Gearing your DIY super fund

Borrowing to invest can potentially multiply your returns, helping you earn more income, capital gains and franking credits from the same upfront investment. But it needs to be managed carefully.

For generations, Australian home buyers have been building wealth by gearing, or borrowing to invest. And you can put the same principle to work in your DIY super fund.

Gearing helps you buy more assets sooner, potentially multiplying earnings and capital gains. Gearing your DIY fund can also help create a bigger portfolio without breaching your contribution caps. And because your fund’s borrowing costs may be deductible, you may reduce the tax your fund has to pay.

At the same time, it’s important to remember that gearing can multiply losses, as well as gains. There are also complex rules governing the kinds of loans DIY funds can use and the assets they can buy with them.

DIY super funds can only borrow to invest in a single acquirable asset, such as a property on a single title or parcel of shares in a company. And they can only use a limited recourse loan, secured by the asset you’re buying. While a limited recourse loan helps shield your fund’s other assets if you default on your loan, it may mean that your fund is not able to borrow as much as a standard loan..

A financial adviser can help you understand whether a gearing strategy is right for your circumstances, then outline the costs and the risks. They can also help guide you through the complex compliance rules involved and help you set up an investment strategy for your fund. In the meantime, here are four gearing strategies you might like to consider.

1. Gearing into property

Borrowing to invest in residential or commercial property is an increasingly popular option, both for accelerating capital growth and for generating a regular income in retirement.

If you own a business, one commonly-used strategy is to buy your warehouse, factory or office through your DIY super fund, then rent it back to the business. That gives you both the security of a guaranteed tenant, and the satisfaction of watching your rental payments go towards your super. But remember that this strategy generally isn’t available for residential properties, where stricter rules about related party transactions apply.

However, given the high cost of property, this may result in your fund having all its eggs in one basket. If anything were to happen to that property, or the property market went through a protracted downturn, this could have a significant impact on your retirement savings. So it’s important to think carefully about the risks and get good advice.

2. Instalment warrants

Instalment warrants are a special financial instrument that helps you invest in shares while paying less upfront. They’re also a handy way for DIY super funds to gear into the sharemarket, without the risk of margin calls.

You start by paying a first instalment, usually around half the price of the underlying share. In return, you get most of the benefits of share ownership, including any dividends, franking credits and capital gains. Then, when your warrant matures, you can choose to pay the second instalment and take full ownership of the underlying share, or simply roll it over into a new warrant.

If the share price has fallen, you can also choose to simply walk away without paying the second instalment, although in that case you will lose your initial investment.

3. Investing in a geared fund

A geared fund is simply a managed fund that uses gearing to create a larger portfolio. Investing in a geared fund is just like investing in any other managed fund, except that both the potential returns and the risk tend to be greater.

The upside of gearing through a managed fund is that it’s much simpler than borrowing directly and the fund manager can almost certainly borrow at lower rates than you can, so the overall costs of your investment could be lower (although do remember to take management fees into account). Depending on the fund you choose, it can also be a great way to access a market you’re unfamiliar with — overseas shares for example.

But because geared funds tend to be more volatile than ungeared equivalents, they should only be used by investors who understand the risks and who are still some way from retirement — ideally seven years or more.

4. Protected equity loans

If you’d like to access the benefits of gearing while reducing the risks, a protected equity loan could be the answer.

You start by borrowing up to 100% of the cost of a portfolio of shares. During the term of the loan, you receive dividends and franking credits as usual. When your loan matures, you also receive any capital gains from shares that have risen. But if any shares have fallen in value, you can simply sell them back to the lender at the original purchase price, repaying your loan without losing hard-earned capital.

Of course, that protection does come at a cost. Protected loans may have higher interest rates and fees than unprotected loans. But they may also offer tax benefits that can help offset the costs. As always, it’s important to consult your adviser before you invest.

-          Important information: The DIY Super Cash Investment Account is a bank account designed for use in conjunction with a Self-Managed Super Fund. It is not a superannuation product in its own right. Terms and conditions issued by Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945 (CBA) for the DIY Super Cash Investment Account (Cash Investment Account) and Term Deposit are available from any branch or by calling 13 2221. As this advice has been prepared without considering your objectives, financial situation or needs, you should, before acting on this advice, consider its appropriateness to your circumstances.

Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814 (CommSec) is a wholly owned, but non-guaranteed, subsidiary of the CBA. CommSec is a Participant of the ASX Group.