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COMMENTARY

Having more choices not always a good thing

The latest CPF proposals contain trade-offs not worth making
Friday, August 5, 2016 - 05:50
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The long-awaited suggestions of the advisory panel on how to get higher Central Provident Fund (CPF) payouts are finally out.

Singapore

THE long-awaited suggestions of the advisory panel on how to get higher Central Provident Fund (CPF) payouts are finally out. All credit to the wise souls on the panel for toiling long and hard over the tricky question. But their answers leave much to be desired.

Take the proposal for escalating annuity payouts (up by 2 per cent a year) to deal with inflation risk. Here's the problem. Assuming you cannot afford to put more in the scheme or wait a few more years, you will suffer a rather big 20 per cent reduction to your monthly CPF Life payout right at the start. You only get more cumulatively, versus the flat payout option, when you are 87 years old. And this is ignoring the time value of the money you got earlier.

The shorter-lived sex, of course, will realise there's a good chance they'll be long gone before they are 87. In fact, a male resident born in 2015 is expected on average to live only till 80, according to the Department of Statistics.

So money in the hand is worth more than money in the future - unless you belong to a family of spendthrift centenarians, in which case the escalating payout option is perfect for you.

Moreover, there is some evidence that the low-income, the ones who need the most help in retirement and dealing with the higher cost of living, might lead shorter lives. It is unclear exactly why, but one reason posited was the decline in smoking among the affluent and educated. If this is the case, low-income individuals should not be encouraged to take the escalating payout option. And if you don't need the money at age 65, you should delay receiving your payout until you are 70. As proposed by the panel last year, for every year deferred, monthly payouts will go up by 6-7 per cent. That's a rate of return you're unlikely to get investing your money by yourself.

The other major proposal the CPF Advisory Panel made this time was to let members get higher returns through private plans, of which the government will actively promote an understanding.

As with the escalating payout, people clamouring for better returns from the CPF scheme will realise that more choice isn't a good thing.

Based on consultant Mercer's model in the panel's report, a life-cycle fund has an expected return of 6.5 per cent a year over 30 years, and a high growth fund, 7.4 per cent, contrasted with 3 per cent in the Ordinary Account and 5.2 per cent in the Special Account. Higher returns are all well and good, until you factor in the risk you are taking with the private options. If the panel's report included the return per unit of risk taken, investors would see their options in a different light.

Good luck to you should you invest in private funds and want to retire in the midst of a market downturn, like in Singapore now. The risks of a high-growth fund that allocates 90 per cent to equities and 10 per cent to bonds need not be said. Even the most conservative life-cycle fund meant to reduce allocations to risky assets as people approached retirement suffered from negative returns during the 2008-9 financial crisis, as annex D of the report pointed out.

When market downturns happen, people hit hardest are lower-income investors who need the money most. In fact, the risk of a downturn might occur when members are 55 and supposed to set aside their basic retirement sum for the CPF Life annuity. What happens if the bulk of their money is stuck in a depressed life-cycle fund? The CPF system must be designed to ensure that members can meet their basic CPF Life obligations regardless of where they invest their spare monies.

People need to be educated on returns and risks. High risks do not mean guaranteed high returns. High risks only mean a chance for better returns, and more importantly a chance for poorer or even negative returns.

Mercer's expected returns are developed from a "forward-looking" framework. But they also depend on current market conditions and historical data which, as we know, provide no guide to the future. All expected return numbers should be taken with a pinch of salt. We can also get higher returns by cutting costs. We are assuming a 0.5 per cent charge a year for the fund manager, whoever it will be. But CPF should bargain as hard as it can. The way passively-managed funds are growing and the way asset growth makes management more efficient, 0.5 per cent a year might yet be too high a price to pay.

Ultimately, one cannot shake off the feeling that the CPF Advisory Panel's recommendations this time round will just end up showing those complaining of low returns how unpalatable their other options are.

The trade-offs do not look good, where inflation-tracking payouts are concerned. And if people want to forgo the safety net of CPF interest rates to take a gamble with their hard-earned cash on non-guaranteed returns, so be it - but they have to be crystal clear about the consequences.

The heart of the CPF debate remains unresolved: That some people want most or all of their CPF money back as soon as possible to spend as they wish, and the government refuses to let them do so.

CPF should continue nudging people in the right direction. That is to leave the bulk of their mandatory retirement savings in the scheme's attractive, risk-free interest rates, while investing the cash they don't need to capture upside potential.

In handling a matter as serious as one's own retirement funds, mitigating downside risk is paramount. Giving more choice to people might perplex more than placate.