So, armed with this perspective, we today look at the recent call by NZ's Financial Services Council (FSC) for a capital guaranteed KiwiSaver. The FSC represents banks, investment and life insurance companies in NZ. It's involved in lobbying the government and promoting the interests of its members locally.
Recent initiatives have included urging the government to make the default Kiwisaver options more growth oriented, increase the mandatory contribution to KiwiSaver, improve the tax breaks accruing to KiwiSaver and advocating compulsory annuitisation of KiwiSaver balances.
A major issue with KiwiSaver, from the FSC's perspective, is that too many KiwiSavers are in low risk, low return conservative KiwiSaver funds.
There are two problems with conservative funds; the problem for KiwiSavers is that the returns are low and the problem for the FSC and its members is that fees on conservative funds are lower than what they could charge on more aggressive funds.
The FSC has previously lobbied the government to default new KiwiSavers into more aggressive funds but politicians won't buy into that because they don't want to risk a backlash from members if the market falls.
So this latest initiative from the FSC is a suggestion that the government should guarantee a KiwiSaver's capital in the last 12 months before their retirement in an effort to persuade Kiwisavers to adopt more risky portfolios.
According to the FSC's news release "if a KiwiSaver member was to retire or put a deposit on a first home in a year within which the stockmarket has fallen they could find that their savings could have declined if they were in a balanced or growth fund".
The FSC suggests that by paying a fee of $2800 KiwiSavers in a balanced fund (or $3500 for KiwiSavers in a growth fund) would protect their savings in that year from a fall in the markets.
The FSC Chief Executive, Peter Neilson, was quoted as saying that "the cost of the guarantee would be dwarfed by the bigger nest eggs KiwiSavers currently in conservative funds would amass by being in higher risk funds". That makes sense but the obvious question is why should KiwiSavers pay all this money when they could simply switch from a higher risk fund to a lower risk fund a year or two before they retire?
The FSC asked Wellington research firm, Infometrics, to prepare a report quantifying the potential benefits of a move toward a more growth oriented Kiwisaver strategy. The Infometrics report estimates that an individual at age 65, after 40 years of saving 12 per cent of the average wage in a growth KiwiSaver fund returning 6.6 per cent, would have a terminal sum of $1.1m, which is a $500,000 increase from what they would have if they were in a conservative fund returning 4.0 per cent.
The FSC assumes a 4 per cent return after fees and taxes from a conservative fund, a 6.1 per cent return for a balanced fund and 6.6 per cent return for a growth orientated KiwiSaver fund. These returns look high to me. In a recent report on KiwiSaver we estimated that the pre-inflation, pre-tax, pre-fee return from a share portfolio made up 67 per cent in international stocks and 33 per cent in NZ/Australian equities would approximate 7.0 per cent pa.
This number was derived using forecasts from the Global Investment Returns Yearbook, Bank Credit Analyst, the Economist Magazine etc etc.
If we further assume that half of the international portfolio is currency hedged and make the rather heroic assumption that local interest rates will exceed US interest rates for the next 40 years then there is an additional hedging gain of around 0.5 per cent to give a total return of 7.5 per cent.
Using the average fee for growth funds from the Sorted website of 1.67 per cent to which we add the average transaction costs typically incurred by equity funds when fund managers trade the portfolio (data ex the London Financial Times) gives a total fee figure of 2.08 per cent pa.
This is probably a bit high because it assumes member charges of 30 basis points. If we deduct this latter figure we get average annual fees of about 1.7 per cent pa. We then need to deduct tax, including FIF tax, of 1.4 per cent. This gives a net return, post fees, post tax of 4.3 per cent.
This is more than a third lower than the 6.6per cent pa assumed in the Infometrics report. I spoke to Infometrics and they stepped well away from the 6.6 per cent saying they used data from a report Morningstar had prepared.
This difference is material because the rationale for the capital guarantee rests partly on the assumption that there are major gains to be had by investing in equities over bonds but the FSC look to have overstated the extent of the differential because of the impact of higher fees on growth funds, the FIF tax regime and very expensive share markets have combined to narrow the difference in prospective return between local bonds and international shares.
The authors of the Global Investment Returns Yearbook reckon that the long term, pre-tax, pre-fee return from international shares is just 6 per cent pa yet the local bond market offers a 5.0 per cent yield virtually risk free from long dated, State Owned Enterprise bonds.
In my opinion the local finance sector has a long history of overstating returns. Other countries have had this problem too and the UK has gone to the trouble of determining what growth factors advisers can use so as to introduce some reality into projections.
NZ hasn't and in the absence of regulation the Financial Services Council continue this unfortunate tradition. Of course the FSC projections could turn out to be correct but both the stock market and the bond market would have to fall sharply to restore value and thus increase prospective returns.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.
