Retirement savings myths

Following is an interesting article by Niranjan Rajadhyaksha in www.livemint.com. For those who have not experienced the new finance paper 'mint' in India, we strongly recommend including it in your regular diet:

"Retirement saving myths

The standard portfolio model is flawed because it ignores human capital, according to economist Joseph Stiglitz
Cafe Economics Niranjan Rajadhyaksha

Most of the financial advice we get is hopelessly inadequate and simplistic—if not outright wrong.

Last week, I heard Joseph Stiglitz launch a typically blunt and brilliant attack on some of the sacred cows of the financial advisory business. The economics professor at Columbia University in the US and winner of the 2001 Nobel Prize in economics is popularly known as a trenchant critic of some aspects of globalization, though his academic work spans a wide range of economic issues, including financial ones.

“Long-term financial planning is a very complex task. Individuals cannot judge what they need to do and so they fall prey to wrong advice. This gives rise to fashionable rules of thumb,” said Stiglitz in a presentation at the Second European Colloquia organized by Pioneer Investments in Vienna at the end of November. (Disclosure: I was in Vienna as a guest of Pioneer Investments.)
Most of our value as economic animals resides in our ability to earn over our working lives—our human capital. The most common rule of thumb is that an individual should invest heavily in equities at a young age and then gradually move into bonds as the age of retirement nears. A popular and pseudo-scientific way of defining this rule is as follows: subtract your age from the number 100, and you get your ideal exposure to equities. For example, a 30-year-old should have 70% of his long-term savings in equities (100-30) while a 50-year-old should bring it down to 50%.

Neat, huh? But also wrong, said Stiglitz.

Most financial advice—and the economics that underlies it—is flawed. It assumes that an individual has only two types of capital: relatively safe fixed-income bonds and equities that are more risky but which also give more returns. The question is how long-term savings should be distributed between the two as we age.

“The standard portfolio model ignores other forms of individual capital,” said Stiglitz. One important form of this is human capital, which is usually calculated as the present value of all the future earnings an individual will earn over his working life.
Most of our value as economic animals resides in our ability to earn over our working lives—our human capital. According to some estimates, nearly 80% of an individual’s capital is human capital. This form of capital and its risk profile should ideally be considered while designing a good financial plan for retirement.

Human capital is usually more risky at a young age, points out Stiglitz. You are just starting off on your career and the future is uncertain. As you age and get settled into your chosen profession, the uncertainty about your ability to earn starts declining. Human capital gets less risky as you age.

Seen from this perspective, most financial plans are built on shaky foundations. A 25-year-old setting out down a fresh career path faces huge amounts of risk in his overall portfolio (financial and human), because his future earnings are uncertain. Ideally, his financial portfolio should have low risk to balance out the high risk in his human capital. He should be buying more bonds than he is usually advised to do. But the cookie-cutter financial advice that he gets is to put most of his savings into equities—and increase his overall risk.

The big question is whether human capital resembles a safe bond or risky equity. In a separate presentation, Stephen P. Zeldes, a professor of finance and economics at Columbia University, asked: “Is labour income stock-like or bond-like?” He suggested there are no easy answers here. Without disagreeing with Stiglitz, Zeldes said labour income has both characteristics, depending on the circumstances.

All this makes financial planning a complicated process. Besides, other factors such as which industry one is working in, the nature of one’s family responsibilities and home ownership also need to be thrown into the consideration. In a country such as India, for example, where a large part of the population is self-employed, labour income would tend to be risky.

Perhaps we are wrong in blindly assuming that we should cut our exposure to equities as we age. In fact, a well-settled professional with stable earnings perhaps has more reason to invest in equities than, say, a young entrepreneur in a technology start-up.

These are nuances that are often ignored, even in our grander debates on how pension fund money should be used in India.

One challenge before those involved in designing social security systems is how to balance freedom of choice and good guidance. Choice is important because an individual knows about his retirement needs than outsiders. But, as Stiglitz pointed out, individuals make rational decisions by learning from past experiences—their own and of others. That’s not possible for retirement planning. A person who realizes at 60 that he has not saved enough for his retirement cannot say: “I’ll do better next time.”

There is no second chance.

Your comments are welcome at cafeeconomics@livemint.com"

India small loans: drying up ?

ICICI Bank is said to be withdrawing from lending small amounts (up to Rs 30,000) to sub-prime customers in India. This is seen as a response to press reports and judicial action regarding excesses their loan recovery agents have engaged in. ICICI is reported to have closed down 100 outlets focused on such small borrowers.

Citibank has also tightened its processes for lending small amounts. It requires face to face interaction for every potential customer and a rigorous analysis of cash flow. They suggest that customers should ensure that monthly instalments on loans should not exceed 70 to 80% of their surplus income.

There has been a buzz recently about micro finance in India and how it can bring about financial inclusion. However, current 30% loan loss ratio in small loans is seeing fair amount of panic in the sub prime lending market. Coming back to first principles - a bank/finance company should lend money to only those who show strong signs of being able to pay back. Your local money lender knows that. If he is unsure, he knows how to extract the money - a process that is not easily transferable to the formal sector !

ICICI Bank fined for loan recovery lapse

ICICI Bank in India has been fined Rs 50 lakhs for employing 'goons' to recover loans.

Press Trust of India reports that the Delhi Consumer Commission fined one of India's leading banks, ICICI Bank Rs 50 lakhs for employing 'goons' to recover loans. The commission also deplored the intimidation tactics that ICICI's recovery agents were using on retail customers. In a recent case, some agents beat up a consumer mercilessly and snatched his car (against which there was the loan) away. The commission has issued notices to the Collection Manager ICICI and the CEO of the recovery agency.

Meanwhile, ICICI is said to have started a process to help prevent such incidents in the future.

India gold purchase: could end use be insurance ?

Gold prices continue to rise. On Friday, gold surged past US$ 800 per ounce in New York. Factors supporting rise in gold prices include:

• Rising oil prices
• Financial worries in the US
• Inflation concerns
• Weakness in US dollar
• Geopolitical concerns
• Potential shortage of physical supplies to back paper traded gold
• Continuing physical demand from countries like India.

Despite this rise, prices have not reached the peak reached in 1980 (US$ 850 per ounce on 21 January 1980). However, some market analysts now feel that gold could test these levels. Newmont Mining Corp predicted, two years ago, that gold prices could touch US$ 1000 per ounce !

On the other hand, some technical analysts suggest that gold is in an overbought position and could weaken should US dollar strengthen. Supports are at US$ 802, 797 and 785. Resistances are at US$ 823, 850 868.

If your risk appetite is low and are buying gold this Diwali season (whether resident Indians or NRI), you may be better off buying it for end-use where you can handle volatility as opposed to buying it purely for speculation. If prices continue to go up, the end-use nature would lock in notional profits, but if prices were to fall, the longer term holding nature of end-use may act as insurance against value loss.

People who have the stomach may opt to continue trading based on macro economic situation and technicals – however, as always, this will require keeping a close eye on gold markets to ensure that proper loss protection devices are put in place.

Mutual funds missing in Indian investor's account !

India related investments and savings sometimes throw up unusual challenges. A mutual fund investor in India learnt an important lesson the hard way.

Mid Day Mumbai describes the case of a lady in Mumbai who invested money in State Bank of India (SBI)'s mutual funds through her broker in July 2007. In October, she called up the help line number to check her balance and was shocked to learn that the invested amount was not reflecting in her name. Further investigation revealed that the broker had set up the account in his own name and had issued her a fake statement confirming deposit of the money. She confronted her broker and the money was duly refunded. A case of fraud has been filed against the broker.

This case highlights the ease with which your money can go walk about unless carefully monitored. An Indian investor is better off watching his/her investments closely to ensure all the hard earned money is put to work at the earliest.

Savings in India: proposed changes to Provident Fund (PF)

If the draft guidelines issued by the government last month take effect, private provident funds will have more flexibility in how they can invest the funds at their disposal.

A summary of the key changes proposed in the guidelines:

• Amount that may be invested in shares of companies listed on the BSE or NSE (subject to being rated “investment grade” by at least one agency) or in Equity Linked Savings Schemes of mutual funds to go up to 10% of total funds, from 5% previously
• 25% of total funds may be invested in deposits of private sector Banks that fulfil capital adequacy and net worth criteria
• Trustees are allowed to decide if a further 30% is to be invested in money market funds, bank deposits or public sector bonds
• Requirement of investment in Central and State Government securities or mutual funds where the underlying assets are such securities, to be reduced.

Should these guidelines be passed, this retirement planning option could yield higher returns. While this is a welcome development, people must realise that the primary objective of a provident fund is to provide sustenance during retirement. Unfortunately, a lot of people withdraw these funds to meet large or unexpected expenses. By doing so, they forgo several benefits:

• When the provident fund in someone’s account completes 5 years (with a single employer or otherwise), the withdrawal becomes tax free. In contrast, early withdrawal requires that the employee pay tax on his or her entire contribution
• The Employee Provident Fund pays a tax free interest of 8.5%, which is attractive compared to many other instruments
• Once can still meet exigencies while not liquidating the corpus since there is a provision that allows the account holder to withdraw funds under specific circumstances, such as medical emergencies or construction of a home.

The provident fund is intended for retirement. As far as possible, it must be protected for this use.