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.