More people are sending their kids to private schools. At the same time, fees are rising. John Collett looks at tax-effective investment strategies to raise the funds.

Since 1996 private school fees have been increasing by 7 per cent a year. With fees costing up to $17,000 a year, you need deep pockets to fund a private school education.

Indeed, the numbers are so daunting that only the super rich are spared the annual crisis of finding enough cash to meet the bills.

Most parents, burdened as they are by heavy mortgages, have the choice of either going further into debt or resorting to some sort of investment strategy early on.

Nobody knows exactly how much of the record amount of debt parents are racking up against the equity in their homes is being used to pay tuition fees.

Lyndal Wilson, a spokeswoman for the Independent Schools Council of Australia, says that anecdotal evidence, from speaking with school bursars, suggests extending the mortgage is a popular way of paying fees.

Wilson says parents often combine mortgage redraw with a second job, typically the mother working part-time and assigning her salary to fees.

Redraw

Parents, particularly in Sydney and Melbourne, have a lot of their wealth tied up in their homes, which have risen steeply in value over the past eight years.

But financial planner Kevin Bailey of the Money Managers warns that the "times when you didn't have to save or live frugally [and] all you had to do was draw on your equity in the home are over".

Bailey says that home owners don't want to load up with debt on the back of an asset that is losing value. "Now equity is disappearing before home owners' eyes, but the debt's still there." Bailey says the old ways are not likely to work as well in the future.

"Funding the kids' education requires two things," says Peter Thornhill, the principal of Motivated Money. "One is the ability of parents to put money away in the first place instead of hoping they can pay for it out of current income. That's 90 per cent of the battle. The second part is where to invest it."

The sooner a savings plan is instigated, the better. Starting a plan when children are young gives you the best part of 10 years to build up capital before drawing it down to meet tuition fees.

That leaves the decision of where to invest the savings. Faced with the array of options, it's hard to know which way to jump.

Scholarship plans

One strategy is an educational savings plan, or scholarship fund. The plans have differing features, but generally the proceeds have to be used for the specific purpose of paying tuition fees. Usually the funds invest in low risk and low return fixed interest investments.

"I am not a great believer in scholarship funds," says Laura Menschik, the managing director of Millennium Financial Services. "If the money needs to be accessed [before your child goes to school] you only get your contributions back, but no earnings." Someone with an investment time frame of 10 years should be able to take on more risk, with the potential for higher returns than can be earned on fixed interest investments, she says.

Thornhill is an advocate of direct shares and listed investment companies for those investing for the long term.

Shares

That's what he did when saving for his three children's private education. By investing in Australian companies, he was able keep the tax low because of the high level of franking credits the companies provide to their shareholders.

Thornhill also invested in some "old style" listed investment companies (LICs), such as Argo Investments and the Australian Foundation Investment Company. They are ASX-listed companies whose business is to invest in other ASX-listed companies.

They have a "buy-and-hold" strategy, which keeps the realised capital gains low, and have very low investment fees. Thornhill says maximising the income that is re-invested through low fees "gives the pot a huge kick".

Gearing

Another strategy is to borrow to invest through a margin lending facility. Margin lenders provide savings plan products, where you contribute as little as $200 a month and the lender kicks in a matching $200 a month. The capital quickly builds up to a sizable amount and most lenders offer a good spread of Australian listed companies and managed funds in which to invest. The interest costs on the borrowings are tax deductable.

The risks with any gearing strategy is that the volatility of the investment gets magnified - on the way up and on the way down. Also, the investor must be able to continue to meet the repayments.

The tax reporting is complex and most investors would need the assistance of an accountant to fill out their tax return each year.

for simplicity, investment bonds are hard to beat. They are just like unlisted managed funds (unit trusts), except the manager pays the company tax rate of 30 per cent on income and capital gains. Investment bonds are tax-paid after 10 years.

Insurance bonds

Many investors choose to have the distributions from managed funds automatically re-invested to buy more units in the fund. The problem with that is investors may have a tax liability even if they do not receive a cent of income from the managed fund. If money is being dripped into the fund at regular intervals, the tax calculations can be quite complex.

With investment bonds - as long as no money is withdrawn for 10 years - nothing has to be entered in the annual tax return.

"Investment bond" is the term for bonds issued by insurance companies and friendly societies. Each bond has a number of investment options, such as shares, multi-sector funds and fixed interest.

Mark Kachor, the managing director of researcher DEXX&R, says 20 years ago investment bonds took more money than unit trusts. One reason for their popularity was that the accruing returns on bonds taken out until the end of 1987 were exempt from the social security income test. This appealed to retiree grandparents looking to maximise their age pensions.

In September 1999, investment bonds suffered another blow when the Federal Government announced they would be taxed the same way as unit trusts with the tax accounted for in an investor's annual tax return. It looked at the time as if investment bonds would become nothing more than a tax-paid version of a unit trust, and some providers closed their bonds to new investors.

To everyone's surprise, in the May 2002 Budget the Government ditched those reforms. However, those providers who have left the market have not returned, leaving only a few providers (see box left).

Best kept secret

Some think that the investment bond market is in terminal decline. But some of Australia's leading financial planners believe they have an important role to play in at least one niche investment area - as education savings plans.

Noel Whittaker, the principal of Whittaker McNaught and a Money columnist, mentions investment bonds frequently in his answers to readers. He says the tax rules are biased against parents or grandparents saving for young relatives. If you invest in their name, or as trustee, you will be liable for children's tax of up to 66 per cent. Technically it's the child who is liable, but in effect it's the parents who pay. The tax was brought in some years ago to stop people using their kids as tax shelters.

Investment bonds are analogous to insurance policies. Like a life policy, there is the life insured and the policyholder. With bonds, the investment is in the name of the parent and the beneficiary can be one or more children.

Millennium's Laura Menschik says: "I am a believer in investment bonds for the right situation." She has one herself, where the beneficiaries are her grandchildren, so that "should I pass away the funds will go to them automatically, in a tax-effective manner." You cannot do that with most other investments without triggering a tax event.

Tax benefits

Menschik says that under bankruptcy provisions, an investment bond, being a type of life insurance policy, is generally protected from creditors - which can be attractive for parents who run small businesses.

The biggest benefits of bonds are for parents who are both earning above the 30 per cent tax rate.

Often one parent, usually the mother, works part-time when the children are young and is unlikely to be paying more than 30 cents in a dollar in income tax. In those circumstances the parents may be better off, from a tax point of view, investing in a managed fund or in a master trust with dozens of investment options, in the lower paid parent's name.

Supporters of investment bonds point out that with bond options that invest in Australian shares, the effective tax rate can be much lower than 30 per cent when tax credits are used from franked dividends and other deductions. Ten years is a long investment time frame and the employment circumstances of the parents are likely to change and hard to predict.

A possible drawback with bonds is the strict rules governing how much can be contributed

each "bond year" (the anniversary of its purchase). Investors can contribute a maximum of 25 per cent more than they did in the previous bond year.

Investors need to be disciplined. If no contribution is made in the year, perhaps because money is tight, any further contributions in subsequent years will restart the 10-year tax-free period on the whole balance afresh.

Alternatively, investors can

leave the investment alone, not make any further contributions, and then draw down the money as needed after the 10-year period is up.

How the investments have performed

Most investment bonds are multi-optioned. That means the investor can switch between the bond's investment options without upsetting the tax structure of the investment.

But investors are limited to the half a dozen or so investment options, so particular attention has to be paid to the merits of the underlying manager.

Some providers offer "nil" entry fees but may have higher ongoing and exit fees. Entry fees - typically 3 to 4 per cent - can be negotiated down with the provider.

As the minimum investment time frame to maximise the tax benefits is 10 years, Money asked InvestorWeb Research's senior analyst, Rodney Sebire, to comment on each provider's share funds.

Researchers will have differing opinions on each option. Performance figures are provided by funds researcher Morningstar and are after ongoing manager's fees and after tax if held for 10 years. These figures can look low compared to regular managed funds, but remember, there is no tax owing on them.

ING Life Tax Effective Investment - Australian shares

This option is managed by the ING Australian shares team. InvestorWeb believes that with ING managing more than $9 billion in Australian shares, this may affect the manager's agility in the sharemarket.

Outlook - InvestorWeb believes the fund may not perform much better than the market.

Performance - The average annual total return for the three years to April 30 was 1.8 per cent. The one-year return to the same date was 14.26 per cent.

Australian Unity- high-growth bond

Australian Unity has a multi-manager approach, which should provide consistent investment returns across the cycle. About half the money is invested in fund managers investing in international shares, and half in Australian shares.

One benefit for investors is that Australian Unity retains the flexibility to terminate underperforming managers and can alter the mix between international and Australia shares. InvestorWeb says there are some high-quality managers in the underlying line-up, such as UBS, Wellington and Acorn Capital.

Outlook - Given the longer-term horizon of investment bonds, a multi-manager offering is, in InvestorWeb's opinion, the most attractive vehicle to invest in.

Performance - The average annual total return for the three years to April 30 was minus 3.09 per cent. The one-year return to the same date is 8.6 per cent.

IOOF Supersaver - Australian equities fund

This option consists of a 50/50 combination of Perennial's highly rated value team and its growth team. Perennial Investment Partners, a boutique manager, is majority-owned by IOOF.

From a style perspective, by combining a value and growth manager, returns should be relatively stable over the cycle.

InvestorWeb has a high regard for the Perennial Value team. The performance of Perennial Growth has not been as good, although there are signs of improvement.

Outlook - Based on its strong view of Perennial Value, InvestorWeb is comfortable with the prospects of this offering.

Performance - The average annual total return for the three years to April 30 was 6.17 per cent. The one-year return to the same date was 15.24 per cent.

Family bonds

Mary Wheatley, 44, wants the option of sending her 10-year-old daughter, Kelly, to the high school (public or private) best suited to her interests and abilities. Kelly, who is interested in drama and dance, attends a public primary school and will start secondary school in 2006.

Three years ago Wheatley opened an IOOF Supersaver investment bond. Each month the family payments she receives are put into the bond.

Wheatley doesn't pretend that the savings accumulating in the bond will be enough to meet all of the costs of a secondary school eduction. She says that as Kelly gets older, the expenses are increasing, and every little bit she can put away helps. Wheatley says she "didn't want anything risky". On the advice of her financial planner, she invested in the "balanced" option, which spreads the money between shares, listed property, fixed interest and cash. The returns have been good - much better than she earns on her bank term deposits.

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