“Back of the envelope” financial planning

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Making financial decisions based on what others are doing can be dangerous

My children and many of their friends are now at the age where they are making very important decisions regarding starting families and meeting housing needs. These decisions, of course, have a strong emotional element. But they also generally have massive financial implications that, once made, lock in commitments that will extend for many years into the future.

Entering into such commitments, without detailed consideration of your “best guess” capability to both meet them and continue to be able to enjoy a desired lifestyle, sets up a high likelihood of serious, unanticipated financial pain later in life. Anecdotes suggest that many young adults who borrowed to purchase in the Sydney housing market over the past three to four years are already finding this out.

A focus on the “here and now” and peer comparison when making financial decisions is fraught with danger. Young adults often wrongly presume because their friends are buying houses and starting families, they can and should do the same.

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What is good financial health?

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Good financial health not measured purely by wealth

When we started Wealth Foundations in 2007, we embraced 20 principles of successful wealth management. These continue to underpin our approach to personal financial planning.

Principle 17 states that: “Money is a means to an end, not an end in itself”. Our original rationale for this principle was as explained below:

“Research indicates that a pursuit of wealth and its trappings for their own sake is unlikely to result in life satisfaction. Also, it is important to realise that maximising wealth may be a poor proxy for maximising life satisfaction.

Therefore, we believe that effective wealth management requires you to first examine and articulate what is important to you in life (i.e. your lifestyle objectives) and then consider what, if anything, may need to change financially for those objectives to be achieved. To blindly pursue increased wealth without first asking “what for?” is really putting the cart before the horse.”

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Low financial literacy: a serious threat to financial health

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Retirement readiness is low, both in Australia and internationally

Recently, the Aegon Center for Longevity and Retirement released its 2018 international Retirement Readiness Survey, a survey it has conducted annually since 2012. For each of the 15 nations surveyed, an Aegon Retirement Readiness Index (ARRI”) is calculated, ranking retirement readiness on a scale from 0 to 10.

A high index score is between 8-10, a medium score between 6 and 7.9, and, a low score being less than six. The results for workers in the fifteen surveyed nations (with a comparison with 2012 results, where available) are shown below:

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The “Jurassic Park” of financial advice

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The usual suspects’ advice practices again under scrutiny …

The latter part of April saw the Financial Services Royal Commission[1] examine some poor financial advice practices that had been brought to its attention. The Big 4 banks and AMP came under intense scrutiny, with the following areas highlighted:

  • Fees for no service, including continuing to charge the accounts of people who had been dead for some time;
  • Investment platform fees;
  • Inappropriate financial advice, that was allegedly in breach of the client best-interests duty that all planners must adhere to; and
  • Improper conduct by advisers.

While the poor practices highlighted resulted in a lot of adverse publicity for the banks and AMP (and, since, a number of board and executive resignations), they didn’t surprise us or, I suspect, most in the financial planning industry.

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Is the search for higher income yield misguided?

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Income yields are down, but should you worry?

The last few years have seen a fairly dramatic drop in the income yields obtained from typical balanced (i.e. roughly equal defensive and growth investments) investment portfolios. Reduced interest rates, lower rental yields on property and flat to declining dividend yields on shares mean that many retirees are no longer able to meet living expenses solely from the cash distributions (i.e. the income yield) generated by their portfolios.

There is often a reluctance to sell investments (i.e. draw down capital) to maintain desired spending. Rather, the apparent solution to the shortfall is often seen as higher yielding investments (e.g. higher risk fixed interest securities, including hybrids, high dividend paying shares and other structured products), with there being no shortage of financial product manufacturers happy to respond. However, yield enhancement always comes at the expense of a combination of increased credit risk, reduced diversification and/or increased taxation.

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Will investors benefit from a reduction in the company tax rate?

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Is a company tax reduction a second best solution?

The Government has proposed to reduce the large company tax rate from its current 30% to 25% by 2026-27. It argues that the reduction is necessary to keep Australia’s company tax rate internationally competitive and will create “jobs and growth”, ultimately leading to wages growth.

It’s been a hard sell, with those opposing the move citing, among other things, the budgetary cost and a lack of confidence in the reliability of so-called “trickle down” benefits to Australian workers.

We don’t propose to enter into the argument as to whether a drop in the company tax rate is a good or bad thing for the Australian economy. However, as a generalisation, we don’t think a tax on companies is a particularly efficient tax, given the scope for avoidance and that shareholders ultimately bear the tax burden. Most likely, it would be more effective to tax shareholders directly.

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What’s the fuss about interest only loans and offset accounts?

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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.

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The changing shape of emerging markets

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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.

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Forecasting share market returns

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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’.

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Household Income, Wealth and Debt in Australia: an update

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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:

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