Impact of a reduction in yield

If you save $500 a month over 35 years, your total savings is $210,000. If you earn 5% per annum during this period, you should get $569,000. Unfortunately, you will not get this full sum, as the financial institution will take away a portion of your gain to pay for their various charges, such as marketing, fund management, administration and profits.

Most high cost products can reduce you yield by as much as 2%, giving you a net yield of 3%. This 2% yield may appear small, but over a 35 year period, it could take away 34% of the accumulated amount, giving you a net amount of $373,000. You are left with a net gain of only $163,000. The amount taken away from you, representing the reduction of 34% is $196,000. In other words, you are left with less than half of the total gain.

It is important that you find a product where the reduction in yield is as little as possible.

If you invest directly in shares, you will not suffer any reduction in yield, but you will need to monitor the shares and make sure that you collect the dividends and rights issues. You may also suffer a big loss, if the particular business performed badly.

To avoid this risk, it is better to invest in a unit trust where the investments are professionally managed and and you enjoy diversification. However, the charges for most unit trust is 1% per annum, which is rather high. The fund manager will tell you that he can add value by picking the good stocks that will perform better than the market, but studies have shown that most fund managers are not able to generate this value.

You can invest in an exchange traded fund, which is benchmark against the stocks comprised in the market index. An example is the Statestreet Trakker fund, commonly known as the STI ETF. The management fee is 0.3% per annum. This is a low charge, compared to unit trust.

Read this table to see the impact of a reduction in yield on a monthly savings plan over a number of years.

Tan Kin Lian

Taking a housing loan

Here are some tips on taking a housing loan. Do not borrow to the limit. Have some margin to allow for future increase in interest rate. Have some spare savings in case you lose your current job. Ask your bank to give you a special term to defer repayment for up to 12 months in the event of loss of employment.

Using bicycle for the last mile

Here are my suggestions for a bicycle service to bring people from their homes to the MRT station and back.

Accumulation of Savings

This table shows the accumulated amount of savings at various rates of interest, and the reduction caused by the charges taken away from your savings by the financial product.

For example, if you save $500 a month and earned 5% per annum for 35 years, you will get an accumulated amount of $569.018. If the financial product takes away 2% per annum (which is quite common) to give a net return of 3%, you will get an accumulated amount of $373,656, or a reduction of 34%.

A good financial product will take away a reduction of 0.5% leaving you a net yield of 4.5% and an accumulated sum of $510,894 or 37% higher than $373,656. An example is an exchange traded fund (ETF) or a low cost unit trust.

Choose a financial product that takes away not more than 1% of your yield. Avoid financial products, including most life insurance policies, that takes away more than 2% of your yield, leaving you with a poor return.

When you buy a life insurance policy, you get a benefit illustration. Look at the figure shown as "reduction in yield". You will find the reduction to be more than 2%. If you do not know where to find it, ask the insurance agent to tell you (it is the duty of the agent to explain this infromation to you).

If you have already bought a whole life, endowment or investment-linked policy, or a variation of these plans, you can ask the insurance company to send you the benefit illustration again and tell you about the reduction in yield.

A survey carried out in my blog indicated that 80% of people who bought a life insurance policy were not told about the distribution cost (which causes a large portion of the reduction in yield) and, after learning about it, almost all of them felt that the distribution cost is too high. They felt that the agent should have told them about it.

The remaining 20% who were told about the distribution cost could have bought a single premium policy where the distribution cost is quite small and is likely to be explained by the agent.

Tan Kin Lian

Note: This new chapter will be added to my book on Financial Planning: Practical Steps

Taxation and social services

Each society needs to provide some social services to its people, such as infrastructure, education, health care, law and order and safety. The cost of these services have to be paid through taxation.

A fair method of taxation is a flat amount to be paid by all residents or households. As each person or household benefits more or less equally from the social services, they should contribute equally.

Unfortunately, in a society where there is a large disparity of earnings, there are many people who do not earn enough to pay for the cost of living. They will not be able to contribute towards the taxation.

A better method is to impose higher taxes on the high income earners. As they earn much more than the median wage, they are able to carry a larger share of the social cost.

Some people argued that a high tax rate will chase away the high income earners to other countries. This may apply to certain businesses that are globally mobile. There are many businesses that depend on the domestic market of a country. The high incomes have to be earned in the country and cannot be moved away.

In my view, a maximum tax rate of 30 percent of earnings is fair, as it would still leave 70 percent in the pockets of the high income earners.

There are debates on what has to be provided by the state and what should be provided by the private sector. In my view, the basic needs that should be provided by the state up to a standard that is necessary and cost effective. Those with higher incomes can opt to pay for a higher standard of service in the private sector, such as private schools or health care.

If the state does not provide for the basic needs, many people will have to buy these basic needs from the private sector and pay a much higher price, due to predatory practices and a high profit margin.

This has already happened in the financial sector which pays a low rate of interest on the savings and sells bad investment products that cause the investors to lose their savings. In the health care sector, some people have to pay higher fees to private doctors, without getting better outcomes.

It is better for the essential social services to be provided by the state on a cost effective basis, and for the cost to be shared fairly among the tax-payers. The higher income earners should be asked to contribute a larger share.

Tan Kin Lian

Free market (7) - Lower fixed cost

Many small business find it difficult to survive. They have to pay high rental and credit to run their business. These high cost have to be passed to their customers in the form of higher prices.

As business premises and credit are under the control of a few people, they are able to increase the rental and interest rate on loans. They make excessive profit and cause a heavy burden on the small business and the consumers.

These high costs can be controlled by the government through legislative measures, e.g. to set caps on rental rates or the cost of capital, or to provide alternative sources of supply through the public sector.

Many years ago, HDB provide shops at affordable prices. It allows the shop keepers to offer their goods and services at lower prices and make a reasonable profit. If they overcharge and make a larger profit, another business will be set up to provide an alternative at a lower price.

This is competition at its best, in bringing the prices down to a reasonable level, based on the cost of doing business plus a fair margin of profit.

In America, the anti-trust law is designed to ensure that there is fair competition and that any business is not allowed to grow so large that they can dominate the market and have unfair pricing power.

We also need controls to ensure that property owners and bankers do not take an excessive share of the value chain, at the expense of the customers, workers and the small business owners. It is desirable for these business costs to be controlled, to promote a healthy competitive market.

Tan Kin Lian

Australia court allows claims against Lehman

* Australia court opens door to Lehman claims
* Town council to pursue claims for subprime losses
* Ruling is not an international precedent - IMF Ltd

Read this article.