Mary Holm column: How to put your kids on the path to financial success

Giving young people control over their money can teach valuable lessons. Photo / Getty Images

Q: Early in your book A Richer You, I read that you’d given your teenage son a lump sum to use each year for clothes and “toys”. I was chuffed to see that because I did something similar with my eldest, and am about to do the same with my younger son.

Here was me thinking that it was a great idea of mine, but perhaps I’d picked it up from your column some years earlier? Anyway, I think it has worked really well. In the first year, he spent it all - together with most of the income from his part-time job - on his favourite brands (Nike, Huffer etc.)

At the end of that year he was shocked at how much more his younger brother had in his bank account, just from saving his modest pocket money. It was a great lesson in “it’s not just about what you earn, it’s about what you save”. And he’s managed things so much better since then - especially as there’s the incentive of being able to spend whatever is left over at the end of the year on whatever he likes.

A: I can’t take credit for the idea. A friend did it first. But it does tend to work well. It can teach the young person valuable financial lessons - as well as giving their parents a break from requests for expensive branded clothes or other “unnecessary stuff”.

Before you start, I think it’s best to talk with the teen about what’s a reasonable annual amount. They will probably welcome the chance to buy items without having to convince you. But parents should continue to provide clothing like socks, undies and pyjamas, or your child may end up short of them. And of course, you need to keep paying for school uniforms.

The key to success is that you must be willing to step aside and watch the teen making purchases you know they’ll regret.

My son, like yours, blew the lot early in the first year on some brand clothes. It was quite hard to ignore his pleas for more money later in the year. But he didn’t do that again.

Too many index funds?

Q: You’ve long recommended that sharemarket investment is best done via index funds.

I’ve often wondered if there was any data on what percentage of the New Zealand or US sharemarkets is invested in index funds?

Is there a risk that - if everyone listened to your advice and over time index funds came to dominate more and more of the market - the sharemarket would simply cease to function, as there would be proportionately fewer and fewer people actually buying and selling individual shares and setting a market price that is linked to company performance?

A: The experts disagree on this. But first, let’s explain the situation to other readers.

Index funds - sometimes called passive funds - invest in all the shares in a sharemarket index. Unlike active funds, they don’t trade shares except when the index changes. The funds are cheap to run - as they do no research on what to buy and sell - so their fees are usually low.

Because they trade rarely, index funds don’t contribute much to the process by which share prices are set, sometimes called price discovery.

This involves the decisions of active fund managers and other investors. They analyse a company’s data and the price of its shares, and if they think they’re undervalued - that the company will do better in future than most people realise - they buy. As more and more people come to this conclusion, the buying pressure pushes up the share price, until the shares become accurately valued.

Similarly, as fund managers and other investors realise a share is overvalued, they will sell, pushing the share price down.

Over time, as a company’s situation changes, its price changes, through price discovery.

The trick for investors is to realise a share is undervalued before others do, and rush to buy before the price rises. Or to realise first that a share is overvalued, and sell before the price falls.

Our correspondent’s concern, and that of many others, is that if most people invest in index funds, there will be too few people analysing companies and share prices won’t be set efficiently.

This doesn’t worry Dean Anderson, CEO of KiwiSaver and investment provider Kernel, which runs lots of passive funds. What matters is not how many shares are owned actively versus passively, but the share of trading volumes, he says.

“Passive funds’ turnover is very low, so most of the data at the moment shows that while passive owns about 35 per cent of the US market, it actually is only responsible for about 10 per cent of trading i.e. the impact on market efficiency and price discovery is negligible.

“If you model this out, you have to get to circa 80 per cent of the market held via index funds before half of the trading value is from index funds.”

A further point I often make: if we got to that stage, there wouldn’t be many active fund managers left who were seeking undervalued shares. So it would be easier to be among the first to find and buy those shares before their price rises.

Active managers would then outperform index funds often. Many index fund investors would move to those active funds until we got back to the current situation, in which analysts don’t often beat the indexes.

Financial adviser Brent Sheather has been buying passive funds personally and for clients since 1989, but he doesn’t buy this argument.

“It ignores the momentum effect and the fact that ‘markets can remain illogical for longer than you can stay solvent’,” he says, quoting economist John Maynard Keynes.

“I worry that sooner or later we are going to have a big blow-up, and passive investment will get the blame. That is the last thing we want.

“Price signals from the stock market are used by capitalist economies to allocate capital and labour. So they are far more important than just determining the fair market price of individual stocks.

“Everybody has a responsibility to pay for the cost of price discovery. How would you feel if every morning your neighbours rang you up and said: ‘Can you give us a lift in your car, and by the way also let us know where we are supposed to be going?’.

“It is about time passive investors and their cheerleaders realise what’s at stake and that everyone has an obligation to pay for price discovery. Furthermore, low-cost active funds exist, so doing the right thing does not need to be painful.

“Bottom line is that best practice is a mix of passive and active funds, and remember low-cost active exists. One just has to do the mahi.”

Sheather doesn’t see imminent disaster, though. “I’ve just been talking to a journalist from the Financial Times on this topic, and he made the point that there are a huge number of hedge funds actively stock picking, so he is reasonably relaxed that price discovery is alive and well.”

Out of KiwiSaver

Q: I am in my early 50s and have increased my KiwiSaver contribution to 10 per cent, with retirement not as far away as it used to be.

I was wondering though, is there a tax benefit of putting money into KiwiSaver above the 3 per cent minimum from employees, or am I better off investing the 7 per cent directly into another fund?

We don’t need the money at the moment, but you never know when life hits you a curveball. Maybe it’s better if we can access those funds instead of having it locked away until 65.

A: I’m pretty sure all KiwiSaver funds are PIE funds, which are taxed at a somewhat lower rate than other income for most people. But probably all other investment funds are also PIEs. So as long as you move to another PIE fund, there will be no difference tax-wise.

As you say, you can withdraw money from a non-KiwiSaver fund whenever you need it, which can be a big advantage at curveball times, not just for you but perhaps a family member. The only people who wouldn’t benefit from such a move are those who might be tempted to spend the money on silly stuff.

Risk near retirement

Q: I recently turned 60 and I am planning on retiring in five years. I intend to continue investing in aggressive KiwiSaver funds up until my retirement on the basis that they tend to provide the best return over the long term. Is this sensible? I have heard you say that five years away from retirement you should move investments to conservative funds as they are less volatile. But I don’t think it matters so much about how close I am to retirement. Rather it is a matter of how flexible I am prepared to be. Worst case I might have to put off retirement for a couple of years.

Answer: I’m afraid you’ve got my message a bit wrong on several counts:

• As I explained last week, I recommend moving your money from an aggressive or growth fund to medium - not low - risk when you are about 10 - not five - years from spending it. And then move to a lowest-risk defensive or cash fund when you are about three years from spending it.
• We need to differentiate between the money you expect to spend early in retirement and your longer-term savings. Many people live into their nineties or older these days. So, while it’s best to reduce risk for the savings you plan to spend soon, it’s good to keep your longer-term money in a higher-risk fund until you’re within about 10 years of spending it, as long as you stick with the plan and don’t panic through market downturns.

Now to your question. If you’re happy to keep working for longer if the markets plunge within the next five years, why not stay put?

Be aware, though, that every now and then share markets don’t fully recover from a plunge for 10 years or so. Would you be content to retire with considerably less than you have now? Or to stay in the workforce for another decade or so?

If not, you might want to reduce risk on just your early retirement money. By all means, leave the cash for your riotous 90th birthday world trip where it is for a while yet.

When gain is not gain

Q: In your column, you have indicated that you are in favour of a capital gains tax.

The major issue that I see is that most of the difference between the current selling price and the historical buy cost is inflation devaluing the currency. The selling price only purchases something of comparable value, and there is seldom any real gain.

Government policies determine inflation and the loss of value of money. Is it reasonable for the Government to propose to tax the difference in dollar amounts between selling and buying, by calling this difference “capital gain”, when in reality, it is only keeping up with inflation?

A: I take your point. While few countries that tax capital gains make adjustments for inflation - probably because it could get horrendously complicated - it’s quite common to tax gains at a lower rate than income tax. And the rationale for this is often the inflation issue.

As I’ve said before, I would love to see our Government look at the best features of capital gains taxes around the world and incorporate them into a good tax for us.

By the way, tax rates on wages and salaries are not adjusted for inflation either. The cutoff points between the rates - for example, the $48,000 of annual taxable income, above which the tax rate changes from 17.5 per cent to 30 per cent - should be regularly inflation-adjusted. But not to some amount like $51,342.78! The nearest $1000 would be good.

Mary Holm, ONZM, is a freelance journalist, a seminar presenter and a bestselling author on personal finance. She is a director of Financial Services Complaints Ltd (FSCL) and a former director of the Financial Markets Authority. Her opinions do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com or click here. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.