Benefits of starting early

The Business Times
Teh Hooi Ling
24/7/2013

HIGH expense fees on many investment products and restrictions on investing in risk assets at an earlier age act to limit the growth of retirement funds of the average Singaporean, a Singapore Exchange (SGX) and Oliver Wyman paper on retirement savings said.

CHART 1 - Risk averse
http://www.businesstimes.com.sg/sites/businesstimes.com.sg/files/BT_20130724_HLRETIREMENT1_680047.pdf

CHART 2
http://www.businesstimes.com.sg/sites/businesstimes.com.sg/files/BT_20130724_HLRETIREMENT2_680048.pdf

Data from the Central Provident Fund (CPF) and research and analysis by Oliver Wyman, a global consultancy, showed that as at the third quarter 2012, CPF members held $196 billion in "fixed deposits" - funds which are invested ultimately in Special Singapore Government Securities. Some $156 billion had been withdrawn for property purchases and only $29 billion were in risk assets. But out of the $29 billion allocated to risk assets, 67 per cent went into insurance policies, 18 per cent into unit trusts and only 15 per cent into stocks, loan stocks and property funds.

Relative to people in other countries, Singaporeans have allocated the highest proportion of their retirement funds to fixed deposits - at 72 per cent. Only 12 per cent were allocated to equities. Malaysians, based on their EPF (Employees Provident Fund) allocation split, had 49 per cent in bonds, 49 per cent in equities and only 2 per cent in fixed deposits in 2011. Australians, meanwhile, parked 69 per cent of their retirement funds in equities, 19 per cent in bonds and 12 per cent in fixed deposits.

Based on its analysis, Oliver Wyman concluded that the average Singaporean in full-time employment today can expect an income replacement ratio (expected post-retirement income versus pre-retirement income) of around 68 per cent. That's still within the range recommended by the World Bank and comparable to those seen in OECD (Organisation for Economic Co-operation and Development) countries. This is attributable to the relatively high savings rate, and the relatively high interest rates paid by the "fixed deposits" offered by the CPF Board.

However, some Singaporeans may aspire to a higher replacement ratio. This can be achieved through both increasing savings rate and to/or target higher rates of return on these savings. But even if Singaporeans were to allocate more of their retirement funds to risk assets, their retirement income is expected to increase only by a measly 3 per cent. The reasons are: one, the high fees on many investment products and, two, investing in risk assets too late in life, concluded the paper. The expense fees on many investment products are too high for long-term investment and can eat up up to about 20 per cent of expected return through time, said the paper. "A high proportion of these fees are paying for the distribution of these investment products rather than actual investment management."

For unit trusts eligible for inclusion in CPF, Oliver Wyman observed total expense ratios (TERs) of between one per cent and 1.95 per cent per annum. These levels are similar to unit trusts' TERs outside the pension system both in Singapore and in other comparable countries. "CPF retirement savers who wish to invest in a unit trust or other investment products typically buy and administer these investments through one of the qualifying Singaporean banks. Much of the fee expenses are used to pay for advice, sales, compliance and administration costs incurred in the process."

Oliver Wyman and SGX observed that in some other countries, systems have been created to offer a simplified, narrower set of investment products for retirement savers. Savers are guided into a particular fund depending on their age together with the use of centralised or similar scalable administration systems.

This creates significant cost savings and typically brings expense ratios down to between 0.3 and one per cent per annum. Some of these systems are state-run, such as the UK Nest or Swedish AP7, while others are sponsored either by corporates, such as the US 401k, and by unions, such as in the Netherlands, or by asset managers, such as i-Shares lifestyle exchange-traded fund products listed in the United States. "If investment costs in the Singaporean system could be reduced closer to this range, this would increase the uplift in expected retirement incomes from 3 per cent to 6 per cent," said Oliver Wyman and SGX.

Meanwhile, the Minimum Sums that are required in the CPF accounts before members could invest the balance in risk assets means that the average Singaporean could invest his or her CPF funds in risk assets only beyond age 40, noted the paper. "If Singaporeans can invest earlier in their lifecycle, the accumulation period of higher returns will be extended and the risk of market volatility should be diminished due to longer holding horizons," the paper said.

A famous Dow Theory letter gave the example of two persons - A and B. A starts saving at age 19. She saves $2,000 every year from age 19 until 25. Then she stops. In other words, she puts only $14,000 into her portfolio. B, meanwhile, starts saving at age 26. And he is very disciplined. From age 26 until 65, he puts $2,000 yearly into his savings. By age 65, he has contributed $80,000 to his portfolio.

Let's assume A and B are able to generate 10 per cent on their savings and portfolios every year. At age 65, the difference in the two portfolio sizes is quite negligible. By then, A's portfolio would be worth $944,641 and B's portfolio would be at $973,704. This, despite A putting in only $14,000 over seven years, while B has contributed $80,000 over 40 years!

That's the magic of compounding. The earlier you allow it to start, the greater the benefits. Now imagine starting investing at age 40, and generating less-than-desirable returns because of all the fees paid to financial intermediaries.

That's the gist of SGX and Oliver Wyman's paper.