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March 30, 2017

The real cost of buying that dream car on credit

The appeal of a new car, particularly a high-end car, can be great for a graduate who is starting out and earning well. But if you don’t fully appreciate the cost of credit, an expensive new car can set you back years.

In  the following example,  millennials Tom and Jack, who earn much the same salary, can both afford to finance a car that costs R500 000.

Tom  rewards  himself  with  his  dream  car   right   away and finances it over six years. However, Jack decides to finance a car that costs R200 000, while saving towards his dream car. He instead chooses to invest the difference between the monthly payments needed  to  finance  a car  that   costs R500  000 and  his R200 000 car.

Both men will therefore be paying the  same  amount (R9 270) each month over the six-year  period.  However, Jack invests a portion of the amount, whereas Tom pays the full amount to the vehicle-finance company.

After  six  years, both men trade in their cars at a 40% residual value and use the proceeds as a deposit to buy the latest model dream  car,  which  has  escalated to R689 400 (assuming an inflation rate of 5.5% per year).

Tom  finances  the  net  purchase   price   via   a   finance company. Jack withdraws  his  investment, which has grown to R519 900 (assuming an after- inflation annual return of 4% per year), and uses it to boost his deposit on the car. Tom, therefore, has to finance  a  new  loan  of  R489  400  (R689   400  – R200 000 [40% of  R500  000])  over  the  next  six years, whereas Jack has to  finance  a  loan  of  only R89 500 (R689 400 – R80 000 [40% of R200 000]– R519 900).

This  example  shows  how  interest  can   work   for   you  or  against  you.  You  should  aim  to   earn  interest on an investment rather than pay interest on a debt. For six years, while paying interest on his  car  debt, Jack also invested R5 562 a month and earned interest.

Jack  again  saves  and  invests  the  difference  between Tom’s loan repayment and his own repayment.

After six years,  the  men  trade  in  their  cars,  at  a  40% residual value, and use the  proceeds  as  a  deposit on  a  new expensive  car.  The  price  of  the  car has grown by  the assumed inflation rate of 5.5%  per year to R950 600.

Tom once again  finances  the  net  purchase  price  via a  finance  company,  whereas  Jack  uses  the  proceeds from his investment, which has  grown  to R692 100 (assuming  an  after-inflation  return  of  4% per year), to reduce the payment required for the car.

However, this time the residual value of his car, R275 800 (R689 400 x 40%) and the proceeds from  his  investment are more than sufficient to buy the car without having to finance it.  Jack  has  a  balance  of  R17 300 ([R275 800 + R692 100] – R950 600), which he

invests. Jack once again invests an amount every month that is equal to the amount that Tom has to pay each month for the newly financed vehicle.

Car and a return

At the end of the 6-year  financing  period,  both  men are driving the same type of luxury car. However, Jack has the benefit of enjoying both the car and a net investment of R1 192 500. After 18  years,  when  his first child starts university, Jack has just less than R1.2 million in the  bank,  which  is  more  than  enough  to buy the next dream car using cash,  or  to  help  cover the cost of his child’s tertiary education.

Tom and Jack paid the same amount  every  month  over the period.  The  only  difference  is  that  during  the first financing period, Jack bought a  cheaper  car and used the balance to start saving for his dream car.

For Tom, the cost of rewarding himself with the dream  car right away and purchasing it on credit, rather than purchasing down (R300 000 less credit) and saving up for the dream car, is about R1.2 million 18 years later in his career.

So, the  next  time  you  find  yourself  trying  to  work  out how much credit  you  qualify  for,  think  of  Tom  and Jack, and consider that you may  be  asking  yourself the wrong question. Instead, ask yourself whether  you  are  prepared  to  spend  money  today that   you   haven’t   yet   earned,    because    that’s what you’re doing when you buy consumer goods on credit.

More importantly, consider the cost of allowing that money to work against you rather than putting it to work for you.

Financial literacy and pension reforms

A year ago our top priority was to implement the T-Day tax reform requirements. The tax harmonisation provisions in respect of contributions towards retirement saving vehicles were eventually successfully promulgated. The measures that failed at the eleventh hour was the compulsory annuitisation of at least two thirds of retirement savings of all new contributions.

A    subtle    tax    policy    change    to    encourage   such  annuitisation   was   already   implemented   in 2008 through progressive lump sum retirement tax tables.  That    policy    change     was     promulgated and implemented without incident. Tax incentives however  play  a  lesser  role  for  lower  marginal  rate tax payers and the effect of  the  tax  changes  on workers have thus been limited.

The recent proposed changes  was  to  force  changes  in funds’ rules at retirement.  The  latter  change  failed for a second time and there is little hope for success

  at  this  stage    for  a   third   attempt,   now  scheduled  for 2018.  The  question   is   why  would  such a policy change attract so much attention?

These attempts at retirement reform are not unique to  South Africa. Since the financial crisis of 2008,  developed countries have been under pressure to undertake wide-ranging reforms  of  their  welfare systems  and  labour  markets  due  to   the   deterioration    of    government    finances. These reforms  are  tested  by  the   principle   that  governments   are    ultimately    accountable    to citizens.  These  reforms  are  not   necessarily  approved directly by referendums, but indirectly politicians are very  aware  that  re-election  is  dependent on track record and the pursued agenda. Since the financial crisis,  a  number  of  countries fighting for economic survival, implemented radical retirement  reforms,   some   only succeeding by forcing it through by decree, even in well-established democracies, e.g. Greece and Italy. In its wake was left a number of politicians who lost their jobs.

In  South  Africa  the  annuitisation  reform  process   was  aborted  due  to  similar  pressures.  The population is however young  enough  and  the economic  situation  not  as   dire   as   to   require  forced radical reform by decree.

Forced   annuitisation,   albeit   only   partial annuitisation,  was  met  with  resistance   not   only  from unions  but  also  more  silently  from  the  wealthier, as it would have reduced flexibility or optionality.

It is clear that retirement savings are spent at  retirement, not to be disenfranchised from a State Old Age Grant due to  the  means  tested  benefits.  Although  the  State  Old  Age  Grant  has  many benefits in society,  it can  also  act  as  a  disincentive  to save.

The State with its well-intended policy measures (annuitisation) to avoid placing a burden on the young and future generations, was confronted with a demand for a broader welfare system. A lesson well learnt from developed economies, will be that very careful social welfare design will be required and  not  place  an  undue burden on young and future  generations.  Current social disruption at for  instance  the  universities, show the consequences of unsustainable financial design, ill-informed promises and expectations.

I  would  argue  that  economic-   and   financial   literacy  is  a  prerequisite   for   retirement   reforms such  as   compulsory annuitisation to find their way   into the system in South Africa.

It will require an understanding that savings  are required not only  to  sustain  yourself  in  old  age  but to become financially independent. An awareness of the impact of debt on household finance that have to facilitate studies is manifesting itself in society at the moment. An understanding that savings, not only for retirement, facilitate investment in the  country, including investment in the youth, is required. Financial literacy is required to create an understanding that protected regulated vehicles such as annuities (be it guaranteed- or living annuities) provide some financial security.

In a low trust environment where immediate cash is king,      an      enforced      policy      measure      such as annuitisation  is  problematic.  From  this  low financial literacy  perspective,  the  intended annuitisation    reforms entail immediate and     easily computable   costs,   i.e.   cash   against an uncertain extended future benefit. These delayed financial welfare concepts are not  simple  and  may take years,  if  not  generations,  to  educate  and change in a relatively young population such as ours.

For more than a decade, Simeka has developed strategies to help educate, inform and change member behaviour in order to ensure good  retirement  outcomes. These include special  member presentations, default benefits and the Day One induction  strategy.  We  are   committed   to   working on more effective  ways  in  which  we  can  help  change  members’   relationships   with   money   as well as to communicate more effectively using  the  latest technology. What we have found is that  the  single most important factor in bringing about the desired change is the commitment and energy of the employer – more particularly the HR professionals.

Addressing communication through generations

During  the  course  of   last   year,  we  prepared  presentations  and  articles  on  the  role  that   the employer should be playing to ensure that they are able to get  the  best  out  of  their  employees to improve  both  employees’  lives  and  improve  the  profitability  of  business. All of the research indicated that employees need and want to be helped.

Something else that  we  put  forward,  was  that  change is happening at a rate that is unprecedented in human history. This change, that  includes  longevity and improvements in technology, means that communication with stakeholders and specifically employees has  become  very  difficult  to achieve  in the event that you choose to use a ‘one size fits all’ approach with regard to communication. Millennials refuse to read articles  and  anything  that  resembles  an information overload (more than half a page of writing). So how do we go about keeping millennials engaged?

For  us,  the  key   is   engaging   with   all employees in   a  meaningful     manner.     An     integral      part    of  our  communication  strategy   is   conducting surveys with  all  staff  to  obtain  valuable  information as to  how  we  should  communicate  with  them. Mailers and posters, while necessary, are simply not good enough anymore. The use of a communication portals, sms  notifications,  that  include links  to fund and general information, is  becoming  more and more of a requirement rather than fancy add-ons. As confirmed via research last year, millennials are now  the biggest generation in the working population. Indeed, they are different and must be treated differently!

According to PEW Research Centre in the US, cell phone owners between the ages of 18 and  24  exchange an average of 109.5 messages on a normal day—that works out to more than 3,200 texts per  month.

Research, specifically regarding millennials, from the same research centre shows that 83% of millennials open text messages within 90 seconds of receiving them. Millennials prefer text messages for the ability to communicate quickly and conveniently.

But what about the rest of the workforce? The Generation X (born between 1965 and 1980) and Baby Boomers (born post World War 2 up to  1964)?  I believe that we cannot underestimate this portion  of  the population  and  their  ability  to  adapt  and  embrace the change that  millennials  thrive  on.  For  the past few years, longevity has been the hot topic in our industry. This extends  beyond  the  ability  of  people  to  physically  live  longer  but  also  means   that our minds are healthier for far longer periods.

Let’s have a look at the social med ia phenomenon, Facebook:

Research by the Pew Research Centre in 2015 showed that, in America, 72% of all internet users used Facebook. The figure for adults aged 30-49 was 79%, and for adults aged 50-64 was 64%.

Indeed,    Facebook    has    become     the     domain  of  parents   and   grandparents   worldwide   with activity amongst parents  and  grandparents  the  highest of any other researched group of people.

Five years ago, I can recall my parents not wanting anything to do with Facebook and today they are multiple times more active than I am! This trend is set  to continue and not just with Facebook but on Twitter and Instagram as well. This has led to the younger generation having to ‘hide’ from parents on other social media such as Snapchat where 86% of users are below the age of 34. However, I am confident that this demographic too will change as Gen X gets more accustomed to other social media platforms.

The  point  is   that   while   we   implement   solutions  in    terms     of     communication     for     millennials, we   must   not   underestimate    the    older generation’s ability   to   embrace   new   technology and the convenience and ease of reference that it brings about.

We are entering an inflection  point  in  retirement  funds. A time when decisions taken by a  generation that  believes  in  hard  consistent  work,   investments in tangible assets and above all patience,  will  determine  the  outcome  for  a  generation  that  believes in immediate gratification and invests in experiences rather than material items.

Member Communication Strategies

It is becoming more and  more  important  for  funds  and employers to have  a  clear  member communication strategy  based  on   the   profile   of their  members.  Understanding  the  change  in dynamic and how your communication to employees must be tailored to account for this,  is  going  to  be  key to putting together  a  good  communication strategy.

Calculating the costs and efficiencies of your retirement fund

Calculating Retirement Costs – One of National Treasury’s key retirement reform objectives is to improve the disclosure of costs in retirement funds. This is a complex matter and it is very difficult if not impossible to express all costs in one number without a series of notes and explanations.

The reason why it is so difficult is that some costs, such as the administration and consulting fees of your fund  are recovered on a monthly basis and are  deducted from the contributions made to the fund. These costs are relatively easily identified and disclosed. Other  costs such as the asset management fees are expressed as a percentage of assets and are deducted directly by the portfolio manager. Few members are aware of or are shown the actual amounts that are deducted. Even though these asset-based fees can be quite significant, members and employers tend to be more focussed on the administration fees and investment returns.

There is a move afoot to express all costs and charges as a percentage of assets. This is relatively easily done but because of the different relationships and scenarios you will not be able to tell whether the ratio is high or low unless you know whether it is a (young) fund with a low asset base or a (mature) fund with significant assets. Because there are certain basic costs, the cost ratio for a smaller fund is also likely to be higher than for a larger fund.

We understand that to try and overcome these constraints an ASISA workgroup is developing a formula that will express the cost ratio over more than one term. This should make it easier to interpret the cost ratio.

Most importantly, such  a  formula  will  provide  a  fund / employer with a cost ratio for their fund that is directly comparable with the cost ratio of other offerings submitted in terms of a market review exercise. This will be a significant step forward for the industry and it enjoys our full support.

The ratio will assess the average cost effectiveness of an entire fund or a sub-fund in an umbrella fund. To be able to do so, the investment return, inflation and salary inflation projections of the cost ratio may have to be standardised.  The  information that will be required to do the calculation is: the Total Expense Ratio plus Transaction Costs (TER +  TC)  of  the  fund’s investment portfolio, all administration fees, consulting fees and  the  other  operational  costs  (typically included in the contingency reserve levy).

Because the cost ratio will calculate a fund average, the ratio may not be very helpful in comparing and  projecting the benefits  of  any  individual  member.  It  will also not be very helpful in determining the most appropriate default investment portfolio.

Determining a default investment portfolio

If the draft default regulations are promulgated in their current form, each fund will have to implement  a  default investment  portfolio  that  is  appropriate  for their members. To be able to make a selection will require each fund to consider all the relevant factors including the potential risks, returns and costs, with a view to providing the best retirement outcomes for its profile of members.

The most accurate way in which such a comparison can be made is to prepare a projected pension ratio or horsepower calculation in respect of each significant member profile in the fund to show how the projected returns and costs of the various portfolios will shape their retirement projections. The horsepower calculation will not only show the impact of the costs but also  the  return projections and the other features of each investment strategy or offering as required in the default regulations.

A whole new dynamic

If the cost comparison formula as well as the new  default regulations are implemented, possibly as early  as 2018, it will introduce a whole new dynamic especially as far as this level of cost disclosure to members is concerned.

If  the  default  regulations  are  implemented,  funds who have already selected a default investment portfolio will have to do so again but this time in  compliance  with the new rules and principles. In doing so the fund would be wise to document their decision in a way that will stand up to scrutiny.

It appears desirable  to  run  the  horsepower  calculation first, identify the most compelling default portfolio and consider strategies in which better economies of scale can be achieved, such as through portfolio consolidation,  before  the  cost comparisons are done and communicated to members.