CENTER FORASSET MANAGEMENTRESEARCH &INVESTMENTS

How does one become financially secure?

Joseph Cherian

February 8, 2011

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• Be financially astute and educated. Know the fundamentals Don’t spend beyond your means

Save For Tomorrow (SFT)

Diversification, hedging, insurance

• Develop your personal, career and financial goals Define and develop

Implement

Monitor and review

• Develop income and net worth statements Income versus expenses

Assets versus liabilities

• Know your personal financial ratios Liquidity ratio

Gearing ratio

The main ideas

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Don’t be a spendthrift when starting out• Unlike your American brethren, do not spend beyond your means

• Especially watch your credit card spending. Do not carry a balance forward, interest rates on unpaid balances are exorbitant

• Save For Tomorrow (SFT) Start your retirement planning & investing early

Save as much as possible for the tax benefits and future security

Get as much a match as possible from your employer

• Use (cheaper) public transport, defer purchasing the BMW 3-series (and Birkin handbags!)

• Work hard, invest wisely and prudently. Avoid “day trader” tendencies

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SFT: CPF and SRS contributions• If you’re 35 years and below, CPF mandates that Singaporeans

Contribute 20% of your gross income, your employer 15%

These contributions are formulaically allocated to various CPF accounts

CPF annual limit is $27,158 (2011)

These are tax deductible

• Additionally, you can voluntarily contribute to the Supplementary Retirement Scheme (SRS)

You can contribute up to 15% of your gross income

SRS annual limit is $11,475 (2011)

These are also tax deductible

Source: CPF Singapore website. Visit this website to get the most accurate facts and figures on the CPF: http://mycpf.cpf.gov.sg

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Chargeable Income

Rate (%) Gross Tax Payable ($)

First $20,000Next $10,000

03.50

0350

First $30,000Next $10,000

-5.50

350550

First $40,000Next $40,000

-8.50

9003,400

First $80,000Next $80,000

-14

4,30011,200

First $160,000Next $160,000

-17

15,50027,200

First $320,000Above $320,000

-20

42,700

Source: Inland Revenue Authority of Singapore (IRAS). Visit the IRAS website to get the facts and figures on the IRAS: http://www.iras.gov.sg

Tax rates and savings for Singaporeans

Example

Chargeable Income: $90,000

Taxes Owed $4,300 (for first $80,000)$1,400 (for next $10,000)----------------------------------$5,700 (6.3%)

Taxes Owed with SRS (max)

Chargeable Income: $90,000 - $11,475 = $78,525

Taxes Owed $900 (for first $40,000)$3,275 (for next $38,525)----------------------------------$4,175 (4.6%)

Tax savings: $1,525!

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0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

-10.0% 0.0% 10.0% 20.0% 30.0%

Prob

abili

ty (%

)

Distribution of annual geometric returns (%)0

2

4

6

8

10

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0 5 10 15 20

Expe

cted

Ret

urns

(%)

Expected Risk (%)

DIVERSIFICATION HEDGING INSURANCE

Back To The Basics: Structuring An Investment Portfolio

Optimally balancing risk and return tradeoffs

Reducing exposure to bad outcomes by giving up the possibility of some gains

Eliminating exposure to bad outcomes by paying an upfront premium

Investment portfolio: The fundamentals

DESIRABLE RISK ADJUSTED RETURNS ARE THE ULTIMATE GOAL IN STRUCTURING OPTIMAL PORTFOLIOS, AND IN SOME SITUATIONS MIGHT REQUIRE ALTERING THE SHAPE OF THE PAYOFF

“give upgains”

“protectagainstlosses”

“increase returns”

“reduce risk”

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

-10.0% 0.0% 10.0% 20.0% 30.0%

Prob

abili

ty (%

)

Distribution of annual geometric returns (%)

“protectagainst losses”

“participateIn gains”

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Popular literature (Myths) Financial Economics (Facts)

Saving is for the short run, investing is for the long run

Saving means income minus consumption; investing means

selecting your portfolio of assets, including cash

The only way to reduce risk is to diversify

The simplest ways to reduce risk are to hedge, insure, or hold safe

assets. A safe way to achieve a future spending target is with CPI-

linked (inflation-indexed) bonds

Stocks become safe in the long run due to “time diversification”

Stocks do not become safe even in the long run. If they did, they

would not have a risk premium

Source: My favorite coauthor, Prof. Zvi Bodie

Debunking some myths with facts

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A word about unit trusts (mutual funds)

• High fees – up to 5% sales load, and anywhere between 1.5% - 2% p.a. in management and trustee fees for actively-managed retail funds

• Nevertheless, well-diversified risky assets such as equity ETFs and mutual funds do have an important role to play in our investment portfolios, although

They may not exactly match the purpose or objectives of our future spending profile and consumption needs, which may be sensitive to inflation

For a matching strategy, the basic building blocks must be denominated in units that match the purpose or objective, and have known maturities (a.k.a. asset-liability management)

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Name of Fund: DBS Singapore STI ETF

Lot Size: 100 units per lot

Fund Structure: Open-ended Listed Unit Trust, with Exchange Tracker Fund feature

Actual Issue Price: S$ 1.62

Benchmark: Straits Times Index (STI); Valuation Frequency: Daily

Dividend Distribution Frequency: At least once per annum

Listing: Singapore Exchange; Fund Auditor: PricewaterhouseCoopers LLP (Singapore)

Manager: DBS Asset Management Ltd

Management Fees: 0.20% p.a.; Trustee Fees: 0.08% p.a.

An Alternative: Exchange Traded Funds

Source: A local bank’s website

√ diversificationX hedgingX insurance

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A goal-oriented lifestyle

• Identify your financial goals – building up a nest egg, buying a house, having sufficient funds for medical emergencies, retiring comfortably, taking care of aged parents, etc.

• Design a financial and asset-liability management program that gets you there via diversification, hedging, and insurance

• Implement the plan

• Monitor and review regularly – it’s all about risk management!

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Example: Buying (and saving for) a houseCost of house $ 250,000 Downpayment (20%) $ 50,000 Mortgage rate per month 0.1667% (i.e., 2% per annum)Number of months 360 Months (30 years)

Borrowing (Present Value) $ 200,000 Monthly payments ($739)

Risk Management (“What If” Scenario)Mortgage rate goes up 0.5% p.m. (i.e., 6% per annum)Monthly payments ($1,199) (pmt increases by $460 p.m.)

CPF Ordinary Acccount (Saving up)Recall: Downpayment $ 50,000 CPF interest rate per month 0.2083% (2.5% per annum)Future Value (in 5 years) $ 50,000 Number of months 60 Months (5 years)

Monthly savings ($783) In Excel: PMT (INT,MOS,PV,FV)

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Some personal financial ratios

• Solvency ratio – ratio of net worth to total assets (usually <1). Solvency ratio of 1 implies no debts!

• Liquidity ratio – ratio of your liquid assets (cash, bank accounts) to total current liabilities (short-term debt). Aim for this ratio to be greater than 1.

• For more details read “Personal Financial Planning” by Benedict Koh (SMU) and Wai Mun Fong (NUS), Pearson, 4th

Edition, 2011

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• We think the average investor is concerned about 3 fundamental issues during retirement:

Receiving a reasonable, level payout every month

It should last for as long as the investor lives

It should be indexed to his or her cost of living

It’s getting harder all the time: The retirement problem

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Safe investing in risky times

• Conventional investment advice today is based on a mistaken principle of “time diversification,” which inadvertently has led to portfolios that are riskier than investors realize... until it is too late!

• Starting point of any retirement portfolio should be 100% inflation-proof, guaranteed annuities (our “safety-net” portfolio)

• Always hope for the best, but prepare for the worst

• Principal-protected, inflation-linked investment products

• Participating equity-indexed and inflation-indexed annuities

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ForwardPrice (F)

Future Risky Investment Value ST

(SGD)

No hedging

Plain forward contract

Retirement Receipts at T +

Participating Forward

Strictly limited downside(indexed to inflation)

Some participation in upside

Receive ST million SGD at future time T upon retirement= ST million SGD at T (inflation-indexed)

Short zero-cost inflation-indexed “participating forward”:

K – ST if ST < KPayoff = 0 if K ≤ ST ≤ F

- ½ (ST – F) if ST > F

Long Put struck at K + Write ½ a Call struck at F

K F

Investment appreciatesInvestment depreciates

Future Realized Investment Value

Getting better all the time: What about Inflation-Indexed Participating Annuities?

K

F = $35K

K = $32.5K

X diversification√ hedging (some form)√ insurance

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What Should The Basket of Risky, Upside Participation Assets Be (ST) ?

Accumulated Investment Capital reaches $780K at

retirement (hopefully!)

Invest in a diversified portfolio of equities, mutual

funds/ETFs, hedge funds, commodities, real estate, etc., based on your individual risk

tolerance profile

“Upside Participation Portfolio, ST”

√ diversificationX hedgingX insurance

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• The most commonly-cited product that provides a level real payout (i.e., inflation-indexed) for life is an inflation-linked retirement annuity

• Such a product would convert accumulated investment capital (say, from your CPF) to lifetime real cash flows for retirement consumption, expenses, and spending

• Ageing populations and changing demographic landscapes in Asian countries will increase the demand for such retirement annuity products

• An alternative: Financially manufacture a laddered portfolio of inflation-indexed bonds from the respective sovereign, assuming such bonds exist

The retirement solution

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Life-cycle investment products around the world today

• Target-maturity retirement accounts – very popular in the U.S.

• Target-maturity college tuition accounts – newer vehicles, popular as well

• Health saving accounts

• Common characteristics Specific purpose

Specific maturity date

Tax advantaged

• Most of the money in these accounts is invested in risky equity and bond mutual funds, which have no guarantees against downside risk or inflation!

• In Singapore: “The top two performing CPF-approved funds in 2Q2009 were United Growth Path 2010 and United Growth Path Today — these are "target maturity” funds, which means they have a limited lifespan. Such funds typically start off by investing in riskier, higher-yielding equities before gradually shifting to bonds and other safer assets as the maturity date approaches.”

The Edge (Singapore), August 2009

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• TIPS’ Principal (or Face Value) is adjusted by changes in the CPI. With inflation, the principal increases. With deflation, the principal decreases

• 5, 10, and 30 year issues are available online in increments of US$100 via TreasuryDirect

• Interest rate (or coupon) is determined in a competitive auction

• Both the sum paid when a TIPS matures and the amount of interest paid every six months is affected by adjustments in the Principal due to changes in the CPI

U.S. Treasury Inflation-Protected Securities (TIPS) example1

1. Also visit: http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm ; http://explorebonds.com/tips/ ; http://www.prospercuity.com/

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• Let’s say you need $35,000 in real cash flows per annum in retirement and have $780,000 in accumulated CPF capital at the point of retirement (today)1

• It will cost you $780K today to buy a laddered portfolio comprising of a series of 30 inflation-indexed government bonds with maturities of 1 to 30 years

• Assuming the government-linker is correctly tracking your cost of living during retirement, you should be able to meet your target consumption needs annually while maintaining purchasing power

Implementation of a laddered portfolio

Accumulated Investment Capital from CPF account

Purchase 1-year, 2-year, 3-year, … … ,

30-year TIPS (zero coupon) upon

retirement

… …

0 1 2 3 30

$35K $35K $35K $35K

1. Assume the real interest rate is 2% p.a. and the inflation rate is 3% p.a. (both flat) over the next 30 years

… … $36K $38K $39K $85K

Nominal Cash Flows

Real Cash Flows

“Inflation-linked retirement annuity stream”

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How do we get to $780K? Option 1

Accumulated Investment Capital reaches $780K at

retirement (hopefully!)

Invest in equities, mutual funds,

commodities, balanced funds, etc., during

Saving / Accumulation Period

“Saving / Accumulation Period”

Hope For

The Best

… …

1 2 3 30

$35K $35K $35K $35K

… … $36K $38K $39K $85K

Nominal Cash Flows

Real Cash Flows

Note: Assume the real interest rate is 2% p.a. and the inflation rate is 3% p.a. (both flat) over the next 60 years

“Inflation-linked retirement annuity stream”“Take a Chance On Me”

(AßßA)

√ diversificationX hedgingX insurance

X diversification√ hedging (some form)√ insurance ( ‘’ )

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Age 30 YR I-Bond Cost Real Cash Flow Pays At Age Nominal Cash Flow

26 $ 19.3 $ 35 56 $ 36.1

27 $ 19.3 $ 35 57 $ 37.1

28 $ 19.3 $ 35 58 $ 38.2

29 $ 19.3 $ 35 59 $ 39.4

: : : : :

52 $ 19.3 $ 35 82 $ 77.7

53 $ 19.3 $ 35 83 $ 80.1

54 $ 19.3 $ 35 84 $ 82.5

55 $ 19.3 $ 35 85 $ 85.0

(All cash flows in ‘000)

Start buying today (say, at age 26) $19,300 worth of 30-year, government-guaranteedinflation-linked bonds annually for the next 30 of your working years, and henceremove ALL uncertainty about future cash flows

“Inflation-linked retirement savings

stream”

Note: Assume the real interest rate is 2% p.a. and the inflation rate is 3% p.a. (both flat) over the next 60 years

How to get there prudently? Option 2

X diversification√ hedging (some form)√ insurance ( ‘’ )

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To get even more educated on personal financial investing and investments science, please read “Personal Financial Planning” by Benedict Koh (SMU) and Wai Mun Fong (NUS Business School), Pearson, 4th Edition, 2011

Summary