How does one become financially secure?

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1 CENTER FOR ASSET MANAGEMENT RESEARCH & INVESTMENTS How does one become financially secure? Joseph Cherian February 8, 2011

2 Be financially astute and educated. Know the fundamentals Don t spend beyond your means Save For Tomorrow (SFT) Diversification, hedging, insurance Develop your personal, career and financial goals Define and develop Implement Monitor and review Develop income and net worth statements Income versus expenses Assets versus liabilities Know your personal financial ratios Liquidity ratio Gearing ratio The main ideas 2

3 Don t be a spendthrift when starting out Unlike your American brethren, do not spend beyond your means Especially watch your credit card spending. Do not carry a balance forward, interest rates on unpaid balances are exorbitant Save For Tomorrow (SFT) Start your retirement planning & investing early Save as much as possible for the tax benefits and future security Get as much a match as possible from your employer Use (cheaper) public transport, defer purchasing the BMW 3-series (and Birkin handbags!) Work hard, invest wisely and prudently. Avoid day trader tendencies 3

4 SFT: CPF and SRS contributions If you re 35 years and below, CPF mandates that Singaporeans Contribute 20% of your gross income, your employer 15% These contributions are formulaically allocated to various CPF accounts CPF annual limit is $27,158 (2011) These are tax deductible Additionally, you can voluntarily contribute to the Supplementary Retirement Scheme (SRS) You can contribute up to 15% of your gross income SRS annual limit is $11,475 (2011) These are also tax deductible Source: CPF Singapore website. Visit this website to get the most accurate facts and figures on the CPF: 4

5 Tax rates and savings for Singaporeans Chargeable Income Rate (%) Gross Tax Payable ($) Example Chargeable Income: $90,000 First $20,000 Next $10,000 First $30,000 Next $10, Taxes Owed $4,300 (for first $80,000) $1,400 (for next $10,000) $5,700 (6.3%) First $40,000 Next $40,000 First $80,000 Next $80,000 First $160,000 Next $160,000 First $320,000 Above $320, ,400 4,300 11,200 15,500 27,200 42,700 Taxes Owed with SRS (max) Chargeable Income: $90,000 - $11,475 = $78,525 Taxes Owed $900 (for first $40,000) $3,275 (for next $38,525) $4,175 (4.6%) Tax savings: $1,525! Source: Inland Revenue Authority of Singapore (IRAS). Visit the IRAS website to get the facts and figures on the IRAS: 5

6 Investment portfolio: The fundamentals Back To The Basics: Structuring An Investment Portfolio DIVERSIFICATION HEDGING INSURANCE Expected Returns (%) reduce risk increase returns Probability (%) protect against losses give up gains 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% Probability (%) protect against losses participate In gains 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 2 0.5% 0.5% Expected Risk (%) -10.0% 0.0% 10.0% 20.0% 30.0% Distribution of annual geometric returns (%) 0.0% 0.0% -10.0% 0.0% 10.0% 20.0% 30.0% Distribution of annual geometric returns (%) Optimally balancing risk and return tradeoffs Reducing exposure to bad outcomes by giving up the possibility of some gains Eliminating exposure to bad outcomes by paying an upfront premium DESIRABLE RISK ADJUSTED RETURNS ARE THE ULTIMATE GOAL IN STRUCTURING OPTIMAL PORTFOLIOS, AND IN SOME SITUATIONS MIGHT REQUIRE ALTERING THE SHAPE OF THE PAYOFF 6

7 Debunking some myths with facts Popular literature (Myths) Saving is for the short run, investing is for the long run The only way to reduce risk is to diversify Stocks become safe in the long run due to time diversification Financial Economics (Facts) Saving means income minus consumption; investing means selecting your portfolio of assets, including cash The simplest ways to reduce risk are to hedge, insure, or hold safe assets. A safe way to achieve a future spending target is with CPIlinked (inflation-indexed) bonds Stocks do not become safe even in the long run. If they did, they would not have a risk premium Source: My favorite coauthor, Prof. Zvi Bodie 7

8 A word about unit trusts (mutual funds) High fees up to 5% sales load, and anywhere between 1.5% - 2% p.a. in management and trustee fees for actively-managed retail funds Nevertheless, well-diversified risky assets such as equity ETFs and mutual funds do have an important role to play in our investment portfolios, although They may not exactly match the purpose or objectives of our future spending profile and consumption needs, which may be sensitive to inflation For a matching strategy, the basic building blocks must be denominated in units that match the purpose or objective, and have known maturities (a.k.a. assetliability management) 8

9 An Alternative: Exchange Traded Funds Name of Fund: DBS Singapore STI ETF Lot Size: 100 units per lot X X diversification hedging insurance Fund Structure: Open-ended Listed Unit Trust, with Exchange Tracker Fund feature Actual Issue Price: S$ 1.62 Benchmark: Straits Times Index (STI); Valuation Frequency: Daily Dividend Distribution Frequency: At least once per annum Listing: Singapore Exchange; Fund Auditor: PricewaterhouseCoopers LLP (Singapore) Manager: DBS Asset Management Ltd Management Fees : 0.20% p.a.; Trustee Fees : 0.08% p.a. Source: A local bank s website 9

10 A goal-oriented lifestyle Identify your financial goals building up a nest egg, buying a house, having sufficient funds for medical emergencies, retiring comfortably, taking care of aged parents, etc. Design a financial and asset-liability management program that gets you there via diversification, hedging, and insurance Implement the plan Monitor and review regularly it s all about risk management! 10 10

11 Example: Buying (and saving for) a house Cost of house $ 250,000 Downpayment (20%) $ 50,000 Mortgage rate per month % (i.e., 2% per annum) Number of months 360 Months (30 years) Borrowing (Present Value) $ 200,000 Monthly payments ($739) Risk Management ( What If Scenario) Mortgage rate goes up 0.5% p.m. (i.e., 6% per annum) Monthly payments ($1,199) (pmt increases by $460 p.m.) CPF Ordinary Acccount (Saving up) Recall: Downpayment $ 50,000 CPF interest rate per month % (2.5% per annum) Future Value (in 5 years) $ 50,000 Number of months 60 Months (5 years) Monthly savings ($783) In Excel: PMT (INT,MOS,PV,FV) 11

12 Some personal financial ratios Solvency ratio ratio of net worth to total assets (usually <1). Solvency ratio of 1 implies no debts! Liquidity ratio ratio of your liquid assets (cash, bank accounts) to total current liabilities (short-term debt). Aim for this ratio to be greater than 1. For more details read Personal Financial Planning by Benedict Koh (SMU) and Wai Mun Fong (NUS), Pearson, 4 th Edition,

13 It s getting harder all the time: The retirement problem We think the average investor is concerned about 3 fundamental issues during retirement: Receiving a reasonable, level payout every month It should last for as long as the investor lives It should be indexed to his or her cost of living 13

14 Safe investing in risky times Conventional investment advice today is based on a mistaken principle of time diversification, which inadvertently has led to portfolios that are riskier than investors realize... until it is too late! Starting point of any retirement portfolio should be 100% inflation-proof, guaranteed annuities (our safety-net portfolio) Always hope for the best, but prepare for the worst Principal-protected, inflation-linked investment products Participating equity-indexed and inflation-indexed annuities 14

15 Getting better all the time: What about Inflation-Indexed Participating Annuities? Future Realized Investment Value Receive S T million SGD at future time T upon retirement = S T million SGD at T (inflation-indexed) Short zero-cost inflation-indexed participating forward : No hedging Retirement Receipts at T + Participating Forward K S T if S T < K Payoff = 0 if K S T F - ½ (S T F) if S T > F Long Put struck at K + Write ½ a Call struck at F Some participation in upside Forward Price (F) K F = $35K K = $32.5K Plain forward contract Strictly limited downside (indexed to inflation) X diversification hedging (some form) insurance Investment depreciates Investment appreciates K F Future Risky Investment Value S T (SGD) 15

16 What Should The Basket of Risky, Upside Participation Assets Be (S T )? Upside Participation Portfolio, S T Accumulated Investment Capital reaches $780K at retirement (hopefully!) Invest in a diversified portfolio of equities, mutual funds/etfs, hedge funds, commodities, real estate, etc., based on your individual risk tolerance profile X X diversification hedging insurance 16

17 The retirement solution The most commonly-cited product that provides a level real payout (i.e., inflation-indexed) for life is an inflationlinked retirement annuity Such a product would convert accumulated investment capital (say, from your CPF) to lifetime real cash flows for retirement consumption, expenses, and spending Ageing populations and changing demographic landscapes in Asian countries will increase the demand for such retirement annuity products An alternative: Financially manufacture a laddered portfolio of inflation-indexed bonds from the respective sovereign, assuming such bonds exist 17

18 Life-cycle investment products around the world today Target-maturity retirement accounts very popular in the U.S. Target-maturity college tuition accounts newer vehicles, popular as well Health saving accounts Common characteristics Specific purpose Specific maturity date Tax advantaged Most of the money in these accounts is invested in risky equity and bond mutual funds, which have no guarantees against downside risk or inflation! In Singapore: The top two performing CPF-approved funds in 2Q2009 were United Growth Path 2010 and United Growth Path Today these are "target maturity funds, which means they have a limited lifespan. Such funds typically start off by investing in riskier, higher-yielding equities before gradually shifting to bonds and other safer assets as the maturity date approaches. The Edge (Singapore), August

19 U.S. Treasury Inflation-Protected Securities (TIPS) example 1 TIPS Principal (or Face Value) is adjusted by changes in the CPI. With inflation, the principal increases. With deflation, the principal decreases 5, 10, and 30 year issues are available online in increments of US$100 via TreasuryDirect Interest rate (or coupon) is determined in a competitive auction Both the sum paid when a TIPS matures and the amount of interest paid every six months is affected by adjustments in the Principal due to changes in the CPI 1. Also visit: ; ; 19

20 Implementation of a laddered portfolio Let s say you need $35,000 in real cash flows per annum in retirement and have $780,000 in accumulated CPF capital at the point of retirement (today) 1 Inflation-linked retirement annuity stream Real Cash Flows Accumulated Investment Capital from CPF account Purchase 1-year, 2- year, 3-year,, 30-year TIPS (zero coupon) upon retirement $35K $35K $35K $35K $36K $38K $39K $85K Nominal Cash Flows It will cost you $780K today to buy a laddered portfolio comprising of a series of 30 inflation-indexed government bonds with maturities of 1 to 30 years Assuming the government-linker is correctly tracking your cost of living during retirement, you should be able to meet your target consumption needs annually while maintaining purchasing power 1. Assume the real interest rate is 2% p.a. and the inflation rate is 3% p.a. (both flat) over the next 30 years 20

21 How do we get to $780K? Option 1 Saving / Accumulation Period Take a Chance On Me (AßßA) Inflation-linked retirement annuity stream Real Cash Flows X X Invest in equities, mutual funds, commodities, balanced funds, etc., during Saving / Accumulation Period diversification hedging insurance Hope For The Best Accumulated Investment Capital reaches $780K at retirement (hopefully!) $35K $35K $35K $35K $36K $38K $39K $85K Nominal Cash Flows X diversification hedging (some form) insurance ( ) Note: Assume the real interest rate is 2% p.a. and the inflation rate is 3% p.a. (both flat) over the next 60 years 21

22 How to get there prudently? Option 2 Start buying today (say, at age 26) $19,300 worth of 30-year, government-guaranteed inflation-linked bonds annually for the next 30 of your working years, and hence remove ALL uncertainty about future cash flows (All cash flows in 000) Age 30 YR I-Bond Cost Real Cash Flow Pays At Age Nominal Cash Flow Inflation-linked retirement savings stream X diversification hedging (some form) insurance ( ) 26 $ 19.3 $ $ $ 19.3 $ $ $ 19.3 $ $ $ 19.3 $ $ 39.4 : : : : : 52 $ 19.3 $ $ $ 19.3 $ $ $ 19.3 $ $ $ 19.3 $ $ 85.0 Note: Assume the real interest rate is 2% p.a. and the inflation rate is 3% p.a. (both flat) over the next 60 years 22

23 Summary To get even more educated on personal financial investing and investments science, please read Personal Financial Planning by Benedict Koh (SMU) and Wai Mun Fong (NUS Business School), Pearson, 4 th Edition,

3. Structured innovations: Inflation-Indexed Participating Annuities for Life. 6. Appendix: A caveat about hedge funds: Asia versus US experience

1. Dynamic asset allocation: facts and fallacies 2. Retirement finance: The Full Monty 3. Structured innovations: Inflation-Indexed Participating Annuities for Life 4. The role of alternative investments