Defusing the Financial Time Bomb: Investing without Fear

Money makes the world go round, so goes the saying. Most of us spend a good part of our days thinking or doing something to make more of it.

So how much money do we really need? Surprisingly enough, that is the million dollar question and the answer of which so many of us have no clue about, or worse, have the wrong idea.

This article is not intended for those fortunate few who already have all that they will ever need nor is it for those who know exactly what to do to get what they want.

This piece is for the remaining 98% of the population - the average citizen who earns a salary, supports a family, and aspires to secure his retirement. And, with luck be healthy, wealthy and free enough to fulfill some of his dreams. (Who hasn’t thought of owning a beach-front bungalow or a snazzy sports car or even a yacht?) It is also for those who wish to grow their money, rather than work hard for every dollar.

So how does the average individual make it? The answer, discussed in this article, is deceptively simple.

So why do so many people not make it? Why is it that a majority of Singaporeans are living with a financial time bomb (often without even being aware of it)?

The answer points to three insufficiencies:

1. Lack of essential yet basic financial knowledge (and it is not rocket science)

2. Lack of implementation of that knowledge

3. Simple lack of time (yes, in this case, it can be too late)

Assuming you have enough time and you are adequately insured, this very article can be the start of your financial freedom.

So, where do you begin?

My first recommendation would be for you to consult with a competent and trustworthy financial advisor. I do not recommend leaving all decision-making to him or following his suggestions blindly (a good financial adviser would naturally involve the client as well as educate him at every step of the process). It is exactly like visiting a physician with regards to your health.

With the financial adviser, one must arrive at a comprehensive and consolidated report which clarifies what your current situation is (assets, liabilities, policies etc.) as well as a precise dollar amount that you need the day you retire and how much you need to save every month now in order to reach the above financial goal.

Example:

Consider Mr. Tan, aged 40, married to a homemaker and has two teenagers. He wants to retire at 62 and we assume that he has a life expectancy of 88 years. His income is $5,000 per month and he manages to save $500 each month. The total current savings (cash, investments & CPF) is $150,000. Inflation rate is 2% per year. He foresees he will need $3,000 per month (in today's dollars) during his retirement years. We are assuming he is adequately insured.

Scenario A

If he invests his money with a bank, he would get about 1% per year.

Scenario B

If he invests his money in good bond funds, he would get at least 4% per year.

Scenario C

If he invests his money wisely in a balanced, high quality portfolio (as explained below), we can safely assume he would potentially achieve 8% per year.

Table 1 – Comparison of Rate of Return

As is evident from Table 1, the key to achieving financial freedom is the investment rate of return.

So how is this rate of return achieved?

Well, the good news is an 8% - 10% return in the long term (5 years and above) is not out of reach for the average investor. A clear evidence of this assertion is that over 1926 through 2004, investing in the biggest US stocks, would have yielded an average return, with all dividends reinvested, of 10.46%! (Source: StandardAndPoors.com). This includes all the biggest crashes in the US markets.

More Good news: Over the last two decades, the rate of return has become even higher… close to 13%.

Figure 1 shows the Dow Jones Industrial Average from 1929 through to the present. We have considered the US stock market since it is the biggest, most mature and most influential market in the world.

Figure 1 - Dow Jones Industrial Average historic performance

Now, instead of simply throwing your money at some stocks, a simple strategy, when implemented over time, gives even greater returns while reducing the volatility dramatically. We call this the ‘magic portfolio’.

Simply park your investable cash into a portfolio comprising of a split of good bond funds and selected equity funds. The ratio of the split (usually 50:50), is based on your risk profile (your FA should help you with both: suggesting quality funds as well as your ratio).

The next step is vital and that is rebalancing.

What this means is simply to re-set the ratio of the equity and bond components of the portfolio periodically. Every 6 months is ideal. All the investor must do is that if the equity component is higher, he sells some equity and buys some bonds and vice versa. The effects are shown in Figure 2.

Figure 2 - Rebalancing

This strategy takes advantage of the fact that bonds give slow growth but lower volatility where as equities tend to grow fast but with sharper ups and downs.

Besides reducing portfolio volatility, this deceptively simple step automatically “buys low and sells high”.

Coupled with that, the investor can use another powerful strategy called dollar cost averaging (DCA). DCA simple means investing a fixed amount of dollars every month or so in bonds and equities in your ratio. This automatically facilitates buying less when the price is high and more when low, and is ideally suited to the salaried person.

Finally, the key aspects that the investor should always remember are:

1. Take a long-term perspective

2. Ensure liquidity of your investments, so that you can get your money when you want it without losses or penalties

3. Have enough diversification across asset classes and geography.

4. Evaluate the quality of your portfolio, i.e. growth prospects of each individual investment

We in Singapore are lucky to have an abundance of excellent unit trusts (also called mutual funds) which give us all the flexibility, liquidity, and convenience, plus some very competent fund managers who are able to consistently beat the markets they invest in. What’s more, unlike stocks, the government allows you to invest all your CPF holdings (after setting aside the first $20k in OA and SA) into unit trusts. So take action & start getting rich now!

The Emerging Voice of Sound Financial Advice

An article co-authored by Sam Wadia and Karen Tang published in iFAST Insight magazine's inaugural issue -

Case Study: "Before and After" comparison after restructuring the financial portfolio of a real client

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Good financial advice can make a world of difference to your financial well-being. Read on for a real-life case study of how one client actually benefited from this.

Mr. Bryan Lee (the name has been changed to ensure the confidentiality of the client), 35, is an IT manager married to a home-maker. They have two children aged 7 and 5. He earns $8000 per month (before CPF contribution and taxes). They own a 5-room executive HDB flat, a mid-size car, and are repaying loans on both. They enjoy an upper middle class lifestyle - eating out during the weekends, buying new gadgets for their home and children, and taking annual vacations. Their life's dream is to provide a good eduction for their children and to see them happily settled, while never being a financial burden to them.

Just a year ago, Mr. Lee felt like most ordinary residents of Singapore, who believed that lifelong financial security is something reserved for millionaires, and who could not foresee a clear end to their working lives. He was luckier than those who are in an even more precarious situation - those who simple believe that their financial security has been taken care of, with just their few existing insurance policies, or some randomly purchased investments, or even their expectations of subsidies from the government when they retire. Mere belief is a dangerous thing to rely on. Instead, actively knowing all the relevant facts - with professional advice - is what is required.

Over the years they had bought quite a few insurance policies sold to them by insurance agents. Some of these agents were friends and family whom they found hard to refuse. Other agents were so persistent in following up with him, he bought policies from them almost just as a form of compensation for their time and effort. Interestingly though, once they had sold such policies, these agents went almost completely out of touch. The only communication he did receive were reminders from their companies to pay his premiums and the occasional letter informing him of a reduction in bonuses.

Mr. Lee is considered to be a conservative person who had always chosen to buy the products from agents of well-known financial institutions. Besides insurance policies, Mr. Lee had also bought a few investment products from his local banks. These were almost always spontaneous decisions which were initiated by the banks' sales staff. His investments included low capital guaranteed funds and some unit trusts that were considered 'popular' back then.

In Mr. Lee's case his 'status quo' regarding his financial holdings was finally disturbed when he received yet another notice of downward revision of bonus for one of his insurance policies. This revision was blamed on 'volatile market conditions'. At about the same time, he checked on his investments only to find that many were still under performing, even after holding them for a few years.

Mr. Lee realized that he need to seek a second opinion from a financial adviser who would be able to provide him with a holistic, unbiased overview of his entire financial situation.

In the process of interviewing him, the financial adviser uncovered the following areas that were currently lacking in his financial plan:

1. More coverage required, especially critical illness & disability.

2. Premiums paid are costly for the existing coverage amount.

3. Regular portfolio review and rebalancing are required.

4. A suitable investment plan that would suit his risk appetite.

5. A savings plan for his children's education needs.

The financial adviser also conducted a thorough analysis of his present and projected financial requirements, with the aim of deriving the required rate of return which his funds would need to grow, to meet his future financial needs.

Currently, at age 35, the amount of investible funds he has is $70,000 (in liquid assets). He is able to invest $1,500 per month for the next 25 years. He would require $3,500 per month (in terms of current dollar value) during his retirement years. He intends to retire at age 60 and wishes to plan for a life expectancy of up till age 90. During his retirement years, his money will be invested in conservative financial instruments which will give a return of about 4% per annum ( a constant inflation rate of 2% is assumed).

After a thorough analysis of Mr. Lee's financial situation, the amount of liquid funds he would need at age 60, is $1,557,300.

As for the funds required for his children's education needs, in addition to a starting capital of $25,000, he is also setting aside a separate amount of $500 a month, and he wishes to grow that amount to $25,000 in 16 years' time.

To meet his requirements, Mr. Lee needs to grow his current and regularly invested capital at an approximate rate of over 7% per annum.

To achieve his investment objectives, it was recommended that Mr Lee hold a diversified portfolio of unit trusts investing mainly in global equities. Other investment vehicles such as bonds, deposits and structured products were inadequate to attain the above rate of growth over sustained periods of time.

Once his needs and financial goals had been established, the financial adviser commenced work on scouring the market for suitable plans that not only had customer-friendly clauses but which were cost effective as well. Although the companies were not as well-known as the big boys of the industry, they were very strong financially and able to pass savings to clients by quoting lower premiums, and were also able to include legal clauses which were beneficial to their clients in their contracts.

Table 1 gives Mr. Lee's existing insurance holdings - detailing the coverage he receives and the premium he has to pay. The total cash premium that Mr. Lee forks out annually for his insurance is $12,952, for a sum assured of $390,000 for death and Total and Permanent Disability (TPD) and $190,000 for critical illness. In this situation, Mr. Lee is actually "under-insured and overpaying".

TABLE 1: BEFORE RESTRUCTURING

* Excludes the single premiums

** Excludes coverage from single premium policies.

After talking into consideration the various factors listed below, the required sum assured for Mr. Lee was derived:

1. Annual premium budget

2. Critical illness treatment expenses

3. Current and future expected income

4. Number of years of income to be replaced in case of death, disability, illness or accident

5. Liabilities

The products (as listed in table 2) were recommended. It can be seen that there has been significant savings of $5,464, or 42% of the original premium, and yet the coverage has been increased by 55% for death/TPD and 216% for critical illness.

TABLE 2: AFTER RESTRUCTURING

The single premium policies were discontinued and the amount reinvested into unit trusts, due to the following reasons:

a. Single premium Investment Linked Policy (ILP) is cost ineffective for both insurance and investment purposes.

b. He did not need the protection provided by the ILP and single premium investment products because all his needs are taken care of by the new program.

c. The cash value of the single premium investment products was redeemed and reinvested with suitable unit trusts.

Endowment policies offer a rather sluggish rate of growth and this would not be adequate for Mr. Lee's retirement funding. The cost for his insurance coverage was also considered high which was why they too were discontinued and the cash value reinvested.

Mr. Lee's revised portfolio provided him with immediate benefits:

1. Insurance plan with limited premium payment term (payment will end before he retires), and yet provides sufficient coverage for life.

2. 42% lower annual premium costs.

3. Effects of the sequence of the various catastrophic events (disability, critical illness, accidents) were considered in the construction of the portfolio.

4. Greatly increased coverage amount in his working years.

5. More 'client-friendly" legal clauses in the contract

6. A comprehensive mix of products, each positioned in light of the other, versus an almost random addition of policies.

Satisfied, Mr. Lee noted that the whole process was by far a more rational approach - a simple comparison of available options in the market that matched his needs and the selection of the most ideal option vis-a-vis his resources.

The New Emerging Financial Advisory Landscape

Ever since the enactment of the Financial Adviser Act, new independently owned financial advisory firms are offering consumers with greater choice for financial advise that is not exclusively tied to any product provider (insurance or investment company). This new entrepreneurial setup ensured that client's , rather than product provider's, interests are considered first n providing holistic financial advice. As a client and consumer, it is beneficial to know that the wider choice available can make your hard earned money work harder, if you choose discerningly.