Readers of tremeritus.com will be familiar with ‘Chris K’s’ contributions. His more than 30-year experience working for European banks in asset & risk management offers a perspective that was lacking if not absent before he decided to do more than comment at TRE. Most who have read his opinion pieces have benefited.
I met Chris via TRE back in Feb 2014. I think Chris’ thoughts deserve a wider audience looking for better clarity and understanding of matters and concepts financial – in layman’s terms. So I asked if he’d like to use this blog to share his thoughts which, I think and hope, visitors will find interesting and educational.
I have combined his original 2-parter into one.
Much and nothing had been said by the government since the CPF furore erupted some months ago. The disbelieving were rightly not placated by what are essentially doubletalk. Here’s a checklist of the government obfuscation about rates of return and inflation rates.
US$ and S$ Returns
The first obfuscation is the rates of return earned by Temasek and GIC. Although Temasek reports its returns in S$, GIC reported in US$, having ceased reporting in S$ in 2010. The government said US$ rates of return are easier to compare against international benchmarks. Any reasonable person would ask why should US$ matter to a Singaporean saving and spending in S$. The real reason may be to obfuscate the abysmal rate of return in S$ because the exchange rate policy mandated to the MAS by the government causes GIC’s returns to depreciate by 1.5% pa over the past 20 years. It cannot be certain that the government will not find yet another reason to revert back to S$ reporting especially the US$ appears to have embarked on sustained strength against S$.
Real Rates and Nominal Rates
Nominal Rates are rates of return generated from investments. The interest rates one received from one’s bank deposits, CPF account, dividend from stocks, interest from bonds etc are nominal rates.
Real Rates are Nominal Rates minus the inflation rate. Real rates are calculated to determine if the nominal rates are enough to offset inflation and are far more important than nominal rates especially investing over long periods of time like a CPF account. Ultimately, it is not simply how much money one has in the future but how much that money can buy.
When the Govt talks about Real Rates
This is when the government want to show how “good” CPF rates are compared to GIC’s returns. Usually they will refer to the US$ Real Rate of Return – low enough to make CPF rates look “good”. But notice they said nothing about S$ Real Rate of Return which is so low citizens will question GIC’s competency or worst, why GIC invests all of CPF monies overseas at the risk of currency losses .
When the Govt talks about Nominal Rates
This is when the government is not comparing CPF rates, which allow them to point to GIC’s nominal rate of returns usually over a sufficiently long period of time like 10 or 20 years to show how “good” GIC’s historical returns were.
The other occasions when the government talks about Nominal Rates is when they talk about CPF rates alone. Notice that Mr. Tharman, the Finance Minister hardly mention CPF rates and inflation rates in the same statement, i.e. he hardly mention CPF’s real rate of return. That is because mentioning inflation rates would undermine his constant assertion that CPF rates are “fair”. This obfuscation is so effective that many have been smoked into believing one has to accept such low real rates of return for a “risk free” long term investment.
Minimum Sum up 6.2%pa but inflation up 3%pa?
The government explained it as citizens demanding a higher standard of living. But what is not said is that even if one does not need a higher standard, one is forced pay for it anyway. This is mostly due to what is called the hedonic pricing – a product’s price increases not only because the price of materials used has increased due to inflation but also the product contains quality improvements which may be real, aesthetic or both. Be a cheapo and buy an Iphone 1 nowadays or makan at no-aircon hawker center along Orchard Road. Essentially higher prices are unavoidable but hedonic pricing is not factored into official inflation. This is the reason people feel the cost of living is much higher than reported by the official inflation rate.
‘THE CPF IS RISK-FREE’ DOUBLETALK
In this follow-up to the government’s CPF doubletalk on rates of return, the writer looks at the mother of all doubletalk; Ministers asserting that CPF principal and interest are guaranteed and as such retirement savings are “risk free”. Let us begin by doing away with the most obvious bits.
Guarantee and Risk Free
From previous articles and comments by the writer and others, it is well known by now the government guarantee to CPF is a contradiction since the government’s guarantee is based on its tax raising powers and it is the citizens who ultimately guarantee their own investment in CPF with their taxes and the net assets in the SG reserves which are derived from unspent taxes, excess returns from investing CPF funds and land sales revenues.
Next, even the safest instrument, the government bond, contains risk. The term “risk free” does not exist outside the theoretical context of the “risk free rate” which uses the government bond yield as an approximation to calculate risk-adjusted returns of comparative investments. The ministers’ use of the term suggests they are either deliberately obfuscating or they do not fully understand the context. The writer does not recall any other government claiming their bonds are “risk free”.
Low Risk Today, High Risk Tomorrow
SG government bonds certainly have low risk to default but a low risk instrument has a low rate of return which exposes savings to other risks. Let us look at annual CPF rates in comparison to the annual rate of increase in the Minimum Sum, which the government has said, is needed to keep pace with the rise in inflation and standard of living which impose cost increases not captured by the inflation rate.
The red numbers show the excess rise in costs over CPF rates due to inflation and standard of living. Clearly, the interest delivered by low risk government bonds to CPF cannot keep up with rising costs. Essentially being invested in low risk instruments exposed savers to different kinds of risks which may be invisible until 20-40 years later, illustrated in the flow chart below
Next, let us compare the 20 year average rate of return from low risk CPF to that of a higher risk model portfolio which assumes CPF monies are invested equally in US equities (S&P500 Index), European equities (EuroStoxx Index) and global bonds (JPM Global Bond Index). Returns in the model portfolio are adjusted to S$ to account for currency risks and are net of taxes. The performance data for the model portfolio over the past 30 years in the table and comparison of the 20 year average rate of return in the chart.
|No. of Annual Losses||No. of Annual Gains||Worst consecutive losses||Best consecutive gains||Worst Annual Loss||Best Annual Gains|
|7 years||23 years||2 years||5 years||-26.1%||+41.6%|
The excess returns of the model portfolio over CPF in red numbers represent the opportunity cost of a lifetime of receiving interest from safe, low risk government bonds. By avoiding investment risk, a low return portfolio is at risk to inflation during working life and especially in retirement when a retiree has little or no means to derive extra income to offset inflation. This is the reason virtually nobody passively invests only in government bonds throughout a lifetime and one should accept risk when one is working to avoid risks in retirement. Even the ultra-conservative $1.5t GPIF of Japan, all of 76 staff headed by a CIO paid just $200,000 per annum, do not invest entirely in government bonds.
Tharman: “It (CPF) protected members from risk.”
It sounded reassuring and altruistic when Mr. Tharman said this in Parliament on 8 July 2014. Perhaps it is but think deeper. The long run reward of accepting higher investment risks is well known. By legally coercing CPF funds to be invested in SSGS, the government has effectively monopolised the historical long run reward of investing in risk assets and captured the excess returns into the net assets of the SG reserves. In effect, this is a highly regressive hidden tax or an astronomical surcharge on savings. Conversely, it means that CPF members are prevented from benefiting from the same historical long run reward, consigning members to low risk low returns which exposes them to other risks as explained above and worse, in retirement when it is difficult to generate additional income.
So next time, if someone insists CPF is “risk free”, the reply should be “free from what risks?”
* Chris K holds a senior position in a global financial centre bigger than Singapore. He writes mostly on economic and financial matters to highlight misconceptions of economic policy in Singapore.