory predicts in the long run interest rates will be less than the average returns on properties and shares. If this not the case in the short run borrowers will stop borrowing. This reduced demand will lower interest rates. Eventually interest rates will fall below the average returns on properties and shares, plus a premium for risk, and borrowing will recommence.
Borrowers will only borrow if they expect average returns on properties and shares to be greater than the interest rate.
Economic history shows the theory to be correct. The ASX Report for 2013 says Australian property earned an average of 9.5% per annum and Australian shares earned an average of 9.8% per annum over the two decades to December 2012.
This means most GPs who borrowed to buy representative properties and shares over the last two decades increased their wealth by doing so. This is because the assets earned more than 9% per annum, but only cost about 7% per annum. This is what we have seen with our clients over this time too. Examples abound, and include:
- the GP who borrowed big to buy a Brighton surgery in 2000 for $550,000, who geared it up again in 2006 to extend it for $500,000, and who in 2014 owns a debt free $2,000,000 CGT free asset producing about $120,000 in rent a year; and
- the GP who started buying index funds in 2007, just before the GFC, and continued buying while the market was falling, and while the market was recovering, and now has a simple, low cost, commission free, investment portfolio worth more than $1,000,000 on top of his super and
Positive gearing is where the income from a geared asset is greater than the interest.For example, in December 2012 ASX Investor Update newsletter Paul Zwi from Clime Investment Management observed that National Australia Bank shares offered a high dividend rate of 7.5% or 10.7% grossed up for franking credits.
GPs who borrowed to buy NAB shares would have experienced positive gearing, income greater than the interest cost. The shares would have paid for themselves, and a bit more, even before capital gains were considered.
Positive gearing reduces risk and by improving cash flow it improves the GP’s ability to reduce debt or make fresh investments or both.
Common sense is needed: the critical question is will the expected income in fact be derived? Do your due diligence, but to be frank if you stick with blue chip investments like NAB shares it’s hard to see what can go wrong.
We have seen structured positive gearing products blow up in GP’s faces. In 2007 one well- known institution marketed a positive gearing arrangement where GPs borrowed from one arm of the institution at 9% per annum, to invest in another arm of the institution at a “guaranteed” 12% per annum. What could go wrong? Well, what went wrong was in the fine print all the time. The guarantee was not a very good guarantee and was in fact discretionary. Not surprisingly, after about 6 months the institution invoked its discretion and stopped the 12% income payments to GPs, but enforced the 9% interest charge on GPs.
From the institution’s point of view the fine print was very fine: there was nothing the GPs could do but pay up and wait for five years to get their money back, less interest.
The institution made a fortune from it.
Negative gearing occurs where the income from a geared asset is less than the interest cost, creating a loss. GPs can usually offset this loss against other income for tax purposes. This creates a tax benefit, in the form of less tax being paid than otherwise, and this tax benefit in a sense adds to the investment return on the asset.Negative gearing does not make economic sense, however, unless the GP expects to earn a capital gain greater than the loss, so that overall the GP is better off from making the investment.
This capital gain is not taxed unless the asset is sold, and even then usually only half the gain is taxed, provided the asset was owned for more than 12 months.
How does negative gearing work?
A simple example shows how negative gearing works. Let’s assume a GP buys $100,000 of property using alternatively no gearing, 40% gearing and 80% gearing, and after one year the property increase in value by $10,000. The position is as follows:
|Equity invested||Amount borrowed||Amount invested||Gain||% Increase|
Gearing leverages the investment to increase gains when asset values rise.
But there is a reverse gear too. Gearing leverages the investment to increase losses when asset values fall. Let’s assume our GP stays in the market with her $110,000 of geared property using alternatively no gearing, 40% gearing and 80% gearing, and in the second year the property falls in value by $20,000. The position is as follows:
|Equity Invested||Amount to be borrowed||Amount Invested||Gain||% Increase|
The tax benefit of $1,800 is a cash benefit, and is the equivalent of $3,272 in pre-tax income, representing an extra 3.3% net return on the investment. Over time rents will rise and depreciation will expire, and the tax loss will become a taxable income.
Our GP knew she would incur this tax loss in the early years, but was prepared to cop it because she expected taxable income in the later years and because she expected the property to increase in value over time. Her time profile is decades, not years.
Has negative gearing worked for GPs?
Historically negative gearing has worked well for GPs. Most GPs who borrowed to invest did well, over time. Gearing has worked best with quality well located residential property, surgery premises and blue chip shares. Australian shares index funds are particularly suited to gearing compared to individual shares, because they have relatively lower risk.
The ASX Report for 2013 says that Australian property returned 9.5% and Australian shares returned 9.7% in the two decades to December 2012. Interest rates averaged less than 7%, which means most GPs who negatively geared property or shares over the last two decades improved their net wealth.
It’s likely that over the next two decades most GPs who negatively gear property or shares will improve their wealth.
It’s not about the tax
It’s critical to see negative gearing as an investment strategy with a tax flavour, rather than a tax strategy with an investment flavour. GPs should never negatively gear an investment just to get a tax benefit. Negative gearing only makes sense where the GP genuinely and reasonably expects the after tax capital gain on ultimate sale, plus a premium for risk, to be significantly greater than accumulated tax losses on holding the asset, adjusted for the time value of money.
What sort of investments should be geared?
Most well located metropolitan residential properties, blue chip shares and index funds are suited to long term gearing strategies. They have stable and predictable income streams and are relatively low risk. It’s safe to say they will stand the test of time and still be there, generating income and holding their value, two decades from now.
What about apartments?
In 2014 we are seeing heavy marketing of apartments, particularly pitched at GP’s SMSFs. Tax benefits feature in the glossy spreads. Yes, there will be tax benefits, but these will not compensate for the poor or even non-existent capital gains on these investments.
All the tax planning in the world cannot make a bad investment into a good investment, and GPs should only borrow to buy good investments. We expect that two decades down the track apartments will not feature in any “great investment” stories.
And apartments definitely should not be geared.
Risks of gearing
We generally encourage GPs to negatively gear investments, particularly blue chip shares and properties. Provided common sense is used, and a very long-term view taken, these investments will probably do very well. But there are some risks. The Australian Financial Planning Handbook 2012-13 (Thomson Reuters) identifies 6 main gearing risks. These are:
- the risk that the investment’s value will fall;
- the risk that interest rates will rise, causing net returns to fall;
- the risk of a margin call, or some other form of equity contribution being needed to preserve the lender’s required debt to equity ratio;
- timing risk, ie the risk that income may lag behind interest payments causing stress;
- occupancy risk, ie the risk that a suitable tenant cannot be found or that a tenant will damage the property (only applies to geared property investments); and
- other risks, such as losing income due to unemployment or
The nature of a GP’s income, ie its height, stability, scalability and longevity, and borrowing ability, mean that these risks should be of less concern than for others. The GP can assume these risks, comfortable that they can ride out any rough patches, and that in two decades time blue chip shares and properties will still be there and will have increased in value.
But obviously common sense is needed.
Noel Whittaker, in his book “Golden Rules of Wealth” (Simon and Schuster 2011) dedicates chapter 32 to a vigorous argument for never guaranteeing someone else’s loan.We agree that GPs should not guarantee someone else’s loan if they are not related to that someone else. What’s the point of doing that? It’s all risk and no return. If the borrower defaults the bank will look to the guarantor first, since the guarantor normally has the deepest pockets.
Yes, the guarantor can recover from the borrower under the doctrine of subrogation, but its complex, may involve legal action and what happens if the borrower just can’t pay?
It’s a good idea for GPs to have a policy of not guaranteeing someone else’s loan. For example, if you are asked to guarantee another GP’s loan for the surgery premises, don’t. Don’t be intimidated into it: if the other GP says they will lose money if you do not give a guarantee it is almost certain you will lose.
Guarantees for a GP’s spouse/life partner are a different matter. Both partners are an economic entity and the bank will see them as in effect one client. If say the husband wants to borrow say $500,000 to buy $500,000 of shares, and offers the family home, value $1,000,000, as security, then realistically the bank will want a spousal guarantee particularly if the home is co-owned by both spouses.
This is fair enough. Both spouses benefit if the shares increase in value, and both spouses should secure the loan. The bank is not being unreasonable. Of course occasionally one partner may not agree gearing shares is a good idea. Here the unhappy partner should refuse to sign the guarantee. Obviously both spouses need to agree with a big decision like this.
Guarantees for a GP’s children are a different matter too. We frequently suggest GPs volunteer to guarantee loans to adult children as a fast track to entering the property market years earlier than otherwise would be the case. In early 2014 the Melbourne median home price was more than $600,000 and the Sydney median home price was more than $650,000. That’s a lot of loan. How can an average income 30-year single person buy a home without parental support? Take care, and make sure your child is buying sensibly, and it’s almost certain the strategy will pay off.
Limited guarantees are a great idea here. The bank limits the guarantee to say 30% of the amount borrowed. This 30% guarantee takes the place of owner’s equity, and means the bank has met its normal debt to equity ratio of say 70:30, and is adequately secured.
Guarantees for a GP’s companies and trusts are a different matter too. Sometimes the company or trust will have plenty of assets and there will be no need for a related party guarantee. For example, a company with $2,000,000 of property will be able to borrow $1,000,000 to buy another property without a related party guarantee.
It’s unrealistic to think a bank will lend money to a company or a trust without significant assets unless the directors and related persons guarantee the loan.
Your bank manager is not your friend
Your bank manager is your opponent. His income is your cost. He sits on the other side of the table and is interested in you paying as much as possible for the money you borrow.
You can be friendly but do not be friends.
Look for the cheapest loan possible
The interest reduces the net return on the investment. The higher the interest rate, the lower the net return. So it makes sense to minimize the interest paid on a loan.
Ensure interest is tax deductible
The first way to do this is to make sure the interest is tax deductible, in the sense of being connected to assessable income. Most GPs pay a reasonably high rate of tax and claiming interest as a tax deduction reduces the amount of tax paid. When debt is used to buy or hold an investment the interest is deductible.
GPs should separate their loans so they are not used for a mix of private and investment purposes. It is better if the borrowings are in different loans. Quarantine them. Don’t mix them up. This makes it clear the debt was used for investment purposes, and helps make sure the interest is tax deductible.
Minimise the interest rate
Make sure you do not pay too high an interest rate. Some banks try to charge higher rates than necessary. The person you are talking to is usually on commission (and that includes many bank managers), the incentive for a lender to help the borrower get the lowest rate possible may not always be high. Your accountant should be able to help here.
Sometimes a GP will take a loan in the name of the trustee of his or her family trust, or perhaps the trustee of his practice trust. This trustee is usually a company, with the letters ‘pty ltd’ after the name. Some lenders will assume that the loan is a business loan and try to apply a higher interest rate. Don’t agree to this. Banks will lend at home loan rates to a company or trust if the underlying security is a residential property.
In summary, if the security is residential property the home loan interest rate should apply.
The home as security for a Loan
Any asset can be used to secure a loan. It does not have to be the asset bought with the loan. For example, a GP may mortgage their home to buy index fund units. The interest will be deductible because the purpose of the loan is to earn assessable income. The interest rate will be low because the home is the best security for a loan.
This is the cheapest way to finance an investment, and one we routinely recommend to GPs.
Sometimes GPs worry about using the home as security for a loan. They are concerned the home may be lost if the borrower defaults. This should not really be an issue. The issue is the net wealth of the borrower. Net wealth is the difference between what the borrower owns and what the borrower owes. If a borrower owes $100,000 on a $500,000 property, for example, and there are no other assets, then the net wealth is $400,000.
Provided the overall net wealth exceeds the value of the home, the home will not need to be sold. The other assets can be sold to pay off the liabilities. Consider an example:
A GP owns a home worth $500,000 and has $100,000 cash saved. This means that she has $600,000 in net wealth. The GP borrows $240,000 against her home and uses it to buy index funds (using dollar cost averaging, of course). She now has $840,000 in assets and $240,000 in debt – her net wealth is still $600,000. If something happens and she needs to repay the loan she can sell the index funds. She will not have to sell the home.
In summary, the advantage of lower interest rates, which means higher net returns and less risk, justifies using the home as security for a loan.
Margin loans are loans secured against the security of a share or similar security, such as units in a managed fund.
The GP can borrow up to an agreed % limit, say 50% or 70% of the value of the securities. If the value of the securities falls the GP faces a “margin call” and has to pay additional capital in, usually within 24 hours, or the lender will sell the securities to repay the loan.
Margin loans were popular with GPs up to the GFC. But harsh margin calls and high interest rates between 2008 and 2011 caused a lot of pain.
Memories linger and in 2014 margin loans are not popular with GPs.
Line of credit loan
A line of credit loan is a flexible loan with an upper limit. The borrower may draw as much or as little as they choose. Interest is only charged on the amount of money actually drawn (subject to a minimum amount).
The borrower can repay some or all of the line of credit at any time.
Lines of credit provide simple access to debt finance and are generally recommended to GPs, even if not needed right away: it’s comforting to know finance is there quickly if needed.
GPs who borrowed money to gear sound investments in the past two decades or so have mostly done very well. Many wish they had geared more investments. Those GPs who lost money tended to sell too quickly. They did not fully appreciate that property and shares investments are long term (at least two decades,) and a year or two of poor performance does not mean they should be sold.
Other GPs just made poor investment decisions, but they tend to be in the minority. Diversification is the key, reducing the prospects of being left with just one or two poor performing assets.
It is hard to accumulate significant wealth without taking on at least some debt for some time. The amount of debt is a personal choice, and reflects an underlying view of, and attitude towards, risk.
GPs who take on debt to invest will probably end up wealthier than those who do not. But there are no guarantees.
Borrowing to invest
If you need more convincing that GPs should be borrowing more, get a copy of Borrowing to Invest: The Fast Way to Wealth. A User’s Guide for Borrowers, by Noel Whittaker and Paul Resnik (Simon & Schuster, 2002). No-one can accuse the authors of not being conservative, and they are elder statesmen in the financial advising community.
Their opening paragraph reads:
Are you prepared to use other people’s money to build a better life for yourself. Have you stopped to think about what will happen if you don’t? Chances are you would never own your own home. Every mortgage is, after all, built on someone else’s money. And, unless you are heir to a fortune, it’s just as likely that your years in retirement will be years of watching the dollars.
In Personal Finance for Dummies financial journalist Barbara Drury explores similar thoughts:
Many people still feel uncomfortable about borrowing money to invest, a practice referred to as gearing. Yet the same people cheerfully borrow to the gills to buy their own home because they understand that the only way to own such an expensive asset is to use other people’s money.
Borrowing to buy growth assets, such as shares or property, and using your own cash or equity in your home as a down payment, helps you increase your returns. You make a profit as long as the investment returns (income plus capital gains) are greater than your interest payments. Say you have $10,000 and borrow another $10,000 at 8% interest to buy shares with a dividend yield of 4%. The dividends of $400 cover your interest payments but you stand to make double the profit when you sell the shares because you bought twice as many shares as you could have done with your own money.
Gearing can substantially increase long-term investment returns, but it magnifies the potential risks as well as the potential rewards. If you choose to gear into shares or investment property, invest in a diversified portfolio of high-quality assets that have the best chance of producing solid capital growth over the long term. Never gear to invest in speculative investments, or to avoid tax.
An investment is negatively geared if its income is less than the interest incurred on any amounts borrowed to acquire it. An investment is neutrally geared if the income is roughly equal to the interest on amounts borrowed to acquire it. An investment is positively geared if the income derived is greater than the interest.
The investment may be property (residential, retail, commercial or industrial), shares or similar securities in listed or unlisted companies, or managed funds or indexed funds. Each of the major asset classes is suited to geared investment strategies.
The word geared is chosen because of its engineering connotations. The idea is that with correct gearing or leverage a result can be obtained that is better than that obtained without gearing. This is usually achieved by expanding the asset base and allowing time for capital gains to
accrue, which more than compensate for the deficiency in cash flow caused by the interest being greater than the income.
This technique usually works, but there is no guarantee. It depends on the quality of the underlying investment. Gearing works in reverse too. The effect of any drop in value will be greater, and it is possible equity in an investment will be wiped out as a result.
An economically rational investor will be prepared to negatively gear an investment if the expected after-tax return, including capital gains, is greater than the expected after-tax cost of holding the investment. The after-tax return will usually be made up of the income from the investment (rents, dividends, or distributions, depending on the investment), and the increase in value, or capital gain, over time. Income can usually be predicted with reasonable certainty. Capital gain is the wild-card. No one knows the future, so the best you can do is expect a capital gain. This is where investing becomes an art rather than a science, as expectation will be the critical issue.
The Australian Master Financial Planning Guide, published by CCH Australia, provides a useful example of how gearing engineers a greater return for the investor:
An investor has several options, based on an initial investment amount of $40,000:
- Investing $40,000 as an ungeared
- Investing $80,000 as a geared investment with borrowings of $40,000.
- Investing $120,000 as a geared investment with borrowings of $80,000.
- Income from the investment is 4%.
- Capital growth is 5%.
- Interest on borrowing is 7%.”
The results are as follows:
|Less interest paid||Nil||$2,800||$5,600|
|Net cash flow||$1,600||$400||$800|
|Return on equity invested||9%||11%||13%|
The example shows that the more the investment is geared, the greater is the return on equity invested, assuming capital growth of 5%. GPs should realize the assumed income levels and capital gains amounts are conservative. Long-term earnings rates are actually much higher, at 9%. Most GPs who geared investments over the past two decades got better results than this.
The author also shows “what would happen if the market value goes down by 5% rather than increasing by 5%”. The revised table looks like this:
|Less interest paid||Nil||$2,800||$5,600|
|Net cash flow||$1,600||$400||$800|
|Return on equity invested||(1%)||(9%)||(17%)|
We do not know of any wealthy person who has not taken on some debt for business or investment purposes. We have also never known of a bankrupt person who has not taken on some debt. Debt can increase investment returns and it can reduce investment returns.
Clearly care is needed.
It is best to keep to sensible debt levels, manage interest costs and favour higher income- yielding investments if the down side of debt is to be avoided.
The Australian Master Financial Planning Guide says:
An investor should only make a negatively geared investment if:
- The investor has secure and permanent income from other sources sufficient to cover living expenses as well as the shortfall under the negative
- Where the gearing arrangement or borrowing includes a liability to make margin calls in certain circumstances, the investor can satisfy the margin calls by supplying further security or by payment from other sources to avoid the possibility of a forced sale [keep in mind that the economic conditions that lead to the need for a margin call will, almost certainly, mean that any forced sale will be at depressed prices and will lead to a significant loss to the investor].
- The investment is made on the understanding that it will be retained for at least 5, preferably 10 years or
- The investment and borrowing have sufficient flexibility to cover events such as death, disablement, major illness or redundancy, the first three of these would normally be covered by insurance or superannuation benefits and redundancy could be covered by an employer pay-out. However, even in these circumstances the negative gearing arrangement may need to be terminated. Check whether this can be done without incurring penalties and with the flexibility to avoid suffering loss through a forced sale of the asset.
- There is flexibility to cover changes in circumstances, such as a transfer overseas (where the tax advantages may not apply) or
- The taxpayer can take full advantage of the tax deduction. Negative gearing normally works best for investors on the highest marginal tax rate but may be of less value to low tax-rate or non-tax-paying investors.
The author warns of the danger of negatively gearing into an already geared investment, such as a listed company or a property trust. This increases both the up-side risk and the down-side risk even further.
Handy hints for getting the money – Pay the interest
The ATO does not like allowing deductions for un-paid interest. There is some doubt as to whether this is correct at law, but we believe it’s easier to pay the interest on time than it is to argue with the ATO. So make sure all interest is paid, and not capitalised, if you are claiming a deduction.
Study the contract
Research the costs before you sign the contract. Make sure you know the interest rate, the principal repayment rate, the administration costs and the penalties for early repayment.
Shop around. The first offer is unlikely to be the best offer. Remember that GPs are good risks so make sure you get an offer that reflects this. Look for a bank that offers special deals for GPs. Most do. The banks know that GPs have virtually a nil delinquency rate on debts, and this means more money can be lent at lower rates while still maintaining profitability.
Some brokers specialise in GPs and other health professionals. Their rates are as competitive as the banks and they usually offer better personalised service, and are less stringent on debt to equity ratios and similar prudential issues, making them easier to deal with.
Make sure your application is clear and to the point. Support it with accounts, company searches, business plans and similar documents where necessary. These materials are best included as appendices to the main application as they may cloud the message you are trying to deliver. If the loan is for business or investment purposes, stress this, as it may be relevant if the ATO questions the deductibility of any interest claimed on the loans down the track.
Ensure your finance application shows that all repayments can be met out of your existing and expected business cash flows. If asset sales are contemplated in the short or medium term say so, as this is relevant to your capacity to service the debt. Financiers may not be impressed if the repayment of principal depends solely on the sale of the object investment.
Do not borrow too much. Most banks work on a debt-to-equity ratio of about 70:30. In working out the value of your equity they discount historical cost by factors representing their expected resale experiences. Take account of these discount factors before you commit yourself to a transaction. Ensure your finance application includes all relevant materials, including all financial information that does not favour your application. If something goes wrong later and the bank finds out that you withheld information, problems will arise.
Keep the communication channels open. If something does go wrong, tell the bank immediately. This is important because banks base their recovery actions on their perceptions of how the borrower behaved. If your word is your bond, then you will get much better treatment if an unexpected situation arises. For example, banks will extend an existing facility over the phone without any extra security when CPs ask for it for whatever reason. Because trust has been established, the banks will help out if needed. Open and honest communication is the key to building this sort of a relationship, and once it is created, you shouldn’t waste it.
Banks will be reasonable if you are reasonable, so play with a straight bat at all times.
Offer subject to finance
If you are borrowing to buy property, consider making your offer subject to finance from a specified branch of a specified bank at a specified time, say a month. If something goes wrong you will probably not lose your deposit. If you change your mind within the specified timeframe you may be able to “arrange” for your finance application to be refused so you can get your deposit back. But make sure that the finance condition specifies which bank and even which branch of that bank. If you do not do this the vendor may arrange finance for you through a lender you would not use.
Hints for income tax time
Consider a facility such as a fully drawn advance, or an overdraft, that allows you to pre-pay interest. Pre-paid interest is generally tax-deductible in the year it is pre-paid, provided the pre- payment period does not extend for more than 13 months.
Non-deductible debt, which is not connected to a business or investment activity, is the most expensive debt. Every $1 of interest takes up almost $2 of pre-tax income. A basic tax planning strategy is to pay off expensive non-deductible debt as soon as possible and defer paying off cheap deductible debt as long as possible.
If you have a 15 year home loan of $200,000 and a 15 year investment loan of $200,000 it makes sense to pay off the home loan at twice the usual rate and pay nothing on the investment loan.
Keep your banks apart
Separate your financiers. For example, consider having your home loan with the ANZ, your business loan with the National Australia Bank and your credit card with Westpac, and do not let them have cross-securities. Each bank should have security over just one asset.
This may sound messy, but if something goes wrong it will be a lot harder if not impossible, for each bank to tie up the various securities provided to them.
Choose the right type of finance
Different types of finance suit different borrowing needs. For example:
- A chattel mortgage may be appropriate for plant and equipment costing $60,000 where you are putting up $30,000. This will speed up your GST refund, maximise your depreciation claim and allow you to include your equity in the plant and equipment in other finance
- Operating leases do not have to be shown in your business balance This can help present a good financial position to other financiers.
- An overdraft may be appropriate for funding your practice outgoings in February, as the effect of your four-week January holiday kicks in, or for funding other short-term dips in cash flow or unexpected But overdrafts are expensive and if they look like becoming permanent then you should convert them to a cheaper, long-term type of debt, using homes as security to minimise interest rates.
- An overdraft, being inherently short-term, is not appropriate for acquiring long-term assets such as practice premises, except where the debt proportion is very small and/or is expected to be paid back quickly, say within 12
Let someone do the work for you
Use a consultant who is experienced in dealing with banks and who can represent your interests competently. The consultant should have a good handle on both the accounting and legal aspects of your practice.
Consider using a finance broker. They are constantly in touch with the market. This saves you time dealing with lenders and saves you money because in most cases the broker can get you a better interest rate. Normally using a broker does not cost you anything because the lender pays the broker, not you.
Try to minimise the time you spend on dealing with the banks. Time better spent in your practice. You can’t bill for time spent talking to your bank manager or worrying about talking to your bank manager.
How to manage debt
Debt is a fact of life for most GPs. It may come from starting a practice, buying into a practice, buying a home or acquiring investments. It requires careful management and control so it does not cause financial loss and pain, rather than wealth creation.
Unless you are born with a silver spoon firmly in your mouth, there is normally no choice but to borrow to acquire assets of any significant value. It is hard to save up $300,000 to buy a home. By the time you do, you will probably be looking for a retirement home anyway.
A controlled amount of debt, used intelligently, can have a great influence on the quality of your life and on your net wealth position. It allows you to acquire assets otherwise outside of your reach and to benefit as the value of the assets rises and as the debt is gradually repaid.
However, misuse of debt leads to financial trouble. Be careful. These simple rules will help you deal with debt and avoid being financially hurt:
- Deal only with the major banks, not fringe players. They have their moments, but generally they are keen to get the medical profession’s business and will offer discounts on normal rates. Shop around. GPs are almost always good credit risks, so make sure you are not dealing with the shark end of the market, because you certainly do not have
- Remember, debt has to be repaid from after-tax A loan of $300,000 may not sound like much, but it requires almost $600,000 of pre-tax income to be repaid. This applies to all debts, not just private debts.
- Never borrow without a clear plan for repaying within a specified Debts can be repaid by fresh borrowings, by selling an asset, by cashing out super fund benefits (conditions apply) and by harnessing the practice’s cash flow properly. Sometimes a combination of these methods may be used. Each repayment method has its place.
- Always pay off non-deductible debt first (eg, debt on private credit cards and to buy a home). These are the most expensive loans because the interest is funded out of pre-tax dollars. Avoid them where Borrow so that the interest is tax-deductible.. Get expert advice before settling your strategy.
- Consider consolidating your debts into one facility with one lender. This normally lowers the interest rate. If things are really out of hand, think about extending the loan. This may take the pressure off a bit and let you get back on your
When should negative gearing be used to reduce a tax bill?
The answer is never. Only borrow money to buy an asset if the expected income plus the increase in the asset’s value exceeds the interest and other costs connected to owning the asset. In other words, the expected return must exceed the expected cost of the investment.
This means that the expected before-tax gross income plus the expected before-tax capital gain must be greater than about 11% a year before a rational investor would borrow to buy an income-producing investment. At a rate below 11% you will lose money.
How high you go above 11% depends on your perception of the risk implicit in the investment proposal. As a guide, don’t go under about 15%. Without such a margin it’s just not worth the effort. Your time will be better spent in your practice. If this base condition is not met, it doesn’t matter that the net loss on owning or holding the investment is tax-deductible. A loss is a loss.
You will be better off paying income tax and putting what’s left of your money in the bank.
This doesn’t mean you should never borrow to acquire appreciating assets. This can be a strategy. But if you are going to be better off the basic rules of investing must be satisfied.
Forms of finance
There are several common forms of finance used to fund business and investment activities.
The bank overdraft is a simple concept. It is like a bank account, but instead of you being owed money by the bank, you owe money to the bank. The amount that you owe fluctuates over time as funds pass in and out of the account. Interest is almost always fully tax-deductible even when a private or non-business cheque is written. The revolving nature of the overdraft means the Commissioner of Taxation is not able to trace through the overdraft account to apportion interest between deductible and non-deductible purposes.
Bank overdrafts tend to be at a high rate of interest. At the moment, 8% or more is common. You also have to factor various bank charges into the cost of the finance. These can easily add another 1% or more to the cost of the overdraft.
Overdrafts have the advantage of being flexible so you only pay for the money you use for the time you use it. Normally banks require a first mortgage over real estate to secure amounts lent on overdraft facilities. The better the security, the lower the interest rate.
WHY CONSUMER CREDIT IS NOT GOOD FOR YOU
Credit cards are typically used to buy consumable goods and services, and these fall in value over time. People using credit cards to buy such goods are usually reducing their net wealth.
Some consumable goods and services are unavoidable. Food, shelter, clothing, and health are all things people need. They are often referred to as non-discretionary consumable items, as the buyer does not really have the discretion to decide whether to buy them.
Some consumable goods and services are avoidable. They are discretionary consumable items, or luxury items, as the buyer does have choice as to whether to buy them.
When the purchase is made on a credit card, and the buyer pays interest, then the price of the purchase becomes even higher. This increases the negative effect on net wealth.
Not all credit card purchases attract interest. Most cards allow an interest-free period. If the user of the card pays the credit card bill in full before interest charges are applied, then they do not pay interest. However, only 30% of credit cards are repaid within the interest-free periods, meaning 70% of credit card users pay interest.
Bank overdrafts are a sensible way of funding most small-to-medium medical practices and are frequently used by GPs.
Term loans are the next most common form of finance. Most practices will have them. Term loans are simply a loan for an agreed period or term. They can be interest-only or principal and interest and they can have a fixed or variable interest rate.
Term loans can be repaid early without penalty if the interest rate is variable. If the interest rate is fixed, the bank loses if the loan is paid out early and this loss is almost always passed on to the customer.
Beware of changing banks just because one is offering an interest rate that is one percentage point below the others. Ask how long this will last and whether the discount continues if the loan is reviewed. The answer is usually no.
Term loans can be used to create flexible debt packages that achieve personalized financial goals. A GP who owes $400,000 on a loan used to buy a property could structure the debt by having $300,000 as fixed interest-only for five years and $100,000 variable interest and principal for five years.
This combination means that the GP can be reasonably certain of the net cost of the finance for five years, as three-quarters of the interest charge is fixed, and ensure a significant amount of debt ($100,000) on the variable interest loan will be paid off within five years. Some principal can be repaid early without penalty. At the end of the fifth year the remaining debt of $300,000 would be refinanced with the same bank or a new bank in line with the market conditions and the GP’s circumstances at the time.
Under a finance lease, the lessee borrows an amount of money equal to the cost of the asset being leased. The lessor owns the asset but the lessee is able to use the asset provided that the lease payments are made on a regular basis and particularly with larger leases, the asset is properly housed maintained and insured.
Finance leases are normally used for plant and equipment, and furniture and fittings purchases, as well as motor vehicles.
The advantage of a finance lease is that all payments made under the lease agreement are tax- deductible, even though part of the payments is a repayment of part of the principal amount borrowed to buy the asset.
The taxation advantages of leases can be overstated. Most items of plant and equipment can now be depreciated over either a three or five-year period. In the case of a four-year lease of computer equipment, the cost of the equipment would have been depreciated over three years anyway, so a lease would be tax-inefficient.
Most lease contracts provide for a residual payment at the end of the lease term. If this residual payment is not made, possession of the leased asset will revert to the lessor. In most cases, the lessee will make residual payments but you should not make a residual payment if for any reason the market value of the leased asset falls below its residual value.
The ATO has released guidelines for the minimum term and residual payments for leases. These guidelines must be satisfied before the ATO will accept that the finance contract is a lease and the lease rentals are deductible losses and outgoings for income tax purposes.
For example, if you buy a computer using lease finance over three years, the Australian Tax Office will only accept that the lease rentals are deductible if the residual value is not less than 30% of the amount of the cost of the computer.
Normally leases do not require any additional security because the leased asset provides sufficient security. However, financiers normally will not enter into lease contracts with companies without directors’ guarantees. Larger contracts or contracts for unusual and hard-to- sell plant and equipment may require collateral security.
The luxury car depreciation rules do not apply to lease contracts. This makes leases particularly attractive for buying cars with a cost of more than about $60,000 (more for environmentally friendly cars such as cars with diesel engines). All lease rentals, including those connected to the cost above the luxury car limit, will be deductible.
COMMERCIAL HIRE PURCHASE
Commercial hire purchase contracts are similar to lease contracts. They are typically used to buy plant and equipment, and furniture and fittings, including cars.
The big difference is that the borrower borrows money to buy the asset and is the owner from day one. This means the borrower is able to depreciate the asset for income tax purposes. The payments made under the hire purchase contract are a mix of principal and interest, and the amount of deductible interest will calculated using the ‘rule of 78’, a method that calculates how much interest has been earned at any stage during repayment of a fixed-interest loan.
The principal component of the payment is not be tax-deductible.
Commercial hire purchase will be more attractive than a lease where the borrower has some equity in the asset being financed. The cost of the asset will be depreciable under a hire purchase contract, including the owner’s contribution, even though only part of this amount is financed using debt. However, under an equivalent lease contract the lessee’s contribution will not be depreciable because the lessee will technically not own the asset. Only an owner can claim a deduction for depreciation.
BORROWING IN SMSFS
For many years SMSFs could not borrow except in limited specified circumstances. This changed in 2007 when the Government announced new rules for SMSF borrowing.
For new borrowings the rules are now as follows:
- single acquirable asset. Only one asset, or set of identical assets (example a parcel of shares in a listed company, listed trust, or other assets that have economically identical qualities) is permitted in each instalment trust arrangement, and which must be dealt with as if they are one asset (for example, that parcel of shares cannot be sold gradually over time, and if sold all must be sold; it’s all or nothing). This rule is very restrictive for shares and similar securities but of no real effect for real estate;
- capital improvement Borrowings cannot improve the asset, but can be used to maintain or repair the asset to maintain its functional value. This is particularly relevant to real estate and, for example, an SMSF cannot borrow to buy an old run down building and then borrow again to knock it down and build a new one. But a SMSF can borrow to repair or maintain a property to maintain its functional value;
- lender’s recourse. This is limited to the particular asset. Other assets cannot be charged in any way. In summary, a charge may be given over an asset acquired through a borrowing arrangement to secure that borrowing, but no other charge is permitted. This effects both shares and similar assets, and real estate;
- replacement assets. Replacement is limited to where instalment receipts are replaced with shares or units under a takeover, merger, demerger or similar reconstruction; and
- refinancing. Loans may be refinanced, and where the loan is re-financed such that a new loan is effectively created, the new loan will be brought within the new “Lesser” refinances may not be new loans and will not be brought within the new rules, but advice is needed each time to make sure the refinancing has not created a new loan. Particular care is needed when refinancing old borrowings for more than one asset, such as a parcel of shares in listed companies. The refinancing may create a new borrowing, and therefore breach the single acquirable asset rule.
Possible planning options
One can expect some great minds to devote a lot of time and thought to how to best use these rules. Preliminary ideas from a lesser mind include:
- consider whether a SMSF borrowing is the best way to Is it possible that the asset can be acquired through some other less restrictive mode, perhaps in the GP’s family? This is sometimes our preferred option: the consequences of a SMSF becoming non-compliant are serious and we believe it is wisest to stay away from complicated areas with a high probability of causing problems;
- consider an uncontrolled unit trust, with the client’s share of the units (less than 50% and no deemed control) owned by the SMSF and the debt held at the unit trust level (specific legal advice should be sought before proceeding here);
- if a geared SMSF property redevelopment is contemplated, consider a higher debt to equity ratio, and preserve existing cash balances and future contributions (concessional and non-concessional) for the redevelopment costs. Joint venture arrangements may also be considered, although these can be messy;
- consider gearing into an uncontrolled unit trust which acquire the property and then borrow at the trust level to complete the renovation/redevelopment. This works well for co-owning surgery premises with more than three equal owners (ie no one owner controls the trust). Specific legal advice should be sought before proceeding here; and
- consider whether SMSFs may be better off gearing in large geared share trusts where the trust borrows, and is not subject to the restrictive SMSF borrowing
It is a good idea for a GP to use a separate, special purpose SMSF for a specific transaction, such as buying a property using debt. The SMSF only holds the minimum amount of benefits needed to complete the transaction, and the other benefits are held in another super fund.
Doing this limits risk, and means any non-compliance penalties will be less than otherwise may have been the case.
Capitalised interest and related party borrowings
We recommend interest be paid at a market rate when it is due, and not be capitalised. This is to preserve the commerciality of the arrangement and to maintain an arm’s length quality at all times. This arm’s length quality will be needed to comply with other aspects of the SMSF law, and is consistent with the ATO’s views as expressed in TA 2008/5.
The new rules are particularly restrictive for shares, and do not allow a parcel of shares in different companies to be held under the one instalment arrangement, and do not allow a progressive sell down of shares. For obvious reasons the “single acquirable asset” rule is less of a problem with real estate assets, which tend to be bought singularly, with fewer properties owned relative to shares.
The SMSF’s investment strategy must include borrowing to acquire investments.
A particularly simple application
One simple application has merit. Consider a forty-five year old GP couple with, say, $300,000 in super. They are concerned about their retirement prospects and, although they are in the 40% tax bracket and have statistically high incomes, they are cash poor because of the high costs of feeding, housing, educating and “holidaying” their family.
It can make sense to set up a SMSF, transfer the existing $300,000 of benefits in, pay future contributions in, and then borrow say $500,000 to complete the purchase of a $800,000 property. The property is then rented out, with the rent income covering the outgoings and the interest, with a bit of help from contributions. The expected capital gains drive this investment, and the trick is to not realise the capital gains until the SMSF is in pension mode, ie until say age 60 in 15 years time, so that the bulk of the return is capital gains tax free.
This advantage overwhelms the disadvantage of low debt deductibility in the SMSF.
GPs who implemented strategies like this when the SMSF borrowing rules started have by now done well. We expect GPs who implement strategies like this now will do well in the future too.
Don’t invest in apartments. There is an over-supply, and the capital gain prospects are just not there.
Some apartment developers are offering up to 10% commission to financial planners to get them to flog their stuff. If an apartment takes a 10% commission to be sold you can be sure it’s not going to be a good investment.
Some apartments will be good investments. But most won’t. So we recommend GPs play it safe by avoiding apartments completely in their SMSF’s investment strategy.
These firms provide a real alternative to traditional bank finance. Companies such as Aussie Home Loans and RAMS now account for a significant share of housing finance in Australia.
GPs who have dealt with these companies report well on them. They seem to provide a good service and are able to provide lower-cost finance because they do not support the infrastructure of the larger banks. They just organize loans and are not the principal lender. The principal lenders are the larger merchant banks that are attracted by the security and low administration costs of this type of finance.
Interest charge checkers
A number of firms have entered the personal and small business financial market as interest charge checkers. Often staffed by retired bank managers, they use precise interest rate calculations to identify interest charge errors and bank charge errors. Small amounts add up, particularly if there is a pattern of overcharging. The firms collect the refunds for you.
GPs should use these services if they believe they have been overcharged on interest or bank charges. There are also some good software packages available that do the checking for you.
Chapter 12 – Retirement
Q: What is the retirement age?
A: There is no mandatory retirement age in Australia.
Conventionally retirement age was 65 for men and 60 for women, and these ages derived from the old age pension start dates. However, the baby boomers are seeing things differently and recent research from Adelaide University’s Australian Population and Migration Centre suggests as many as 74% of people age between 50 and 65 intend to keep working after age 65, even if this is on a part time basis.
Notwithstanding these good intentions, the time that most people call it quits tends to be earlier, and is strongly influenced by two critical qualifying ages. These are:
- the superannuation preservation age, ie the age at which super can be accessed; and
- the old age pension qualifying age.
Most of us know that the Australian population is ageing, and faces a worsening ratio of employed persons to retired persons. One writer (Emily Millane writing on the Drum) has recently observed:
It is possible that we can reconceptualise retirement from a binary ‘work/non-work‘ condition to a staged process. This is beneficial for the individual and for society. It allows that individual to boost their personal retirement savings. It postpones the time at which the individual draws down fully on the aged pension, therefore meaning less strain on public resources. There are also less tangible, less measurable benefits, for example, the value to an individual of the social networks of a workplace or the sense of purpose that goes along with ‘going to work‘.
We have long recommended that GP’s retirements not be an all or nothing proposition, and that they be staged, starting in the mid-fifties and continuing into the seventies. Everyone wins:
- the GP earns more;
- the patients get better service;
- spouses are happier (I am serious here);
- the GP’s own health tends to be better; and
- there are some great tax benefits, particularly after age 65, which mean average tax rates are often less than 10%.
A GP who has reached preservation age and stopped working can access their super as a lump sum, subject to taxation.
At age 65 super benefits can be accessed tax-free without stopping work. Your preservation age depends on your date of birth and the position is tabulated here:
|Date of birth||Preservation age|
|Before 1 July 1960||55|
|1 July 1960 – 30 June 1961||56|
|1 July 1961 – 30 June 1962||57|
|1 July 1962 – 30 June 1963||58|
|1 July 1963 – 30 June 1964||59|
|From 1 July 1964||60|
For example, Dr Fleming is 57 and was born on 4 May 1959. She has just stopped working and does not intend to work again. Dr Fleming is over her preservation age of 55 and can access her superannuation benefits as a lump sum without restriction (but will face tax charges unless she waits until she is age 60).
Dr Fleming could instead consider a transition to retirement pension, ie a pension able to be paid after the preservation age without stopping work, rather than a lump sum. She can access as much as 10% of her superannuation benefits each year. The amount is taxed until she is age 60: most GPs would not start a transition to retirement pension until age 60 for this reason. (And most GPs will start a transition to retirement pension at age 60, since doing so means the superannuation benefits are not taxed at all.)
The pension age is 65 for men and women. It used to be 60 for women, but was increased to 65 some years ago as a gender equality measure.The Federal Government’s May 2014 budget announced the pension age will ultimately increase to 70 by 2035, subject to transitional rules.
The relevant dates are tabulated here:
|Date of birth||Eligible age|
|1 July 1952 to 31 December 1953||65.5|
|1 Jan 1954 to 30 June 1955||66|
|1 July 1955 to 31 Dec 1956||66.5|
|1 January 1957 and 30 June 1958||67|
|1 July 1958 and 31 December 1959||67.5|
|1 January 1960 and 30 June 1961||68|
|1 July 1961 and 31 December 1962||68.5|
|1 January 1963 and 30 June 1964||69|
|1 July 1964 and 31 December 1965||69.5|
|1 January 1966 and later||70|
So, a GP born on 4 May 1961, ie between 1 January 1961 and 31 December 1961 will not qualify for the old age pension until age 68.
Thirty years ago the magic age for retiring was 65 for men and 60 for women.
These dates were based on the age when men became eligible for the old pension in 1908: this was the average lifespan at that time, and if you lived that long you got a basic government pension to sustain you until you finally dropped off the perch. It was not a luxurious lifestyle and for most it was a pretty short lifestyle as well.
Things have changed dramatically in the last thirty years. The 2014 Federal Government Budget sums it up: strong and controversial measures to limit the amount of the old age pension and the number of people eligible for it, with the rate of growth cut back and the eligible age progressively increased to age 75 at 2030.
People are generally living longer, and many people, particularly women, will spend thirty years or more in retirement. Most people age 50 and above are concerned about their retirement. When will it start? What will it involve? What will their income be? How will they pay their bills? Will they be able to help their children? Will they leave a financial legacy? Will they have enough to live on?
GPs are no exceptions. Most meetings with GPs age 50 or more focus on when and how they should retire. The issues are almost always the same. GPs want to retire, in the sense of getting a break and enjoying a bit more time to themselves. At the same time GPs do not want to retire, because they will miss helping patients and working with their colleagues. This tug of war is complicated by the GP not knowing how to retire, ie not knowing how to disengage from practice and how to re-set the financial levers to reflect their new circumstances.
The good news is most GPs can afford to retire.
More than 80% of retirees receive all or part of the old age pension, and most experience a significant drop in lifestyle on retirement.
We do not have figures for retired GPs, but we would bet less than 10% receive all or part of a pension and most do not experience a significant drop in lifestyle on retirement. The reason is simple: the height, stability, scalability and longevity of the GPs’ income means most GPs can build up enough assets to pay for a comfortable retirement.
About 80% of Australians over the pension age receive a full or part pension.
Most need it to live, ie they rely on the pension to buy food and other life necessities. Old age can be bleak. It’s particularly bleak, and particularly stressful, if you do not own a home and do not have somewhere secure to live.
Others do not need it to live. It’s a bonus, something used to fund extra life luxuries. Assets tests and income tests apply, but it is still possible to receive a part pension with close to $1,000,000 of assets plus a family home. Millionaires get the pension too.
GPs see patients at all ages, and can often predict long-term health outcomes. Similarly we see clients at all ages and can often predict long-term financial outcomes. The good news is, as we stress throughout this book, the height, stability, scalability and longevity of the GP’s income means everything goes right in retirement for most GPs, at least eventually.
This makes GPs, and doctors generally, the most independent of all occupations. Let’s use a client example to explain how well most GPs retire.
The story of Simon and Mary
Dr Simon is a valued long-term client, a good GP and a friend. He and Mary raised six kids in a mid-north Victoria, and at age 70 Simon and Mary moved to Melbourne to be closer to their grand-kids and part of their children’s lives.
Simon and Mary had done everything right planning their retirement. They had:
- owned their practice, and enjoyed a higher than average income (even for a rural GP) for nearly forty years;
- lived well, but not wastefully, and used their left over cash-flow to pay of their home loan, pay maximum super contributions for themselves (Mary was the practice manager) every year, invest their SMSF in blue chip Australian shares and index funds, and buy three negatively geared properties back in the 80s and 90s as investment properties, using their family trust (which back then doubled as a service trust);
- from about age 55 on they really concentrated on the SMSF, paying large non- concessional contributions whenever they could. Simon and Mary knew the SMSF would tax free once they turned age 60, and that very little tax would be paid before then, particularly if they never That’s one of the reasons why they only bought blue chip shares and index funds;
- put sensible wills in place, leaving everything to the survivor, and on the death of the survivor leaving everything to a testamentary trust controlled by their six children and run for the benefit of their children and grandchildren. The assets in the SMSF and the family will end up in the testamentary trust too;
- helped their kids when they could, guaranteeing early home loans and, once or twice, business loans to help good ideas get off the ground;
- travelled a lot, including taking the extended family on several tropical cruises;
- sold the old family home and bought a more manageable town house, not an apartment, in a Bayside suburb. It’s easy to live in and easy to clean and close to all urban amenities;
- not worked too hard after about age 60, once the kids were off their hands and down in the city,
- let their life insurance lapses around age 60. They just didn’t need them; and
- most importantly, enjoyed life. They are involved with their family and active in their ommunity. Simon and Mary, like most GPs, are givers, and they will keep giving for as long as they can.
Simon and Mary were particularly diligent about migrating their wealth to their SMSF as they got closer to age 60. They knew using the soon to be tax free SMSF as the investor would significantly improve long run after tax investment returns, and that this would compound and compound making the investments ever better and better.
The SMSF was easy to manage. It only had 12 shares and one large holding of Vanguard Australia Shares Index Fund. Keeping it simple and never selling meant more than $2,000,000 of equities were managed easily and simply every year, with accounting and audit costs less than $2,000. The properties were easy to run too: they use a Bayside estate agent as a property manager and everything is done for them, to the extent the property manager sends the financial reports direct to their accountant. There is nothing much for them to do, which irks Simon because he likes to keep busy.
Good long term planning, smart use of investment structures (ie a SMSF and a family trust), hard work and favourable taxation laws combine to produce great results for Simon and Mary.
Simon started to see his own GP at age 55, and developed a health management plan. Previously Simon self-diagnosed, which is not a smart move. The main problem was Simon worked too hard, which meant he did not exercise enough, ate too much and slept poorly. It was not too late, and now Simon is much fitter and healthier than most men his age.
Their income and tax profile looks like this:
|Simon’s net practice income||$30,000||Nil||No tax paid on income less than $34,000 for over age 65 taxpayers|
|Mary’s salary||$10,000||Nil||As above|
|Car fringe benefits||$20,000||Nil||Tax free under concessional rules|
|Super contributions||$70,000||$10,500||15% tax|
|SMSF dividends||$2,500,000||$60,000||($20,000)||Franking credits refunded because SMSF tax free|
|SMSF unrealised Capital gains||$100,000||Nil||SMSF tax free|
|Family trust rents||$2,500,000||$60,000||$6,000||Rents distributed to adult children|
|Family trust unrealised capital gains||$100,000||Nil||Unrealised capital gains not taxed|
|Family home||$1,000,000||Tax free|
Mary and Simon are in good health, travel a lot, spend time with each other and their family and generally enjoy themselves. Simon is working two days a week, sometimes more when the practice is really busy. Keeping his hand in as a GP means Simon feels he is contributing to the community, and his younger colleagues and older patients appreciate his efforts.
Simon does not have to work: the investment earnings on $6,000,000 of assets are more than enough to live very comfortably, forever. Simon works because he enjoys it, and feels that it keeps him vital and in touch with the world.
Mary is glad Simon is out of the house most days: he would drive her crazy if he could not work.
Simon and Mary are proud they will leave each of their six children at least $1,000,000 each, and that they are still investing and living well on much less than they earn each year.
Simon and Mary never had a retirement plan as such. They just used common sense strategies that adapted to their changing circumstances as the decades slipped by and the new generations grew up. They just acquired sensible assets, properties and shares, using tax efficient investment structures, and then let time do the rest.
Are most GPs like Simon and Mary?
Happily most GPs are like Simon and Mary. It’s part of being a GP: the height, stability, scalability and longevity of the GP’s income means everything goes right in retirement for most GPs, at least eventually.
The good news is even if things go wrong, and the GP has no assets and no independent income, good results can still be achieved with careful planning. This is, once again, due to the characteristics of a GP’s income: its height, stability, scalability and most importantly, longevity mean even older GPs who have left retirement planning too late can still catch up and install sound strategies for their advance old age.
The only condition here is good health, in the sense of being healthy enough to work at least part time as a GP. Strangely, one of the key advices to an older impecunious GP can be to get his or her (but its usually his) own GP and develop a health plan based on maintaining the capacity to work into his or her seventies.
This brings our mind back to Angela, 2007. She was an unusual presentation: an itinerant GP, almost literally a GP with no fixed address. She travelled from rural locum to rural locum, sleeping on site, even camping out between engagements. When she needed a longer break she stayed with a sister in Manly.
Angela worked about one week in three, and her income was just a bit over $100,000 a year. Statistically it was quite high for a 60 year-old woman, but for a GP it was at the low end of the scale. Angela was at Monash Uni in the sixties, and deep down she never stopped being a flower child. She was a good GP who heard a different drum.
That drum was changing beat by 2007. She was sixty and feeling it. She had no assets except for about $30,000 in the bank, and owed nearly that on her tax. She was two years behind with her tax returns. In her words, she needed to ‘grow up and settle down.’ We preferred to suggest she simply ‘nest somewhere.’
The consultation took a few meetings over a few weeks and in the end a strategy hatched. It was for Angela to:
- settle down and stay in one spot, a semi-rustic and semi-rural enclave in Melbourne’s outer southern suburbs;
- sell her practice to Primary Health Care for $500,000, subject to an ATO advance opinion that this amount would be received on capital account, and be treated as a tax free capital gain;
- practice for at least five years at a Primary Health Care centre, with an expected net income of $200,000 a year;
- pay $35,000 a year into HESTA Super fund (you could do this back in 2007);
- teach yoga at a nearby yoga centre, join the rural ambulance as a volunteer medic and generally become involved in community life; and
- buy a small home on a ten-acre block for $1,000,000, using the $500,000 from Primary Health Care and a further $500,000 borrowed from NAB. Remember, the NAB did not see a 60 year old woman with no savings. They saw a GP, and a GP’s earning capacity.
Seven years down the track Angela has left Primary Health Care and is working at a community health centre closer to home. She has paid off all but $200,000 of her home loan, and is about to withdraw her super benefits from HESTA tax free (she is over age 65) and pay off the last bit of the home loan.
Angela is working two days a week, but is only making about $50,000 (the community health work does not pay as well as other medical centres). She intends to continue working for as long as she can. Her tax profile is very efficient: she does not pay any tax because the first $34,000 is tax free and the rest of her income pays for her tax deductible four wheel drive and her $6,000 a year super contributions.
Angela’s home is now worth $1,300,000.
Angela will retire on the old age pension. It’s about $20,000 a year plus some benefits. Her cash flow will be augmented by $150 a week ($7,600) board from her grand-nephew who lives with her, and studies at Monash, and a draw down on a reverse mortgage of as much as she wants, even $800 a week.
Angela’s reverse mortgage merits more comment. It was deliberately recommended that Angela buy a relatively expensive home back in 2007 because homes don’t count in the old age pension asset test. Assuming capital gains of 4% a year, Angela can borrow say $40,000 a year every year and not cut into her equity of $1,300,000.
This means Angela’s annual cash flow is as much as $67,500, and is completely tax-free. This is more than Angela was earning after tax when we first met back in 2007.
Angela is enjoying herself, is in good health and is not worried about her financial future. Once again, it’s the nature of a GP’s income coming into play: its height, stability, scalability and longevity means Angela was able to create and implement an effective retirement plan at age 60, ten years after most women her age had left the workforce.
It’s easier to forever be a flower child if you do not have to worry about money.
Are many GPs like Angela?
There are not many GPs like Angela. Angela was unusual because she was there pretty much by choice, not by circumstances beyond her control. She was a free spirit who did not want to be bothered by money matters. Similar techniques can be used with other GPs with few assets – perhaps coming out of bankruptcy (caused by poor investing, not poor medicine), GPs who have suffered poor health, including extended incapacitation, and GPs coming out of drug addiction.
The shortage of GPs is a blessing. It means these GPs have been able to set a short term, ie ten year, goal of owning a home and making sure they are eligible for the old age pension, and augmenting cash flow by continuing to work part time and using reverse mortgages.
Reverse mortgages have an undeservedly bad reputation. Unfortunately unscrupulous spruikers have grabbed the concept and ripped off vulnerable old folk, charging ridiculously high fees and interest rates, and borrowing far too much and even losing their homes.
Used sensibly reverse mortgages can be powerful financial planning tools and can maximise a retirees’ quality of life and reduce financial stress on the younger generation.
For example, Dr Sam has three siblings, and his parents’ will, quite rightly, divides things four ways. His parents are pensioners, and own a home worth about $800,000, and not much else. Dr Sam and each of his siblings will inherit $200,000 when their parents pass away.
Dr Sam was annoyed that his impecunious parents always looked to him for financial support. He shelled out for a new car, a trip to the UK to visit a daughter (Sam’ sister) every two years, house repairs and some large payments like health insurance, water rates and so on. It was costing about $20,000 a year. Dr Sam did not begrudge his parents this support, but thought it unfair that his siblings did not chip in. They said he was the well-paid GP so he could well pay for the parents.
Two solutions presented. The first was to ask the parents to sign a loan agreement covering past payments and all future payments so Sam could get his money back, plus a little bit of interest, out of his parents’ estate. This meant ultimately his siblings were paying one quarter each, which Sam thought fair. But Sam felt uncomfortable asking his parents to sign a loan agreement, and his parents felt uncomfortable having to ask for money.
The better solution was for Sam to arrange a loan for his parents, secured against their home, and guaranteed by Sam, at normal home loan rates (about 5%). Sam then arranged for an automatic transfer of $5,000 a quarter to his mum and dad’s bank account. They got their dignity and they got their cash. They now get $30,000 a year from the pension, and $20,000 a year from the reverse mortgage. They have $50,000 a year and is more than enough to enjoy life and pay for economy air fares to the UK and return every two years
If their home goes up by 3% a year they get a $24,000 a year tax free capital gain. They are only drawing $20,000 a year, so their net equity position should remain safe.
There is really no risk because obviously if things went pear shaped, and interest rates jumped up and property values fell, Dr Sam would bail his parents out. He has guaranteed the loan anyway.
The reverse mortgage achieves a better balance between material living standards now and inheritances to children. They can work for GPs who otherwise would be subsidising all their parents’ living costs, and they can work for GPs like Dr Angela, who has no children and no other significant assets.
ASIC has had some bad experiences with reverse mortgages and warns the risks include:
- Interest rates are generally higher than average home loans
- The debt can rise quickly as the interest compounds over the term of the loan – this is the effect of compound interest and is something you need to be aware of before making any decisions
- The loan may affect your pension eligibility
- You may not have enough money left for aged care or other future needs
- If you are the sole owner of the property and someone lives with you, that person may not be able to stay when you die (in some circumstances)
- If you fix your interest rate then the costs to break your agreement can be very high
It’s unusual for a GP to have to retire entirely on an old age pension.
Once again, this is due to the special characteristics of a GP’s income, being its height, stability, scalability and longevity. Most GPs have more opportunity to build up retirement reserves and, health permitting, have less need for them since they can work on high incomes into their 70s.
The single pension is around $800 per fortnight, or $22,000 a year, and the couple pension is about another 50% of that. The pension triggers certain other benefits.
An income test and an assets test apply, and the pension is reduced as assets and income increase. The family home is not included in the assets test. The part pension rules are generous
and it is possible for a couple owning a home of say $2,000,000 and other assets of say $500,000 and still draw a part pension and qualify for the extra concessional benefits.
The Centrelink website is a great place to find out more about pensions and other forms of social welfare. It’s free, informative, and worth a look if you are concerned about old age pensions and similar entitlements.
The staff are caring, confidential and discrete, and treat all clients with dignity and respect.
Planning for the old age pension
Normally GPs don’t need old age pension planning, and we confess it’s not something we frequently deal with. However, exceptions do arise where qualifying for the old age pension emerges as a sensible and safe strategy.
A tax-free pension of $30,000, effectively secured by the government, indexed by inflation, and payable for life with a reversion to a single pension of $20,000 a year on the death of one partner, is like an annuity or private pension, and has an equivalent economic value.
This value may range from $400,000 to $600,000 depending on health and age: remember, many women will live into their nineties and spend thirty years or more as pensioners. Planning for the old age pension can make sense in cases where the GP’s assets are light and other sources of income not reliable (for example, due to poor health or a disability).
Planning techniques include:
- deferring retirement as long as possible, building up more assets and reducing the need for the old age pension;
- genuinely gifting assets to children or uncontrolled trusts more than five years before the start of the old age pension
- liaising with organisations like Primary Health Care, as Dr Angela did, and selling a practice for $500,000 CGT free. Although its fair to say this option does not suit every GP, particularly older GPs who realistically may not be able to work fifty hours a week for the following five years; and
- reverse mortgages, as discussed above, can make a lot of sense, allowing the GP to access the equity in their retirement years.
Happily, an impoverished old age is rarely encountered by a GP. It’s the nature of the job: a high, stable, scalable, insurable and long income that virtually guarantees a comfortable lifestyle and a contented old age. This, coupled with intelligence and prescience, means most GPs are quite comfortable by retirement time, and enjoy a pleasant retirement.
Please Contact MartinCo for more information click below >