Interest-only with offset: a winning product?

Interest only loans for residential property purchase, for both owner occupiers and investors, have been in the news lately. With no requirement to repay principal, the concern for financial regulators is that many borrowers don’t have the incentive to build sufficient equity “buffers” to cope with any falls in housing values and/or rising interest rates.

The rapid growth in interest only loans was considered such a threat to financial stability that in March last year the Australian Prudential Regulation Authority (APRA) placed a 30% cap on interest-only loans as a share of new bank housing loans.

In October 2017, Westpac chief executive, Brian Hartzer, made the shock admission to the Parliamentary Standing Committee on Economics that about 50% of Westpac’s housing loans were interest only. He also explained that his bank was expecting to comply with the APRA requirement by making interest-only loans considerably more expensive than traditional principal and interest loans.

In response to the following question from the Committee chairman:

“ … so basically half of all people who have a mortgage with Westpac are not paying back any principal, they are just paying interest?”

Hartzer defended his bank’s position by noting that many interest-only borrowers voluntarily repaid principal or held significant balances in offset accounts:

“so the amortisation of interest-only accounts is roughly similar to the amortisation of someone who structured the product as principal and interest. People do that for tax reasons and they do it to manage their cash flow.”

Before responding to Hartzer’s defence, it may be necessary to explain what an offset account is. It’s a savings or transaction account linked to a mortgage. The balance of funds in this account is offset against the mortgage, for interest calculation purposes i.e. interest is only payable on the net balance. However, the owner is free to withdraw any funds from the account whenever they like.

A large percentage of interest-only loans now come with an offset account facility. This combination is the latest evolution in housing loan products that forty years ago comprised only principal and interest loans. Next came the ability to access equity built up in the value of your home (through loan repayments and/or valuation increases) that was then followed by loan redraw facilities i.e. ability to redraw loan repayments made ahead of schedule.

The benefits are great, but what about financial stability?

Undoubtedly, the latest housing loan incarnation (i.e. interest only loan with offset account) provides the housing borrower with many valuable features. As Hartzer suggested, it offers significant potential tax benefits.

For a residential property investor, the tax deductible character of the total interest only loan is always preserved despite the possibility that the net balance outstanding[1] changes and may be significantly less. For the owner-occupier, the funds in the linked account effectively earn the after-tax interest cost of the mortgage i.e. rather than the usual lower pre-tax rate on a stand-alone deposit account, on which tax must then be paid.

The arrangement also simplifies cash management. Provided all cash inflows (e.g. salary, dividends, etc.) are directed to the linked account, with expenses deferred by disciplined use of a credit card, the net loan balance and interest payments are automatically minimised.

And, clearly, Westpac (and the other major banks) had little difficulty in selling the combination. An apparent win for both customers and the banks, so what could be the problem. When assessing the implications for financial stability of growing household debt, the Reserve Bank (RBA) suggests that, at the aggregate level, particularly when offset account balances are included (the dashed lines in the chart below), there is nothing to be concerned about. Both housing debt and interest to income fall considerably when offset accounts are netted off.

But, as the RBA has also previously acknowledged, financial stability issues arise with the marginal borrower rather than the average borrower. While the net interest-only loans and offset accounts balances may have behaved, in aggregate, similarly to that of principal and interest loans, at the individual borrower level this can’t be guaranteed.

For example, if a customer with a large offset balance feels wealthier because of a rise in house prices and decides to treat themselves to a new car, expensive holiday or major renovation, the apparent reduced net loan balance can virtually disappear overnight without the bank having any say in the matter. Under a standard principal and interest loan, the customer would have required, and may not have received, bank approval to access this “equity”.

In a similar vein, many young couples often seek the largest interest only loan with offset account they can, based on their current dual incomes. They expect that in the near future they will have children and become a single income household, at least for some time, and will struggle to meet interest payments (let alone, principal). Any surplus borrowing requirement is therefore placed in the offset account purely for the purpose of meeting future interest payments. For such borrowers, netting of loan balance and offset account to assess financial stability is illusory.

Interest-only with offset may be dynamite in the wrong hands

For disciplined cash flow managers, we think an interest-only loan with offset account is (subject to cost) a great product. But for those that are less disciplined or for those that are, or expect to be, financially stretched, they are potential dynamite.

By increasing the cost of interest-only loans to comply with APRA’s requirement[2], our concern is the banks may inadvertently light the fuse.

[1] i.e. after netting the linked deposit account balance.

[2] APRA requires banks to reduce the proportion of their interest only loans to 30% of all mortgages.

 

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What’s the fuss about interest only loans and offset accounts? is a post from: Wealth Foundations Blog

Emerging markets have recently re-emerged

The two years to end December 2017 saw the MSCI Emerging Markets index (the most widely used benchmark for emerging market shares) massively outperform the MSCI World Index (the benchmark for developed market shares). Emerging markets recorded an annualised return of 19.2% p.a. for the period, compared with 10.8% p.a. for developed markets.

This stellar performance has escaped the attention of many, perhaps because the previous five years saw very lacklustre relative returns for emerging markets. They returned only 2.0% p.a. compared with developed market returns of 15.4% p.a. for the period from December 2010 to December 2015.

Soon after the worst of the Global Financial Crisis, many subsequently disappointed investors jumped onto the story that the future belonged to emerging markets – remember the BRIC excitement (i.e. Brazil, Russia, India and China) – with prospects for developed economies generally assessed as bleak.

But, as often is the case, the most attractive growth stories don’t translate into the highest future share market returns.

Share market prices very efficiently reflect consensus views of what the future holds. The outperformance of emerging markets versus developed markets for the period from the December 1998 inception date of the MSCI Emerging Markets Index to December 2010 of 9.7% pa. compared with -1.9% p.a. suggest the “growth story” had already been heavily factored into share prices!

The obvious question is whether now is a good time to again look hard at investing in emerging markets. Our usual response to such a question in the past has been that, as an asset class, emerging markets offer a higher risk / higher expected return than developed market shares and potential diversification benefits, provided they don’t comprise any more than about 10% of a well-structured portfolio.

However, a recent paper by Ben Johnson of Morningstar, titled “The Evolution of Emerging Markets”, reveals the characteristics of emerging markets are changing rapidly. The rest of this article examines whether these changes warrant a change in our thinking on the place of emerging markets in clients’ portfolios.

Emerging markets are changing

Johnson notes that as at end September 2017, emerging markets shares made up 11.6% of the global stock market, compared with less than 1% thirty years ago. So, they are no longer an oddity but a significant and most likely growing component of global share markets.

The chart below, copied from Johnson’s article, shows how country weightings of total emerging market capitalisation have changed since 2003.

The growth of China and the fall of Brazil, since the peak of the commodity boom in about 2010, is apparent. The change in sectoral composition charted below reveals the rise in energy and materials shares to around 2008 with other sectors, particularly information technology, now becoming increasingly more important.

The table below compares the annual return and volatility (a proxy for investment risk) data for emerging markets, international and Australian shares, for the period 31 December 1998 to 31 December 2017. It also provides this information for a 50%/50% weighted Australian and international share portfolio and a 50%/40%/10% weighted Australian, international and emerging markets portfolio:

31 December 1998 – 31 December 2017

The data reinforce the high return/high risk view of emerging markets. The diversification benefit of adding 10% emerging market exposure to an equally weighted Australian and international share portfolio is also revealed, with a significant return uplift resulting with only a small rise in volatility. It appears that our longstanding view on emerging markets as an asset class is supported.

However, when the data period is broken down into two periods – the period from 31 December 1998 to 31 December 2010 and the period from 31 December 2010 to 31 December 2017 – a more ambiguous picture emerges, as shown in the tables below:

31 December 1998 – 31 December 2010

31 December 2010 – 31 December 2017

While the first period provides strong support for adding emerging markets to a share portfolio, taken at face value the past seven years suggests that the asset class is no longer a high return/high risk proposition, having little impact on the portfolio’s risk and, at least for the period examined, worsening portfolio return.

Despite the changes in emerging markets, our portfolio advice will not change … for now

The experience of the more recent data period is far too short to form any reliable conclusions. But with the increasing maturity of emerging markets and sectoral weightings that increasingly reflect global weightings (as opposed to a previous overweighting to materials and energy), it would not be surprising if the return/risk characteristics of the asset class are changing and will continue to change.

Ultimately, there may not be any additional diversification (i.e. volatility reduction) benefit from holding emerging markets exposure over and above that from holding just Australian and international shares. However, given both the likely growing share of global share markets and the expectation of higher returns reflecting higher risk, we continue to remain comfortable with more risk tolerant clients directing up to 10% of their portfolios to emerging markets.

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The changing shape of emerging markets is a post from: Wealth Foundations Blog

Our investment philosophy relies on capitalism continuing to work

A key tenet of our investment philosophy is that it’s extremely difficult to reliably predict short term (i.e. out to five years) movements in share markets. Markets are very effective in distilling all that is currently known about individual companies, their markets and the relevant economic and political environment to determine “fair” values both for the companies that make up a share market and for the market itself.

Now “fair” doesn’t necessarily mean correct. But it does mean that it should not be an easy task to reliably outperform a share market index by identifying and buying “undervalued” companies (and, perhaps, selling “overvalued” companies) or by entering or exiting that market based on views of its future direction. There is a mountain of robust academic research to support this view of “fair’.

Another central tenet of our investment philosophy is that for capitalism to continue to work, over extended periods well-structured risk should be rewarded. This view suggests that patient share market investors should anticipate and most of the time receive a reward in excess of a risk free rate (e.g. in Australia, the RBA cash target rate) for the system to continue to work. Investors would refuse to commit funds to the share market if the long term expectation was that the prospects for business profits implied share market returns less than those available by keeping your money in the bank (or under a mattress).

Our philosophy leads us to the conclusion that while we don’t know what share market returns will do in the short term (i.e. for periods less than about 10 years), in the long term we expect (but can’t guarantee) positive, after-inflation returns in excess of holding funds in bank deposits, from well diversified exposures to Australian and international share markets.

In the rest of this article, we examine US market experience since 1926 to assess the historical reasonableness of our viewpoint.

Excess returns are less certain in the short term than the long term

In the following analysis, we use the S&P500 index as the proxy for the US share market and the US one month Treasury Bill (“T-Bill) rate as the proxy for the risk free interest rate. Both the S&P500 index and the T-Bill rate are adjusted for inflation.

The first chart below shows the excess return for risk (i.e. difference between the share market and risk free return) on a monthly basis for the period January 1926 – June 2017:

The excess returns for risk are all over the place, varying from a largest positive return of about 44% to a largest negative of -30%. While it isn’t readily apparent, the excess returns were mostly positive (i.e. 64% of the months) but forecasting a month out appears fraught with uncertainty.

How do things look when we take a six monthly view – are the excess returns more reliable. The following chart provides the data:

While it is now more readily apparent that the number of positive excess returns exceeds the negative returns, the percentage of positive returns hasn’t increased greatly – from 64% to 68.4%. Forecasting certainty hasn’t changed much.

On an annual basis (see below), there is still a lot of variability in excess returns, with positive excess returns recorded 70.7% of the times but with no apparent pattern with regard to when the direction of the returns change (i.e. from positive to negative and vice versa).

However, as shown in the chart below, with ten year holding periods, the percentage of positive excess returns rises significantly to 86.1% with risk taking usually well rewarded. But even with this time horizon, investors who entered the US share market around March 1999 experienced a negative 7% excess return over a ten year period that encompassed both the “Tech Stock Crash” and the “Global Financial Crisis”.

Finally, when the risk taking horizon is extended to 20 years, the chart below reveals that all excess returns were positive. With the benefit of hindsight, patient investors were always better off taking share market risk rather than the risk free alternative.

Of course, some of those investors received little additional return for the rollercoaster ride they endured, while others were generously compensated (e.g. most recently, those who commenced their twenty year investment periods in the late 1970s/early 1980s).

Increased certainty of returns requires an extended investment horizon or no risk, at all

History supports our approach to investing. Unless you have some special abilities (which you probably wouldn’t want to share with others), with a well-diversified share portfolio and a 12 month investment horizon, you have about a 70% chance of earning an excess return. In other words, you should expect to lose (relatively) about 30% of the time.

As your investment horizon extends, your chances of earning an excess return increase. We generally consider that you have no business holding share market exposures unless you have a minimum horizon of at least 10 years. Even then, history suggests you will be worse off (compared with holding bank deposits) about 14% of the time.

If this level of losses isn’t tolerable, your unpalatable options are:

• extend your investment horizon even further; or
• invest everything at the risk free rate.

Investing everything at the risk free rate implies foregoing the expected excess returns that share markets have delivered to patient investors and, correspondingly, the potential need to accumulate considerably more investment wealth to fund a given desired lifestyle.

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Forecasting share market returns is a post from: Wealth Foundations Blog

A summary of household wealth and income

Every two years, the Australian Bureau of Statistics (“ABS”) releases its survey of Australian household income and wealth. The latest release[1] relates to the 2015-16 year. It provides the opportunity to update our “Household Income, Wealth and Debt in Australia” article of September 2015, that examined various findings from the 2013-14 survey, and to drill down a little to further into the growing level of debt held by Australian households.

The left hand side of the chart below shows how household wealth or net worth was distributed in 2015-16, while the chart on the right hand side shows how that distribution has changed (in 2015-16 dollars) over the 12 years since 2003-04. Some takeaways from the charts include:

• Only 4.6% of households (or about 250,000 households) have net worth in excess of $3 million;
• The percentage of households with net worth in excess of $5 million has not changed significantly since 2003-04; and
• Those with net worth less than $0.5 million fell from 59.1% of households in 2003-04 to 48.2% in 2015-16 while those with net worth between $1.0 to $3.0 million rose from 14.5% to 23.2% over the same period. Presumably, much of the increase was explained by the increase in the real (after-inflation) value of residential dwellings.

The following charts examine the distribution of household income for 2015-16 and the change in that distribution over the past 12 years (in 2015-16 dollars).

They reveal that in 2015-16 about 11.1% of households (or about 998,000 households) had gross income in excess of $208,000 p.a. (i.e. $4,000 a week), compared with only 4.4% in 2003-04. It is important to understand that gross income includes an estimate of imputed rent for those that own their home suggesting that at least part of the growth in household incomes apparent since 2003-04 reflects increases in the real cost of housing accommodation.

The chart below shows changes in average real household net worth, and its major components, from 2003-04 to 2015-16. The latest survey revealed a strong increase in net worth (11.3%) on the 2013-14 survey, driven by large gains in financial assets of 13.3% and non-financial (primarily property) assets of 11.0%, offset by a rise in liabilities (primarily property related debt) of 12.8%.

A closer examination of household debt

Our 2015 article focused on Australian households’ willingness to take on increasing amounts of debt, particularly property related debt. Despite being at what we regarded as worryingly high levels in 2013-14, the level of property related debt, relative to household income, has risen significantly in the two years since the last survey, as revealed in the chart below.

What are some of the characteristics of the households who are borrowing all this debt? The left hand chart below looks at how the proportion of “households with debt” has changed for each net worth quintile for the six surveys conducted since 2003-04 (survey not completed in 2007-08). There is no apparent trend in the percentage of households holding debt by net worth quintile.

However, when the criteria is “Debt 3 or more times income”, the right hand chart reveals that across the three highest net worth quintiles the relevant proportion of households has risen dramatically, particularly since 2011-12. The ABS categorises such households as “over-indebted”. It is our view that once debt to income ratios rise too much beyond three, it becomes increasingly hard to both repay the debt and accumulate sufficient wealth for financial independence.

Some commentators have suggested that rising household debt levels aren’t a financial stability concern because much of the increased debt is held by households with higher net worth. But the fact that wealthier households are increasingly stretching themselves in terms of cash flow indicates that such complacency may be misguided.

This cash flow concern increases when the debt data is examined based on the age of the reference person that responded to the surveys. The left hand chart below shows that since 2003-04:

• For those survey respondents where the reference person was aged under 34, the proportion of households with debt is little changed; and
• For respondents older than 55, the proportion has risen significantly.

This is consistent with the common view that younger adults are finding it increasingly difficult to purchase a first home, at least partly because they are being outbid by baby boomers purchasing investment properties.

But for us, the most worrying debt trend is revealed in the right hand side chart above. It shows, by age of reference person, the percentage of households with debt of more than three times income. While rising for all those aged over 25 since 2003-04, the most disturbing aspect is that in 2015-16 it was 20.6% for those aged 55-64 and 7.6% for those aged over 65, compared with 12.7% and 4.9%, respectively, in 2003-04.

Few of the over 55’s would be able to repay debt that is in excess of three times income from savings alone. Lenders are therefore heavily reliant on sale of assets to repay the borrowing. As we have suggested previously, this is not good banking practice. It also has worrying implications for the retirement plans of many baby boomers should supporting asset prices fall heavily.

 Increased household wealth not an unambiguous positive

The net worth of the average Australian household has grown at a real rate of 4.2% p.a. over the four years from 2011-12 to 2015-16 – at this rate, real wealth doubles about every 17 years. It has been fuelled by strong growth in the values of both financial (6.4% p.a.) and non-financial assets (3.3% p.a.), particularly residential property. It has also at least been partly facilitated by a large increase in liabilities (4.6% p.a.).

These growth rates are well in excess of the underlying growth of the economy over this period (GDP of 2.6% p.a.) and may have even increased over the two years since the 2015-16 survey was conducted. It’s hard to resist the conclusion that the desire to share in these gains has caused many to become financially stretched, regardless of wealth. They would be very vulnerable should asset prices stall, or reverse, for any significant period.

[1] Released on 13 September 2017

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Household Income, Wealth and Debt in Australia: an update is a post from: Wealth Foundations Blog

It’s maintaining real spending power that matters

When clients consider how much they expect or wish to spend in the future, they naturally think about it in terms of today’s dollars. The implicit assumption is they don’t want price inflation to erode the amount of goods and services they are able to purchase.

In our cash flow modelling, we assume an inflation rate of 2.5% p.a., mid-way between the Reserve Bank’s target of 2-3% p.a.. With inflation at 2.5% p.a., the spending power of a $1 would be reduced to about 48 cents over a thirty year period.

So, while a financial projection that shows your investment wealth grows from, say, $1 million now to $2 million in 30 years’ time may appear impressive, after adjustment for inflation of 2.5% p.a. the future $2 million is only worth $953,000 in today’s terms i.e. you’ve actually gone backwards in spending power.

While we are very focused on after-inflation, or “real” projections for our clients, it’s not a straightforward matter to choose an appropriate measure of inflation, for modelling purposes. The reality is that given every client’s spending patterns are different, the inflation each experiences will also be different.

To simplify things, we assume that the All Groups Consumer Price Index, Australia (“CPI”), published quarterly by the Australian Bureau of Statistics, is the best indicator of changes in retail prices experienced by our clients. But given that it is a “representative” weighted average of the prices of many items, across eight capital cities, it’s likely that it may not reflect anyone’s inflation reality.

The rest of the article drills down a little into the CPI construction, with the aim of helping both clients and other readers reconcile their sense of what is happening to prices and the headline CPI inflation rate that the media focuses on.

Broad inflation measures capture the “average” inflation experience

The chart below shows annual changes in the CPI since September 1989 to June 2017, together with the average for the period and the RBA target inflation bands (inflation targeting began in the early 1990s).

Based on the more recent experience, the assumption of 2.5% p.a. inflation used in our projections appears reasonable.

The CPI, charted above, is a weighted average of the price movements of number of major commodity groups, or categories, which themselves are broken down into subgroups and expenditure classes. The cumulative price movements for most of the commodity groups are graphed below and compared with the cumulative movement in the All Groups Index:

The prices of a number of commodity groups (e.g. Education, Health and Alcohol & Tobacco) rose much more than “average”, while others (e.g. Communication, Clothing & Footwear) were virtually stagnant over the almost 28 year period. Clearly, a person whose expenditure pattern was more heavily weighted (than the representative pattern used to calculate the CPI) to health/education/alcohol & tobacco would have a much different perception (and experience) of inflation than another who was more heavily weighted to communication/clothing & footwear.

A potential surprise revealed in the chart is that the price of housing services (the green line) rose roughly in line with average inflation over the period examined. For those in Sydney and Melbourne, given our recent experience with any prices associated with housing, this defies logic.

The primary explanation for the disconnect is that movements in the price of land (the main driver of movements in the prices of dwellings) are excluded from the CPI. Land is regarded as investment (or non-consumable) rather than consumption spending. The CPI measure attempts to capture changes in the price of housing related services and home building (i.e. things that are consumed).

Also, consistently above average inflation rises in housing services are a relatively recent experience, as revealed in the chart below. It shows the same cumulative price movements in the commodity groups as above, but for the 15 years from June 2002:

When the housing group index is broken down into its subgroups – see chart below – it’s revealed that utilities (i.e. electricity, gas and water & sewerage) are major contributors to the above average inflation price growth. This is consistent with most people’s experience and is behind the often expressed concern that prices are increasing faster than the headline CPI indicates. But in terms of their current weighting in the CPI, these items only make up about 4.4% of average household spending!

As a final dive into the CPI, we also examined how the prices of some goods and services that affluent, active retirees tend to purchase relatively more of (e.g. travel, eating out, attending sporting and cultural events) moved compared with average inflation. The results are provided below for the period since June 2002:

Preservation of real spending can’t be guaranteed, but ignore inflation at your peril

Although hardly rigorous, there’s nothing to suggest from the small sample above that affluent, active retirees face greater than average inflationary pressures. However, as retirees become less active and more unhealthy, spending on health could be expected to take a greater share of household spending, implying a higher inflationary experience than average.

We take some account of historically rising health costs in our cash flow projections by assuming both medical expenses and health insurance rise at a rate of 3% p.a. above average inflation. Also, given the historical above average rises in education spending, we again assume growth of 3% p.a. above the average inflation rate.

We acknowledge that our broad brushed attempts to ensure clients preserve their real spending power have shortcomings. But, unless cash flows and investment returns methodically, even if imperfectly, take inflation into account, the worth of any financial planning projection is questionable.

 

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How “real” are your financial planning projections? is a post from: Wealth Foundations Blog

Retirement expert reconsiders previous thinking

Most planning advice, both regarding saving for, and the enjoyment of, retirement, is given by people who are not retired. So, while the advice may be well meaning, it could inadvertently suffer from a lack of empathy with the realities of retirement.

In addition, the experience and expectations of current and previous retirees may differ significantly from that of the vast numbers of baby boomers that will increasingly dominate the ranks of the retirees over the next decade. As a result, retirement advice based on researching earlier generations may not be as relevant as desired.

A recent article in “The New York Times”, titled “Three Things I Should Have Said About Retirement Planning”, touches on the above issues. It is a confession by Paul B. Brown, who co-authored two books on saving for retirement in his 30s and 40s and is now aged over 60, that his typical advice suffered some inadequacies, now made apparent by his own life experience.

He provides three examples where his fairly generic approach to retirement planning failed to accord with the reality he experienced. The remainder of this article discusses Brown’s examples, together with some commentary on how we respond to the issues raised.

Generic retirement planning meets reality

The first example concerns a typical response to inadequate retirement savings. Rather than suggest to a client that they need to save more/spend less, the more palatable advice is often to suggest they work longer. Together with the fact that we are, on average, living longer, working longer doesn’t appear an unreasonable proposition.

The obvious argument against this for those in labour intensive jobs is they may be physically incapable of working longer. But Brown’s experience is consistent with that of a number of our clients:

“… I now realize … just how hard it is to keep working as you age. My job doesn’t require much more than typing all day long, and I find myself getting fairly tired by day’s end. I can’t imagine I am going to have more energy a decade from now.”

So, unless you remain extremely passionate about your work, working longer to rectify an inadequate savings problem isn’t necessarily the easy option that it is often held out to be. If our clients are to work beyond a desired retirement age, we prefer it to be by choice, rather than driven by financial necessity.

Brown’s second example concerns an assumption that “life moves in straight lines” e.g. “once you begin saving, you keep saving”. His earlier advice assumed that once children moved out of home and were financially self-sufficient, the money previously directed to children would then all be available for retirement savings.

His reality was that for some considerable time those “available” funds went to home repair that had been deferred during the high cost years of raising and educating children. His planning advice had not allowed for the significant and ongoing cost of what we call “capital maintenance”.

A previous Blog article, “What will you spend in retirement”, explains our approach to both capital maintenance, in particular, and retirement spending, more generally, in some detail. In our view, Brown’s previous planning advice failed to sufficiently drill down into the financial expectations of his clients (and/or book purchasers).

This is supported by the third example, where his personal experience included a large once-off expense for a combined major trip/wedding that had not been contemplated and, apparently, seriously affected the family’s financial position. It underlines the need to budget for future desired ongoing holidays and other major, highly likely, expenses (e.g. weddings, support for adult children), so that should a large unplanned once-off expense occur it does not cause an entire financial plan to unravel.

“Rules of thumb” solutions may not be helpful

Brown’s solution to the conflict between his previous advice and his actual experience:

“And no matter how much money you think you are going to need, save another 15 percent, just in case”.

Unfortunately, we think this advice will also fail to adequately handle reality. In our view, there is no substitute for:

• A detailed examination of the financial implications of a client’s lifestyle expectations; and
• Regular review (in our case, annually) of the resulting lifelong cash flows, given that changes will inevitably occur.

Short cuts will likely leave you short changed.

The actual experience of a do-it-yourselfer accountant, who sought a second opinion from us regarding the veracity of his financial planning, is salutary. He planned to retire within two years and, among other things, estimated a desired retirement lifestyle of $120,000 p.a.

A more thorough analysis of his expected spending and incorporation of an overlooked allowance for capital maintenance (of a principal residence, holiday house, investment property and two luxury cars) suggested that $200,000 p.a. was an agreed, more realistic, assessment. An additional 67% retirement capital requirement, and/or a dramatic change in lifestyle expectations, was indicated – “save another 15 percent” would have been a wholly inadequate remedy.

We accept that the future is unpredictable. Also, we know that your view of a desired lifestyle for a time that is many years ahead may change by the time you get there. But not making some reasonable guesses about all aspects of your desired future and regularly reviewing those guesses makes it almost certain that unplanned adjustments, most likely significant, will be needed at some stage.

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Pitfalls of retirement planning is a post from: Wealth Foundations Blog

Rentvesting: a cheaper way to own a home?

Before attempting to answer the question posed by the title of the article, it may be necessary to explain what “rentvesting” is. Essentially, it involves purchasing a residential property to rent to a third party while, at the same time, renting another property to live in.

It’s the mechanism that many young (and some not so young) adults are using to get a foothold in increasingly less affordable housing markets, particularly in Melbourne and Sydney. Many property spruikers, who previously would have used the old chestnut that “rent money is dead money” to promote residential property purchase, now promote rentvesting as a smart way to rent and buy property.

But does rentvesting make financial sense? We have identified at least three approaches to rentvesting, making it difficult to generalise. The three approaches are:

1. You rent where you want to live and buy for rental what you can afford – generally, the investment property is in a less desirable/ less expensive area than where you wish to live. The primary motivation for this behavior may not be to save money, but simply to get into the property market;
2. Purchasing and renting out a property you would like to live in but can’t afford, and renting something cheaper to live in or, often, living with parents – again, the primary motivation is to get into the property market but there is also an expectation of saving money; and
3. Less often seen, but offering a more pure situation to examine the pros and cons of rentvesting compared with owner occupation, is purchasing a residential property to rent to a third party while at the same time renting a comparable property to live in.

We look at the economics of the third alternative in the rest of the article. The other alternatives described above are variants of this like for like comparison.

Rentvesting versus owner occupation

We assume the property (a 2 bedroom apartment) purchased for rent or owner occupation costs $1.2 million. As a rental property, it has an initial gross yield of 3.3% p.a. (i.e. rent of $39,600 p.a.). A deposit of $200,000 is available, implying a borrowing requirement of $1.0 million. The interest rate on the loan is 5.0% p.a., both for investment and owner occupation purposes.

Property costs common to both investment and owner occupation (e.g. strata fees, maintenance, rates etc.) are 13.0% of annual rental, (i.e. $5,148 p.a.), with purely investor related costs (e.g. property management fees, tax and administration costs) assumed at 8.0% of annual rental (i.e. $3,168 p.a.). It is also assumed the investor can claim depreciation of 1.0% p.a. of the initial value of the apartment (i.e. $12,000 p.a.).

The table below shows the potential first year’s tax calculations for the investor, together with the resulting tax benefit for the various marginal tax rates (plus Medicare Levy):

It reveals that the taxable income loss provides the investor with a significant cash tax benefit, that increases with the investor’s marginal tax rate.

Next, the following table compares the first year expected cash flows for a rentvestor (who purchases the apartment, rents it out and then rents a comparable property) with a marginal tax rate of 47% with those of an owner occupier (who purchases the apartment and lives in it):

The far right column shows that for this example the rentvestor is $11,269 (or about 0.9% of the value of the apartment) better off in the first year than the owner occupier, indicating that rentvesting is a potentially cheaper way to obtain home ownership than actually living in the home you buy.

But even ignoring the different capital gains tax treatment that applies to the sale of an investment property versus your principal residence, it doesn’t take too much to undermine the above analysis. For example, the reworked table below assumes a 39% marginal tax rate investor (more typical for young adults attracted to rentvesting), a 7.7% vacancy rate (i.e. 4 weeks a year) and a 0.7% premium for investment loans compared with owner occupier loans (typical of recent market trends):

The rentvesting financial advantage reduces to only $2,683 (or 0.2% of the value of the apartment), with the rentvestor also subject to the typical uncertainties of any renter (i.e. uncertainty of tenancy, variable property management performance etc.) not faced by an owner occupier. A somewhat marginal proposition!

Just renting may be the sensible alternative

The relatively recent phenomenon of rentvesting is driven by the combination of declining housing affordability and negative gearing (i.e. the ability to claim excess tax deductions associated with property rental against other income).

It is a potentially cost effective approach to home ownership. But our concern is that many young (and some not so young) adults are being seduced into a highly compromised home purchase alternative they really can’t afford by the lure of tax benefits, that can quickly be eroded by other elements of the rentvesting strategy.

If unaffordability is the issue, the lower risk and lower initial cost alternative is to simply rent. For the example above, and assuming a 2.5% p.a. interest return on the property deposit, cash outflow in year 1 would be $36,550 – a $15,915 saving on rentvesting. Admittedly, unpalatable for those who are convinced that Australian house prices will only ever go up.

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Does “rentvesting” make financial sense? is a post from: Wealth Foundations Blog

The “big picture”: Matching your lifetime financial assets and liabilities

Most people don’t really grasp what we regard as the primary purpose of personal financial planning. As a result, they often fail to identify some long term issues that should significantly influence their current decision making.

Personal financial planning is often viewed as having three increasing levels of complexity or sophistication. They are:

• Financial planning as investment advice – those without experience of financial planning usually associate it primarily with providing advice on investments. Some planners, while paying lip service to the more sophisticated levels of financial planning, also see their key role as advising on and managing investments;




• Financial planning as technical advice – while also providing investment advice, planners provide advice of a more technical nature in areas such as superannuation, taxation, insurance and estate planning; and




• Financial planning as strategic advice – more generally known as comprehensive or lifestyle planning, detailed long term cash flow analysis examines the consistency of a client’s lifestyle objectives with their current and projected financial resources. Relevant investment and technical advice is also provided to increase the chances that any gap between the client’s current and desired position is closed with no more investment risk than is necessary.

Successful implementation of the strategic advice approach usually implies the need for the financial planner to also act as a “money coach” to help clients avoid behaviours that may feel emotionally appropriate but are objectively likely to be inconsistent with achievement of their objectives. Some planners go even beyond this level, seeking to ensure that clients stay committed to their objectives by attempting to align those objectives with revealed deep seated values.

We are definitely in the “Financial planning as strategic advice” camp but often feel that with increasing complexity the “big picture” purpose of personal financial planning can easily be lost. That “big picture” is, in our view, to help you achieve a desirable match between your financial assets and liabilities over your lifetime.

While simple to state, the reality of many moving parts means success can never be guaranteed. However, some “back of the envelope” calculations based on this high level view of personal financial planning can often reveal some key potential issues, particularly for those early in their careers. The rest of this article provides an illustration.

Is there a gap between your lifetime financial assets and financial liabilities?

While the example discussed below is fairly unrealistic, the messages drawn remain generally valid. We assume a household, the Martins, with a 35 year old major breadwinner. The Martins currently have assets of $0.75 million and no liabilities. They rent a property that meets their projected lifestyle needs for $60,000 p.a. They have an intended retirement date of age 65 and want to be able to finance a 30 year retirement to age 95.

Their projected lifetime financial assets comprise current net financial assets plus:

• their expected household earnings to age 65 – we assume $400,000 p.a., growing with inflation;
• access to either employer sponsored defined benefit and/or age pensions – we assume zero; and
• any inheritances/windfalls received – we assume zero.

Projected lifetime financial liabilities consist of any existing debts, plus:

• taxes on earned and pension income – we assume $150,000 p.a., growing with inflation, to age 65;
• desired lifestyle spending – including rent of $60,000 p.a., we assume $200,000 p.a., also growing with inflation, to age 95; and
• any desired estate – we assume zero.

The table below details these projections and provides total projected financial assets and liabilities (all in after-inflation or real dollars):

Based purely on an assessment of their current circumstances, the Martins appear to be doing nicely – at age 35, they have accumulated $0.75 million, live a nice lifestyle and are still able to save $50,000 p.a., after rent. However, the above simple high level analysis reveals a major potential long term issue that should be addressed immediately i.e. lifetime financial liabilities exceed lifetime financial assets by $3.75 million!

While a well-considered investment strategy and sound technical advice can be expected to assist to close the identified asset-liability gap, the high level view isolates what should be obvious, but often isn’t: the Martins’ work and lifestyle expectations are the primary determinants of their projected financial future.

To at least partially close the gap, and to reduce the reliance on any appropriate technical strategies and uncertain investment returns, the Martins must either increase their financial assets and/or decrease their financial liabilities. The alternatives include:

• looking at ways to earn more, including investing in the acquisition of new skills (i.e. investing in your human capital);




• working longer;




• spending less; and/or




• buying or renting less expensive accommodation.

The asset-liability framework reveals potential changes only you can make

The “big picture” asset and liability matching approach often reveals potential financial planning issues that may not otherwise reveal themselves until well into the future. It provides a simple, yet powerful, framework to understand and consider what changes should be made immediately to reduce the probability of having to make unpalatable adjustments “down the track”.

It also highlights what should be obvious: that your objectives and behaviours are key determinants of the whether your desired financial future is achievable. While sound technical advice and a disciplined investment strategy, that is effectively implemented, are also essential ingredients for “success”, they are unlikely to be able to reliably compensate for objectives and financial behaviours that imply a large, unfavourable mismatch of your long term financial assets and financial liabilities.

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The purpose of personal financial planning is a post from: Wealth Foundations Blog

High level aggregate data suggest household balance sheets are in good shape …

In both actual dollar terms and relative to household incomes, Australian households have never been wealthier. The chart below (or a variant of it) is often used to demonstrate that despite the potentially worrying levels of debt being taken on by households, net wealth as a percentage of income has completely recovered from GFC lows and now exceeds the previous pre-GFC, September 2007, high.

Increases in the values of dwellings and financial assets since March 2009 have more than offset increases in the value of liabilities (primarily increases in housing related debt), suggesting household balance sheets, at least at the aggregate level, are in good shape.

A number of commentators use this chart to refute the claims of housing and housing debt doomsayers that suggest households are borrowing too much, housing values are too high and the economy sits on the edge of a precipice. The doomsayers argue that dwelling oversupply and/or increased housing loan defaults could see house prices and housing wealth collapse savagely, plunging the economy into recession.

We don’t know what the future holds. But we don’t take any comfort from seeing net household wealth rise relative to household income, driven by increasingly expensive asset prices (relative to incomes) and rising debt. At some point, these prices will become (if they’re not already) “too high”, exposing those with high levels of borrowing to at least unrealised losses and, in a major adjustment, significant realised losses.

This article looks at data underpinning the household wealth chart shown above to better understand aggregate household financial behavior. It supports the view that the national household balance sheet has become increasingly fragile but can’t say whether it’s “too fragile” and a collapse is imminent.

… but there are some concerning long run trends

The first chart below looks at the change in the composition of aggregate household assets, from September 1988 – December 2016.

Somewhat unexpectedly, it reveals that dwellings as a percentage of total household assets have remained reasonably constant over the period, rising from 52.2% of total assets as at September 1988 to 55% at December 2016. Less surprisingly, superannuation has risen from 10.4% to 19.8% over the period, offset by falls in financial assets less super and consumer durables.

The next chart shows how household assets have been funded i.e. by borrowings or households’ equity (i.e. net wealth).

Over the period, liabilities (primarily borrowing for housing) have grown from 12.1% to 20.7% of total assets i.e. household balance sheets have become increasingly leveraged. While the 8.6% rise of assets funded by liabilities may not sound like much, it is important to understand that the data is for all households, many of whom do not have any borrowings. The increased leverage reflects both more households with borrowings and higher levels of borrowing, resulting in higher levels of financial risk.

Liability funding (i.e. leverage) reached a maximum of 24.0% in March 2009, primarily due to the significant fall in asset values during the GFC rather than large increases in borrowings. Since 2009, leverage has fallen because asset values have risen relatively faster than liabilities have increased.

We don’t find this reduced leverage comforting. The table below provides details of how liability funding changed from previous wealth (to income) peaks to their subsequent lows:

It shows that for all significant declines (of 5% or more) of Household Wealth, leverage increased due to relative declines in asset values. Leverage at each Household Wealth peak was higher than at the previous peak. A potential concern now is that leverage is currently above that of the previous wealth peak in September 2007.

The next chart below examines how the key components of household wealth and household income have grown over the period under examination. The vertical axis is a logarithmic scale, enabling changes in growth rates to be more easily identified.

It shows liabilities have grown significantly faster than asset values, resulting in net wealth growth lagging growth in asset values. This also explains the increased leverage discussed above. However, liabilities simply can’t keep on growing faster than assets for ever, as negative household net wealth would be the eventual result. But it’s not easy to identify when liabilities have become excessive.

Also clear from the chart is the failure of household income growth to keep pace with the growth in asset values, particularly since around 1996-97. A clear flattening in income growth from the bottom of the GFC around March 2009 is evident, while asset values bounded ahead to their currently unprecedented multiples of income. This trend also can’t continue indefinitely, but what will precipitate a fall in asset values relative to income? Lower asset value growth and/or higher income growth?

Borrowing to invest looks riskier than ever

Rising household wealth, relative to income, is a mixed blessing even though it may feel good! We don’t believe the trends underpinning this rising household wealth are sustainable. The longer they last, the more inevitable it is that some adjustment will occur.

Unfortunately, even if our view of the trends is correct, it gives no clear insight as to how and when that adjustment will occur. While it is easy to see potentially catastrophic scenarios for highly leveraged borrowers, a more benign outcome could result if the adjustment primarily occurred through a relative acceleration in household income growth.

However, the aggregate household data does suggest that, although borrowing to invest strategies are always high risk, risk is currently at elevated levels.

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Australian households have never been wealthier is a post from: Wealth Foundations Blog

Our clients respond to an online “Client experience” survey

In late February-early March 2017, a representative group of our clients was asked to participate in a confidential on-line “Client Experience” survey. The survey aimed to help us, among other things, better understand:

• what our clients look for in their relationship with us;
• how they measure the value of our service;
• their greatest personal finance fears; and
• how they felt we were doing.

We were pleased with the 70% response rate we received and thank those clients who participated.

The same survey was simultaneously offered to clients of other financial advisers that choose to use the services of global fund manager, Dimensional Funds Advisors, both in Australia and internationally. The results provide us with the opportunity to compare our clients’ feedback with that of almost 19,000 other respondents.

Unfortunately, we don’t know the response rate to the global survey. However, the high response rate from our clients and the large numbers that responded to the international survey provide a high level of confidence that the findings are robust.

In summary, the good news is that for both us and other financial advisors that participated in the survey there appears to a strong alignment with what is offered and what clients value and a generally high level of client satisfaction. The findings could not be further from the jaundiced view of financial planning that pervades the mainstream financial media and public opinion. The bad news is that not enough people are aware that a better personal financial advice alternative exists.

To provide some flavour of the feedback received, the remainder of this article compares our clients’ aggregate responses with those of all participants in the international survey to four key questions.

An executive summary of the “Client Experience” feedback

The first question we examine is:

Would you recommend your advisor to friends, family members, or colleagues?

In the chart below (as for all the charts), Wealth Foundations clients’ responses are shaded green while those of all participants are shaded blue.

The results, both for us and all the financial advisers involved, are very gratifying and set an extremely high bar to maintain. But, hopefully, they provide clients with some comfort when considering future referrals to us that they are not “going out on a limb”.

The next chart is in response to the following question:

From the following, choose the attribute you consider most important in your advisor relationship:

Our clients put a much higher weight on “experience with clients like me” and “client service experience”, rather than “investment returns”. It is consistent with an understanding that investment returns are the outcome of a disciplined investment strategy, rather than an input that can be directly controlled.

With reference to the high weighting given to “experience with clients like me”, it appears that our client base has higher funds under management than the average international survey respondent, as suggested by the chart below:

The third question we examine is:

How do you primarily measure the value received from your advisor?

The responses are charted below:

Consistent with the previous question, our clients are focused on what we consider to be core objectives of our service i.e. “progress towards my goals” and “sense of security, peace of mind”, rather than “investment returns”. This alignment with what we believe we can reliably offer and what clients value is reassuring.

The final chart examines the responses to the following survey question:

My greatest fear about my personal finances is:

Our clients are significantly more concerned about “not having enough money to live comfortably in retirement” than the international average. While this may simply reflect the reality that the future is inherently uncertain, we aim to build resilience in our clients’ financial plans to allow for both an adverse external environment and changes over time in what is perceived as “living comfortably in retirement”.

The survey also provided us with more detailed and helpful feedback on what aspects of our service were regarded as most important by our clients and their satisfaction with those services. Some areas for potential improvement have been identified.

Responses to questions regarding “Advisor Communication” were also revealing. For example, based on external “expert” advice, we have been considering moving some of our communications to a video or audio format and away from our current written/presentation style. The responses from our clients, mirrored closely by the international survey, indicated that this may not have been well received. The preference for video/audio is currently very low, particularly as the age of respondents increased.

Survey suggests an “easy” fix to woes of financial planning industry

In summary, we were pleased with, but are definitely not complacent about, the feedback received from the “Client Experience” survey and, again, thank our clients for taking the time to participate. But we were also particularly heartened by the overwhelmingly positive feedback received by other financial advisers whose clients participated in the survey.

A distinguishing feature of most (if not all) of these advisers is that their personal financial advice isn’t conflicted by any formal alignment (e.g. through ownership or incentive arrangements) with financial product manufacturers. Perhaps, our regulators should be shown the survey results in the hope they realise that no amount of additional regulation, disclosure or education will more effectively “clean-up” the generally poor perceived performance of the financial planning industry than legislating the separation of the provision of personal financial advice from financial product manufacture.

We won’t be holding our breath!

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At last, a “good news” financial planning story is a post from: Wealth Foundations Blog