September 29, 2017 Investing, KiwiSaver Annuity, Lifetime Income, Retirement, Simplicity 1 Comment

Simplicity Guaranteed Income fund, What’s that and How it Works?

by Alpha

Simplicity, the non-profit and low-cost KiwiSaver provider introduced a new fund last week called “Guaranteed income fund.” Guaranteed income investment products had been around for years in other overseas markets, but it’s very new to New Zealand. So in this blog post we will look at what is guaranteed income fund, how does it work, the pros, the cons and do you need it.

What are Guaranteed income fund and annuity

The guaranteed income fund is basically an annuity. They provide a stable and secure source of retirement income. You will need to surrender a sum of money in exchange for a stream of income that’s guaranteed for life. The annuity has been around for a very long time in the overseas market. Usually, annuity service is offered by an insurance company because there is a guaranteed element in this product. New Zealand just had our first annuity service from LifeTime Income Ltd not long ago.

How does it work?

Simplicity now partners with Lifetime Income Ltd and provide a guaranteed income fund that offers 5% guaranteed return at age 65 for the rest of your life. The minimum amount is $50,000, the annual cost is $30, fund management cost is 0.31%, and insurance cost is 1.3% of your protected income base. Protected income base is your initial investment if you start receiving cash payment immediately. If you decided to delay receiving the cash payment, your protected income base would be either your initial investment amount or the current fund value, whichever is higher. We will explain that later.

You can think of it as you borrow some money to another person. That individual will keep paying you interest at 5% for the rest of your life.

Here is an example of how it works. Assume you are now 65. You decided to put $50,000 into Simplicity Guaranteed income fund and start receiving the cash income immediately. Every year, you will receive 5% of that $50,000, which is $2,500. It will payout fortnightly at $2,500 / 26 = $96.15 for the rest of your life. The $50,000 are still with Simplicity as an investment. That money will continue increase or reduce according to how the investment market performs, tax and fee charges. The cash you receive will also come from that fund as well.

Here is a simplified calculation

Your capital + gain or loss from investment – tax – annual fee ($30) – management cost (0.31%) – Insurance cost (1.3% of initial value) – cash payout (5% of initial capital) = end balance

Apply that to our $50,000 example with 6.5% return, Taxed under FDR rule with PIR at 17.5%, here is the performance for the first year.

Initial Capital $50,000 + Investment return $3,250 – Tax $465.94 – Annual fee $30 – management cost $163.63 – insurance cost $650 – cash payout $2,500 = End year balance $49,440.43

Here is the performance for next 25 years with the same return at 6.5%

Here is the graph of your fund value over the years.

What if my fund runs out?

As you can see with 6.5% return, your fund value will keep going down, and you will run out of money some day. If your investment fund is exhausted, there will be no money to draw from. At this point, the insurance policy will take over and pay out that guaranteed amount ($2,500/year) for the rest of your life. That’s why there are a 1.3% insurance charges on the fund.

Now I will use the same example but lower the return on investment to 2.5%.

Your investment fund exhausted age 82. You can only draw $1,495 from your fund at that year. The insurance company will pick up the tap and continue to pay the guaranteed income for the rest of your life.

Here is a closer look at guaranteed income. Insurance policy kicks in at age 82 and continue.

Can I delay and get more Cash Payout?

The 5% is the minimum income guarantee. It goes by 0.1% each year that you defer taking out the guaranteed income. When you start getting the income at 65, the guaranteed rate is 5%; if you start getting it at 70, the guaranteed rate is 5.5%. It tops at age 90 with 7%. The money in the fund will increase or decrease with the investment return but there is no cash withdraw.

Here is an example when you join at 65 but only start to get income at 70 and get 5.5% guaranteed income.

What if the receiver pass away?

If the receiver passes away, whatever left in the account will be passed on to their estate. Now, let’s go back to our 2.5% return example.

If the receiver passes away at age 77, there are still $16.962 capital in the account. That amount will pass onto receiver’s beneficiary. On the other hand, if the receiver passes away at age 86, there will be no money left in the fund. So there will be no money to receiver’s beneficiary, and the insurance payment will stop.

What so good about Guaranteed income fund

Imagine you are now retired and you only living on superannuation plus your saving. Every time you spend money on the power bill, water and food, your retirement saving go down a little bit. Do you worry you may outlive your retirement savings and have to live on superannuation alone? This is a real concern for many retirees and it reduces their spending in retirement years.

Below is the typical situation for New Zealand retiree. Their retirement is partly funded by superannuation and their own savings/income to reach their ideal standard of living.

Since we don’t know how long we are going to live, some retirees worry they may outlive theirs. So they reduce their spending and stand and hope the saving will least long enough. The living standard reduced as a result.

Since guaranteed income fund and annuity provide a steady stream of income for life, it is a powerful tool for retirees. You can surrender part of your retirement saving and exchange for a guaranteed income for life. Add that on to superannuation from the government, you will have a bigger part of fixed income every fortnight. So it will help to bridge the gap between your living expenses and superannuation. Also, It will reduce the concern if you will out the saving. The most significant benefit its gives you the certainty that you can always fall back to Superannuation + guaranteed income level.

What are the Limitation & Risk

There is always a catch with investment and insurance products. There are certain restrictions and risk regarding guaranteed income fund.

KiwiSaver Only – currently this fund is only open to the KiwiSaver member. If you are not eligible for KiwiSaver or you already left KiwiSaver, you can’t join the fund. Also, you’ll have to be 65 to start receiving a cash payment. Alternatively, you can get the annuity from Lifetime Income with a higher cost.

Fixed amount – It is great that you will have an income for the rest of your life. However, that amount is set for life as well. So inflation will be your biggest problem. With inflation, the same amount of money will have less buying power. In the early 2000s, the price of petrol was well below $1. I can fill my tank for $30-$40. Now, I can only fill 60% of the same tank with $40. Here is a table of the real value for $2500 after 2% inflation. 10 years in at age 75, that $2500 will worth about $2000 today, it lost about 20% of its value.

Since the cost of living and superannuation are rising along with inflation, you will have to fund more of your living expenses out of your retirement savings. Just like the graph below.

However, people tend to spend less as they age. Although the cost of living increased, the cost for an ideal living standard will decrease and it softens the effect on inflation.

Cost: This fund is very similar to Simplicity balanced fund and they have the same admin fee and management cost. However, guaranteed income fund have an insurance policy attached to it and it cost 1.3% of your initial fund amount. No matter how your fund performs, it will charge the same amount of insurance fee.

Insurer risk: Since this fund has an insurance policy, there is always the risk of insurance company collapse. The insurer is Lifetime income limited, which is not a big insurance company like AIG.

Access to fund: You will need to surrender a large sum of cash to the investment provided to start your income guaranteed fund. There are limitations on how you can withdraw your fund from the plan. First, your fund may not have enough money due to the fees and investment return. If there are fund to pull out from, you can either withdraw up to 20% of your fund and take a pay cut by the same percentage you took out. The other options are completely empty your fund. The good thing is Simplicity will not charge a fee on that.

Do I need it?

I think it’s great that there is one more option for New Zealand retirees with Guaranteed Income fund. It will reduce the concern of retirees outlive their savings and provide a fallback for them if they have to scale back their spending.

Make sure you understand Guaranteed Income fund is just one of the many options for retirees and you should not put all of your eggs in one basket. I will include them as part of the retirement plan along with term deposit, investment fund or property and superannuation.

The key point is you should not put all of your money into Guaranteed Income fund and annuity. One way to work out how much guaranteed income you’ll need is to decide how much income you wish to be guaranteed along with superannuation income.

For example, a married couple will get $1200.60 each fortnight. They also worked out their ideal living standard will cost them $2350 each fortnight including nice food, shopping, dining out, travel and avocado on toast every Sunday. On the other hand, we can cover their basic expenses (power, water, communication, petrol and basic food) for $1500 each fortnight.

If the couple wants to the guaranteed income cover their ideal living standard, the guaranteed income needs to be $2500 – $1200 = $1300 each fortnight. To get that amount of guaranteed income, the couple will have $1300 x 26 / 5% = $676k in the fund. That is not a small amount for most people.

How about we just need to cover the basic. The guaranteed income will be $1500 – $2500 = $300 each fortnight and the fund value will be $300 x 26 / 5% = $156k. This amount is not too big and seems reasonable to average retirees. It will cover the basic for the couple at their early stage of retirement. They will be happy to know if anything happens that cost all of their life-saving, they will still have enough to cover the basic living with superannuation and guaranteed income. They can even increase the fund value to hedge against inflation.

Conclusion

Simplicity offer Guaranteed Income fund for the KiwiSaver member.
The investment fund is similar to Balanced fund with $30/year admin fund, 0.31% fund management fee and 1.3% insurance cost based on the initial fund value.
Investors will receive 5% of the initial fund value as cash payment every year from 65 for the rest of their life.
The cash payment is drawn from your investment fund. If the investment fund runs out, an insurance policy will kick in and provide the cash payment.
This is a great option (in combine with superannuation) for retirees to set a safety income line.
Do not over commit. This fund should be part of your retirement plan along with superannuation, term deposit, and other investment.

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September 19, 2017 ETF, Index Fund, Investing Children, investnow, Kids, Superlife, Vanguard 9 Comments

The Best Way to Invest for Your Children in New Zealand – What to Invest

by Alpha

This is the second part of my investing for children series. In a previous post, we talked about why should we invest for your kids and what you need to know beforehand. Now, let’s dive into what to invest for your children in New Zealand.

Index Fund & ETF for Kids

In case you don’t know, I am a big fan of the low-cost index fund and ETF because this is a low-cost investment option with a diversified portfolio and low entry requirement. Naturally, I will put my kid’s investment into them as well as a managed fund with ETF and Index fund in it. However, lots of investment services won’t accept anyone who is under 18 years old as investors. Basically, under their terms and conditions, you will have to be 18 years old or over to sign that agreement. Therefore, there are not a lot of choices for children.

Looking for investment options for my kids

Furthermore, a good investment for kids is kind of the hidden gem out there. The one that advertised heavily aren’t very good, and you will have to dig deep to find the good ones. After lots of googling, emailing and reading, here are my top picks.

SuperLife MyFutureFund

Hidden Gem No.1 is Superlife MyFutureFund. This is a different service from SuperLife KiwiSaver and SuperLife Invest (non-KiwiSaver Service). This service doesn’t have a web page at the moment so you won’t find it on SuperLife web site. The information is buried under SuperLife Invest Product Disclosure Statement, page 26 and 27 of that PDF file.

(Superlife is currently redesigning their website. The myfuturefund page will return after that.)

MyFutureFund itself is NOT an index fund or managed fund, it’s just a way that allows children to invest in SuperLife’s product. The account is in the child’s name but the guardian/person opening the account has control of the account including access to the funds through until 18 years of age. The account is separate from parents account, but you would be able to view the account through a “linked” membership.

MyFutureFund has access to the all Superlife investment options. There are over 40 different investment options available for kids including ETF, index fund, sector fund and managed fund. My personal picks for my kids are SuperLife 100 and Overseas Shares (Currency Hedged) Fund.

SuperLife 100 is made up of mostly Vanguard Index fund and ETF plus fund from Somerset. The investment included, 55% of international shares, 33% of Australasian shares and 12% listed property. The management cost is 0.52% and risk indicator at level 4. Three years return after tax (PIR at 28%), and fees are 8.35%. Seven years return is not available.

Overseas Shares (Currency Hedged) Fund is made up of eight Vanguard ETF. Invested 100% in international shares and mainly in US and Europe stock market. The management cost is 0.48% and risk indicator at level 4. Three years return after tax (PIR at 28%), and fees are 7.52%. Seven years return is 11.47%.

I picked those two funds because they are both diversified and contain 100% growth asset. Regarding fees, the management fees are relatively low, and SuperLife’s annual admin fees are only $12/years. They do not have regular contribution requirement, minimum investment amount can be just $1. So Superlife is great for both regular and irregular investing for your kids. I already got an account with SuperLife on my own so linking the kid’s account is straightforward and easy.

What about Investment for Mid-term

Those two fund that I suggested were 100% growth asset, so they are aggressive fund. They provide a great return for long-term investing. However, they will be too risky for mid-term investment. If you plan to use that money within 4-10 years, you may consider some other fund with lower growth asset.

SuperLife 30, 60 and 80 are similar to SuperLife 100 but added a different percentage of income asset. Fund with more income asset will have a lower range of gain and loss in any given year, and better return during recession compare to 100% growth asset fund. On the other hand, when the market is booming, those funds will have a lower return.

I think Superlife 30 will be ideal for 4-6 years investment, Superlife 60 will be great for 6-8 years, and Superlife 80 will be ideal for 8-10 years. For example, if your kid is 12 years old and planning to use that money for the university at 19-year-olds. Your investment timeframe will be 7 years, and you should consider Superlife 60. For any plan under 4 years, term deposit with the bank is a good choice.

How To Join MyFutureFund

SuperLife doesn’t have the easiest way to join so there is how you can join them. You will need to fill in the application form from SuperLife and send it over by mail or email.

Download and read SuperLife Invest Product Disclosure Statement
Go to Applications form (page 22 of the PDF file) and fill out your kid’s details and use a separate email set up for kids investing.
Under Saving section, you choose how you are going to invest. It can be one lump sum investment, regular investment or both. The example below starts with $500 lump sum investment with NO regular contribution.
Fill out the Communications and ID verification. You should be using NZ passport or NZ Birth Certificate for the kid.
Under Investment strategy, they will ask if you would pick their managed fund first. If you wish to join SuperLife 100, just tick as below.
If you wish to join other funds or join multiple funds, you’ll need to tick “My Mix” and go to the next page.
At page 5 of the application form (page 26 of the PDF file), fill in initial investment or regular investment. You can set the amount by actual dollar value or by percentage. At the example below, I invest 50% to Superlife100 and 50% to Overseas Shares (Currency Hedged Fund).
On the right side of My Mix page, you can decide what to do with your investment income. They can be reinvested into the fund or save the return in cash fund. Reinvestment is the most common choice for kids. Below that, you can decide rebalancing options, I suggest to use the standard rebalancing for the kids.
At the next page (page 25 of the PDF file), after you pick the beneficiaries (usually “My estate”), DO NOT sign at the bottom. You should move onto the next page.
At the next two pages (Page 26 and 27 of the PDF file), you will have to fill in your own information as the guardian, supply the ID information, and sign it.
Once you completed the application form, you can send it over to SuperLife, and the investment account will be ready in a couple days.

If you have any other questions, contact Superlife with superlife@superlife.co.nz or call them at 0800 27 87 37.

InvestNow’s Vanguard Fund

The second gem is InvestNow. InvestNow is an online investment platform provide multiple investment fund for their investors with low entry require and no middle-man fee. You can check out my blog post on InvestNow here. Unlike other investment services, InvestNow’s term and condition do not have an age restriction. Therefore, InvestNow opens the door are a whole range of investment fund for your kids. You can check out the full range of investment fund from InvestNow here.

Out of all those investment options, my pick for my kids is Vanguard International Shares Select Exclusions Index Fund. That fund launched for AUS and NZ market in late 2016. It contains about 1500 listed companies across 20 developed international markets (without Australia). This fund is an ethical fund as they excluded Tobacco, controversial weapons and nuclear weapons investment.

The BEST things about this fund are the cost. It only charges 0.20%/year on management fees and NO annual admin fee. The fund itself is a wholesale fund, which means it usually only accept institutional invest. The minimum initial investment required was AUD $500,000. The good news is, investors can join this fund via InvestNow with just $250 investment. (InvestNow will lower that requirement to $50 shortly.)

There is two version of this fund, one with NZD currency hedged with 0.26% management fee and one without currency hedged with 0.20% management fee. Without currency hedge, the fund is exposed to the fluctuating values of foreign currencies. So this fund will have a higher risk and lower cost. On the other hand, you will pay a higher fee for a more stable return with the currency hedged fund.

Here is the link to check out those two funds in details.

Vanguard International Shares Select Exclusions Index Fund

Vanguard International Shares Select Exclusions Index Fund – NZD Hedged

Pay Tax on Investment

Those two funds have a different tax treatment compare to common PIE fund. With PIE fund, the investor usually just need to submit their IRD number and PIR rate once, then they don’t need to worry about tax. With those Vanguard funds in InvestNow, they are Australian Unit Trusts and will be taxed under Foreign investment funds (FIF) rule. Investors are required to submit their income from FIF and file a tax return every year. If the holding amount is under NZD $50,000, which should be the case for most children investors, you will need to pay tax on the dividend you received with the kids’ RWT rate. If the holding is over NZD $50,000, you will have to calculate your taxable income with either Fair dividend rate (FDR) method or Comparative value (CV) method.

For children investors with portfolio value under $50,000, filing a tax return on dividend received is not too hard. You will need to file a Personal tax summaries (PTS) with IRD, and it can be done online. I will share how I do that with my kids next year. Regarding FDR and CV method, I personally don’t know how to do it. You better to talk to a tax accountant for that.

How to Join InvestNow

InvestNow sign-up process is very straight forward so there won’t be a step by step guide. You’ll need to click on the join link on InvestNow home page and use a separate email address to sign up. After you sign up an account, InvestNow will ask you to provide information on identification. You don’t have to complete that. Instead, contact them directly with contact form or call them at 0800 499 466 and let them know you want to set up an account for your children. Make sure you got the following information ready

Email address of the account
NZ birth certificate or a passport for a child
IRD number of the child
PIR and RWT rate for the child
Proof of guardian’s address

InvestNow will be able to set up an investment account from here. They can also link multiple child accounts to your current InvestNow account if you have one already.

Update on functions

Currently (at 19 Sept 2017), InvestNow don’t have auto-invest function, and the minimum transaction amount is at $250. So it’s not the best choice for someone who wants to regularly invest for their kids because they will have to transfer $250 into InvestNow, then login to their platform and manually invest that money into the fund. The Good news is InvestNow will implement auto-invest function and lower the minimum transaction limited to $50 shortly. So Investors can set up instruction to let InvestNow automatically invest into your preferred fund everytime you transfer money to them.

(Update, InvestNow added auto-invest function with $50/transaction.)

Conclusion

Here is the breakdown of my top picks compare to our kid’s investment requirement.

Superlife MyFutureFund provides a full range of fund for different investment timeframe. They have all necessary function for you to setup different investment plan for your kids. A great “set and forget” solution. However, they don’t have the lowest fee.
InvestNow allows user to invest in a great Vanguard investment fund with 0.20% management fee and no annual fee. However, you will have to do a tax return for your kid every year.
Feel free to contact them before you sign up and understand the process. I found both companies is great with answering customer questions.

In next part of my investing for kids series, we will look at some other investment options including KiwiSaver, Bonus Bond, SmartShares and more. If you are currently invested in or considering some investment program for your kids and want me to cover them, drop me an email at thesmartandlazy@gmail.com. I will try my best to cover that.SaveSave

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September 12, 2017 Investing Children, Kids 16 Comments

The Best Way to Invest for Your Children in New Zealand – What You Need to Know

by Alpha

I am a father of two pre-school kids and I been researching on how to invest for them in New Zealand. There are some options out there, but the good one is surprisingly hard to find. So here is my finding on the best way to invest for your children and what you need to know.

There is a lot to write about investing for kids, so I am breaking this topic into three parts. I will talk about why invest for your children and what you need to know before investing here. Part 2 will be my pick on the best investment options for kids and part 3 will be my view on some other investment options in New Zealand.

Why Invest for Your Children

Education: The main reason I invest for my kids is that I want them to know about personal finance. I personally know a few smart and bright teenagers who are horrible with money, which leads them to big money problems (I used to work in student accommodation and know lots of students who left home and flatting with others). It seems like we don’t teach personal finance at school and we don’t talk much about money at home. When some of those kids leave home, they have no idea how to handle money and make a mess with their finances. So for my kids, they will learn about personal finance from a young age. I won’t start them off the complex financial product, but eventually we will get there. That will be a great example to show how their own money is working for them.

We will start with a piggy bank first, but we will get to managed fund… eventually

Prepare for their future: I can’t predict whats going to happen in the future, so I want to do my best to prepare for it. For now, you can get an interest-free student loan for study, but it is not always the case. Student loan used to carry interest and before that, Univesity used to be free. For my kids, I have no idea what sort of society they will be facing, so it’s always better to have something prepared. No matter if they want to go to Univesity, go overseas, start their own business, there will be some money for them.

Best time to invest: There is a Chinese proverb said something like, ““The best time to plant a tree was 20 years ago. The second best time is now.”. For us, we can’t go back 20 years ago and invest for yourself unless we get our hands on a DeLorean DMC-12. At least we can do it for our kids. “It’s not timing the market, it’s time in the market.” By investing at their young age, that investment will have all the time in the world to grow and ride out of recession. It almost guarantees those diversified investments will have a great return once your kids reach adulthood.

You can’t go back 20 years ago to start investing, but you can do it for your kids.

There are two New Zealand personal finance bloggers wrote on this topic I think you should check them out. Ruth from the happy saver wrote a great blog post on ‘Teach kids about money’. Ryan from Money for Young Kiwis wrote another great piece on “Should you invest for your children”.

What do you need?

Before we go into the details, here is a checklist of what you need to set up an investment for your kids.

IRD number for the kids
Set up a new email account for kids’ investing purpose
Identification document for kids (Birth cert, Passport)
Identification document for guardian (Passport, Driver license)
Prove of relationship between guardian and child (Birth Cert)

Tax Matter

Some people think children do not pay tax as they have little or no income and that is not true. No matter how cute your kids are, IRD is going to charge tax on them. There is two type tax your kids will be paying, Resident withholding tax (RWT) and Prescribed investor rate (PIR).

Resident withholding tax (RWT) will be familiar to most people because you can see that on your bank statement when you received interest. Resident withholding tax is a tax deducted from a New Zealand tax resident customer’s interest income before they receive it. So it’s basically a tax on your interest and dividend received. Your kids will be using this tax rate if they earn interest from bank deposit or receive a dividend from shares.

Prescribed Investor Rate (PIR) is the rate at which an investor pays tax on their share of taxable investment income from a Portfolio Investment Entity (PIE) investment. It basically taxes on your investment funds like KiwiSaver, index fund and managed fund.

All investment service require IRD number so you MUST register your kid with IRD. If your children don’t have an IRD number, go to this website and get an IRD number for your child. You can check out IRD website to find out the correct RWT and PIR for your kids.

Tax Rate Difference between Adults and Kids

For most kiwi kids who have no income, their RWT and PIR will be at 10.5%. This tax rate is important because average working adult RWT is at 30% or 33% and PIR at 28%. So kids pay much lower tax compared to an adult, and this is a great advantage for kids.

Some parents already set aside some money to invest for their kids under their name because of convenience. There is nothing wrong with that, but it’s not tax efficient. Let’s look at an example below:

Parent A and B both put $500/years into an investment fund with an average return at 7% after fees before tax. Parent A invested under their own name with PIR at 28%. Parent B invested under their child name with PIR at 10.5%. Here is the result after 15 years.

Parent B’s fund ended up with a higher balance because it was taxed at 10.5%. The actual tax paid with PIR 28% was 1.4% of the fund and 0.525% with PIR at 10.5%. The different is just 0.875%/year. When the kids paid less on tax, more money kept in the fund to grow. At year 15, it resulted in 7.39% different in value.

Remeber, your kids are NOT your tax shelter. Don’t put your own investment and life-saving under your kid’s name to pay less tax. IRD may treat that as tax evasion, and this is a criminal offense. When you invest for your kids, that money supposed to be their money or planning to use for them.

Skip the Bank Account

A popular thing parents do for their kids is to set up a bank account and put money into it for saving and earn a bit of interest. When I look at bank saving, it’s a safe option but not a good investment. Yes, you do earn interest from the bank, but the returns aren’t very good. Also, inflation and tax will reduce your return. You may get some interest on that money but it may worth less in the real terms after inflation.

Take a look at the interest rate on high interest saving account from January 2003 to August 2017 below.

Before 2008, you can get about 4% – 8% interest on your deposit and now is above 2%. Let’s add tax and inflation to those interest rate. I will be using RWT at 10.5% as tax rate here.

The green will be the real return on bank interest. It was around 2%-4% before 2008, dropped below 0% at 2010 and currently sitting just above 0%. Therefore, if you keep your kids money in the bank as ‘investment,’ the return is only a better than inflation.

For me, I will still open a bank account for my kids, but the purpose will only be temporary saving. The bank account is not an investment for my kids, it’s just a safe keeping. Most for their money will be sitting in some funds.

Long-Term Investment

Some parents may think investment funds are too volatile for their own risk appetite, that’s why they choose saving account. This is true as saving account provide a low but safe return, investment funds’ return can range from 20% to -20% in a single year. However, we need to separate parent’s risk appetite with kids.

Kids have a lot more time ahead of them compared to their parents. For an average Kiwi kids in an average income family, here is a list of some life events that they may need to use that investment fund.

Pay for tertiary study at 18-20 years old
Moving out for job or school around their 20s
Overseas experience around their 20s
Buying their first home between 20-35

Most of those events happen around their 20. If you kids are under 10 years old, the investment time frame will be at least 10+ years for them. The common wisdom is you should take more risk when you have a long investment time frame. You shouldn’t worry too much about market downturn as they will definitely occur within their investment timeframe. By staying in the market for a long-term, you will ride out of the recession.

Investment Requirement for Kids

As we’ve established, Kids have different tax treatment, long investment time frame, and higher risk appetite compares to adult. Furthermore, Kids investment fund usually started with a small amount without regular contribution. Therefore, the investment requirement will be different as well. Here is a list

Age requirement: Must accept under 18 investor
Investment Time Frame: Mid to long-term
Risk: Medium to High
Asset mix: Mostly growth asset
Tax treatment: Prefer multi-rate PIE fund or RWT
Management fee: As low as possible (of course!)
Annual admin fee: As low as possible for good reason
Initial investment amount: As low as possible
Lump sum investment amount: As low as possible
Regular contribution: Prefer not to have regular contribution commitment

The reason we prefer not to have regular contribution is that kids don’t have a regular income. They may only get money once or twice a year for their birthday or Christmas gift. So we prefer an investment without regular contribution commitment, low initial investment and low lump sum investment amount. Parents and relatives can put in some money, no matter a little or a lot, whenever they want.

Watch Out for Annual Fees

Regarding fees, the amount of annual admin fee can be more important than management cost because that fund usually started with a small amount. When you investment fund valued at $20,000, that $30 admin fee is just 0.15% of your holding. However, if your fund valued at $500, that $30 admin fee will be 6% of your holding. Way more than the usual management cost you will be charged. So we prefer an investment with low annual admin fee.

Also, be aware if you started with a small amount and forgot about it for a couple years, the annual fees may eat up your entity portfolio. Check out the graph below on a small portfolio with $30 annual fees, 7% return after tax and management fee and with no further contribution.

For those portfolio balance with $200 or less, the annual fees will reduce your investment down to zero within 10 years. You won’t be able to keep your initial investment unless you start with $500 or more(based on $30/year annual fee and 7% return).

Therefore, if you plan to put some money in the let it sit for couple years without any contribution, you should start with $500 or more. If you plan to put some more money in at least once a year, you can start at around $250. Anything less than $200 should be kept in the bank. Also, pick an investment service with low or no annual fee will help.

What’s Next?

This is part one of my investing for kids blog. Next part will be my personal pick of the best investment options for kids and how to join them. Part three will be my take on other investment options in New Zealand. If you are currently in or considering some investment program for your kids and want me to cover them, drop me an email at thesmartandlazy@gmail.com. I will try my best to cover that.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.

August 29, 2017 Personal Ffinance, Saving & Spending Bill, Cash management, Council Rate, Insurance Leave a comment

Council Rate & Insurance: Pay Monthly, Quarterly or Annually?

by Alpha

I’ve got the latest Auckland Council rate bill earlier this month and the council rate went up again. As an Auckland rate payer, you will have a choice to either payment annually or quarterly. If you choose to pay annually, you will have a massive discount of… 0.83% on your bill.

Thanks, Phil

It got me thinking: how should other rate payers and I decide if we should pay annually with that discount or quarterly without a discount? Will that discount big enough to offset my lost interest? What sort of return on investment do I need if I plan to pay quarterly?

Not a Simple Math

I was discussing this problem with a friend and he said, “it’s really easy to work out, just take the discount you’ve got from the council and compared that to your bank interest rate. If your interest rate is higher, keep your money at your bank.” I know there are some people using this method as their back-of-the-envelope calculation. However, it’s a bit more complicated than that. We will need to fire up excel to analysis this.

Prerequisite

Before we jump into the analysis, we need to check on two things:

Will you benefit from the service for the next full year?
Do you have to cash to do either option (pay annually and quarterly)?

If you answer no to either question, you should pay quarterly. There is no point to pay for something you know you are not going to use or enjoy. In the context of Council rate bill, I am planning to own this house for the next year, so I’ll benefit from this payment. I also have to cash to do both as I’ve been expecting this bill.

Two Choices: Annually and Quarterly

The difference between pay annually and quarterly is how are they are going to affect our cash position and the interest gain from that cash. If we pay annually up front, we will take a hit on cash but rewarded with a small amount of surplus cash from the discount. That cash can sit in the high-interest account to earn interest. On the other hand, if we pay quarterly, we will have more cash to earn interest at the beginning.

Here is the assumption in our analysis:

Cash on Hand: $2,500
Quarterly Payment Amount: $625/Quarter
Annual Payment Amount: $2,479.25
Discount on Annual Payment: 0.83%
Serious Saver Interest Rate: 2.2% (not change during the year)
Resident withholding tax rate: 33%

The quarterly payment is $625/quarter, so the total cash included in this analysis will be $625 x 4 = $2500. I used BNZ rapid save account as our serious saving account here. (By the way, BNZ Rapid Save is one of the better serious saver accounts out there.) The interest rate is at 2.2% and its allow one withdraw per month without losing the bonus interest.

Pay Annually: If we pay annually up front, we will have $20.75 in cash after discount. We will keep those cash in a serious saver account for a year and the amount of the end of the year will be $21.06.

Pay Quarterly: We will start with $2,500 cash and pay out $625 every 3 months. All cash will keep in a serious saver account. The interest generates more interest in the beginning as the cash level was higher. Towards the end of the year, the remaining cash amount at $13.96.

Therefore, if you keep the cash in a serious saver account with 2.2% interest, you will be better off to take the annual payment discount.

Breakeven Point

If we keep increasing the interest rate (or expected rate of return), pay quarterly will eventually yield better return for your money. The reason is when we pay quarterly, the cash we kept in the beginning of the year is able to generate enough interest to offset the discount from paying annually. Check out the chart below.

After some boring math (get equation on both lines then apply quadratic formula), the breakeven point is at 3.33%. Therefore, in the context of Auckland Council rate bill with 0.83% up he front discount, you should pay quarterly if you can get over 3.33% pre-tax return (2.23% after-tax or tax-free) on your cash. Any rate below 3.33%, you should just pay annually and take the discount.

When you Should Pay Quarterly?

You may think it is not hard to get an investment return over 3.3% given you can get a similar return on term deposit (3% – 4.2%), or index fund around 6%. However, the time frame is only 1 year, and you will have to withdraw part of them out every 3 months. So index fund is out of the window because expected return in a single year can be between 25% to -25%. A term deposit is not an option as well as you can’t take part of the money out every 3 months.

The better choice I can think of is Offset Mortgage on Home Loan. You keep more cash in your account to offset mortgage interest fits all criteria. The return is tax-free and guaranteed at around 5.75% plus you can access your cash every 3 months. To do that, you’ll have an existing home loan and had set up with offset mortgage or revolving credit.

Other good options include:

Pay off consumer debt – very high return, but you will have existing consumer debt in the first place
Top up KiwiSaver for member tax credit – very high return, not available if you are full time employed
SuperLife NZ Cash Fund – better than bank return, 7 years after tax and fees return at 2.62%, can easily get your money out, not recommended if you are not existing SuperLife investor

In my opinion, if you don’t have offset mortgage and consumer debt, just pay it off up front. It’s easier, and you don’t have to deal with the bill every 3 months.

Insurance: Annual vs Monthly Payment

The same analysis can apply to insurance payment. Most Car, house, and contents insurance will provide different payment options. Check out the example below for a car insurance quote.

The discount from insurance company are much better at (42.6 x 12 – 469.32)/(42.6 x 12) = 8.19%. If we apply the same analysis, here is the result.

Pay up front have a superior return on your cash and the breakeven point is at 28.5%. I don’t think there is any investment options other than paying off a high-interest loan can top that. Therefore, if you have the cash and you will benefit from the insurance for a full year, you should pay annually on your insurance.

Here is a simple graph that shows the break even return rate on different payment discount.

You simply look at the annual payment discount and refer to the break even return rate to decide if you should take the annual payment discount. For example, you’ve got a 7% discount if you pay your house insurance annually compare to monthly. According to the graph, if you have an investment with 24% pre-tax return (like use that money to pay off the credit card), you should pay monthly.

Conclusion

Pay quarterly if you don’t have the cash or not going to benefit from the service for a full year.
With Auckland Council rate, pay annually if the 1-year return on your cash is below 3.33%.
If you have existing consumer debt or offset mortgage facility, pay quarterly on council rate and use the cash to pay off or offset your loan.
Insurance usually offer a great annual payment discount so try to pay annually if you can.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.

August 23, 2017 ETF, Investing, Personal Finance Advanced Investing, IRD, New Zealand, PIE, PIR, RWT, SmartShares, Superlife, Tax 5 Comments

Different Tax on SmartShares and SuperLife ETF

by Alpha

Recently a tax accountant contacted me regarding my post on comparing cost on ETF investing between SmartShares and Superlife. He pointed out that apart from the admin fee and management cost, investors also need to consider the tax implication when investing. I’ve known about this issue but did not include on my blog because I did not fully understand the rules. After I’ve asked around and done some research, here is my finding on different tax treatment on SmartShares and Superlife ETF and why does it matter to New Zealand investor.

Disclaimer: I am NOT a tax accountant or expert. In fact, I am pretty bad at tax despite I’ve done a couple tax papers at university. So what I am going to say would be incorrect. If you notice anything wrong in my blog post, please let me know and I will correct that ASAP. You should contact a tax accountant or IRD for tax advice.

What are PIE and PIR?

According to IRD website, a portfolio investment entity (PIE) is a type of entity, such as a managed fund that invests the contributions from investors in different types of investments. Eligible entities that elect to become a PIE will generally pay tax on investment income based on the prescribed investor rate (PIR) of their investors, rather than at the entity’s tax rate.

Prescribed investor rate (PIR) is the tax rate that PIE fund use to calculate the tax on the income it derives from investing your contributions. It based on your taxable income, e.g. income from salary, wages and any additional sources of income (including the income from your investment) that you would include on your income tax return.

For an individual, your PIR can be 10.5%, 17.5% and 28%. Check out IRD web site to work out your PIR rate.

How PIE Works?

I will explain PIE with ‘interest on saving account’ as an example. You usually received interest by saving money in a bank account. If you look closely at that interest transaction, you can see the bank gave you some interest, then IRD take away some as ‘Withholding tax’. Check out the transaction below.

So I earned $0.79 in interest, but IRD took $0.26 away. The amount decided how much IRD can take is based on my Resident withholding tax (RWT). In this situation, the RWT is 0.26/0.79 = 33%. You can work out your RWT here.

For people who are having a full-time job, their RWT rate will likely to be 30% or 33%. That’s where PIE come in. The most common PIE fund you will see is the PIE account at your Bank. There are ANZ PIE Fund, Term PIE at BNZ, PIE Funds at Kiwibank and Westpac Online Saver PIE.

If you put money in those PIE accounts, in stead of paying 30% or 33% on your interest earned, you will be paying the max PIR rate at 28%. So in my situation, IRD will only tax $0.22 on my $0.79 interest income. The amount may seem tiny here, but if you have $20,000 saved in a PIE Term deposit with 3.5% interest, you will just have to pay $196 on tax instead of $231.

Different PIEs with SmartShares and SuperLife ETF

There are different types of PIEs and we will talk about Multi-Rate PIE and Listed PIEs here.

Multi-rate PIE (MRP) is a type of PIE that uses the investors’ prescribed investor rates (PIRs) to calculate the tax on the investment income it earns from the investors’ contributions. Most PIEs are multi-rate PIE including SuperLife and Simplicity fund.

A listed PIE is a type of PIE listed on a recognised exchange in New Zealand, and they calculate the tax on a fixed rate regardless of investors PIR. SmartShares ETFs are listed PIE, and they will pay tax at 28%. Check out section 6 on SmartShares’ product disclosure statement.

So the main difference between those two investments are you will pay 28% tax on SmartShares ETF and with SuperLife ETF Fund, you will pay tax according to your PIR.

Why Does it Matter to Investor

An investor needs to work out their PIR so they can decide each provider is more tax efficient. You don’t want to overpay your tax. There are three different PIRs for individuals: 10.5%, 17.5% and 28%.

For people who earn over $48,000 a year for the past 2 years, their PIR will likely to be at 28%. In this case, there is no tax different between SmartShares and SuperLife ETF as you will pay 28% on taxable income with both funds.

For people who are on low or no income, their PIR could be at 10.5% or 17.5%. They can be students, children, part-time/casual worker, stay-home mum/dad and retirees. In this case, they will pay tax on their PIR with SuperLife ETF Fund while SmartShares will still charge 28% tax on them. Therefore, they will pay extra tax with SmartShares.

Here is an example on US 500 ETF valued at $20,000. We will compare the value after tax and fee with the different tax rate. Assume there was no contribution and no value change during the year. Taxable income calculated at 5% of the portfolio under FIF rule. Ignored Smartshares $30 setup fee.

Despite SmartShares have a lower management cost and no annual admin fee, investors with 10.5% or 17.5% PIR will end up better with SuperLife as they paid less tax. That’s more reason for you to choose SuperLife ETF Fund if you are on low PIR rate.

Conclusion

If your PIR is at 28%, pick SmartShares or SuperLife based on cost, functions, and experience. In my opinion, SuperLife is the better choice for most ETF except US 500 ETF. You can check out my comparison here.
If your PIR is at 17.5% or 10.5% SuperLife ETF Fund provide a better return due to the lower tax paid. The amount of tax saved will increase the value of your portfolio.
Investor at lower PIR can get the excess tax back with a tax return.
Since most of the investment funds are multi-rate PIE. It is essential you work out the correct PIR and submit that to your fund manager. You can work out your PIR here.
Consult IRD or a tax accountant for tax advice.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.

August 18, 2017 ETF, Investing ETF, investnow, Sharesies, SmartShares, Superlife, US500 3 Comments

InvestNow Added SmartShares ETFs into their Offerings

by Alpha

InvestNow announced they added 7 SmartShares ETFs into their investment platform. They are the following:

You can access to those ETFs from SmartShares, Superlife, and Sharesies (on some ETF) already. I’ve compared the cost on those ETFs on the previous post and concluded you should get most of the ETF from Superlife except US 500; SmartShares was the better choice for US 500. You can check out the related post below

Cheapest Option for US 500 ETF

Smartshare was the cheapest option for investing in US 500 ETF because of the low management fee at 0.35% and no annual admin fee. There is a $30 set up fee if you use SmartShares contribution plan and at least $30 exit fee when you sell your ETF.
If you buy or sell the ETF on the share market, there will be $30+ transaction fee on each transaction. Superlife US 500 ETF fund has a higher management fee at 0.49% and charges a $12 annual fee. Sharesies have the same management fee with SmartShare, but they charge $30/year on admin fee. Therefore SmartShares contribution the cheapest option for US500 ETF investing.

Now InvestNow added SmartShares ETF into their offerings, it further lower the cost of US500 ETF. InvestNow offers an investment platform for investors with no annual admin fee. Investors can also bypass the $30 set up fee and the cost of exit the fund on SmartShares ETF. The minimum investment amount lower at $250 and no contribution commitment required. The management fee will be the same with SmartShares at 0.35%. Check out the comparison below. (Update: InvestNow client can now set up regular investment with just $50/transaction.)

Screen Shot 2017-08-17 at 10.15.08 PM.png

Comparing cost on US 500 ETF. Best option in yellow.

Different Way of Contribution

By looking at the number, InvestNow investors can save on $30 set up and the $30+ cost of exit, so it appears to be a better deal to SmartShares. There is a difference on how you contribute to the fund between Smartshares and InvestNow. Take a look at the function difference below.

The main limitation for InvestNow investors is the lack of small amount direct debit. SmartShares Investor will be committed to at least $50/month contribution (can be stopped at request). InvestNow investors are free to contribute whenever they want. However, the minimum contribution amount will be $250/transaction. If you only have $50/month to invest, you will have to put money in InvestNow once every five months to reach the $250 requirements. So on the one hand, you will save $30 in the beginning, but you will miss five months possible loss/return. (Update: InvestNow client can now set up regular investment with just $50/transaction.)

Compare Return Between InvestNow and SmartShares

(Update: InvestNow customer can now set up regular investment plan with just $50/transcation. InvestNow will be a better choice over SmartShares in terms of cost.)

To work out which one is the better deal on US 500, I ran an analysis to compare the return between InvestNow and SmartShares.

I assume the investor has $500 available to invest and can contribute $50/month. With SmartShares, the fund going to start with $470 due the to $30 setup fee and the investor will contribute $50/month. At InvestNow, investor’s fund will start with $500 and will contribute $250 every five months. The investor will continue for five years (60 months) without any withdrawal. Expected return rate is 10.32% before tax. Here is the breakdown.

Although SmarShares charge a $30 setup fee up front which lowered the starting amount to $470, they ended up with a higher end balance at $4,640.51. The reason is Smartshares investor contribute $50 every month, and those funds are growing while InvestNow customer’s money is sitting in the bank doing nothing.

Here is the result of different levels of contribution at the end of the fifth year.

SmartShares investor has a higher return over InvestNow at a lower rate, the gap close as they reach $250 marks. I stopped at $250/month because once you can contribute that amount, you can put money in InvestNow every month. From this point, InvestNow customer will always have better return over SmartShares

It seems SmartShares will be a better deal if your contribution under $200/month. However, there is a flaw in this analysis.

In my assumption, I set the rate of return at 10.32% for all five years. It assumpts the share price of the ETF going up in a straight line and investor will have a positive return every month. However, in real life share price goes up and down every day. By contributing less frequently, InvestNow investor may lose some of the gains during those five months, but they also avoid some drop as well. Afterall, the share price looks like this in real life.

Applying Real Data

So I collected the share price of US 500 ETF for the past 24 months and plugged that into our analysis. Here is the result. Click here to see the ROI.

This time InvestNow ended up with a higher balance over SmartShares. In fact, Investnow beats SmartShares on every contribution level with past data. Check out the result below.

The Real Deciding Factor

No one knows how the US 500 ETF is going to perform in the future so either service can be cheaper. If you look closely at the amount, the cost difference between InvestNow and SmartShares are insignificant, less than 0.1% of your fund. So investors will need to consider their contribution level and the experience of those two services.

In my opinion, InvestNow functions and its user interface are much better than SmartShare. InvestNow have a modern, clean and easy to understand platform. SmartShares’ holder will be checking their current stock holding on Link Market Service web site. The interface feels like it stuck in 2010.

Related post on InvestNow and SmartShares (Link Market Service)

The main limitation on InvestNow is lack direct debit option, so it’s not a “set and forget” type of investment solution. The investor will have to deposit the money into InvestNow platform and manually invest US 500 ETF on InvestNow website. InvestNow said the direct debit function is on the road map so the situation may improve in the future.

Link Market Service interface for SmartShares is not good, but you can view your holding on other services like ShareSight, Google Finance, and Yahoo Finance to improve that experience.

Conclusion

It’s great to see InvestNow adding more and more fund onto their platform. I prefer InvestNow interface and function over SmartShares. However, I understand everyone circumstances are different so here are some recommendations which service you should consider on US 500 ETF.

~~Use SmartShares if you want a ‘Set and Forget’ solution and you plan to contribution between $50 – $200/month.~~ (Update: InvestNow customer can now set up regular investment plan with just $50/transcation. InvestNow will be a better choice over SmartShares in terms of cost.)
Use InvestNow if you like their user interface (you can register for free on InvestNow to check out the interface), don’t want to commit to a monthly contribution plan and happy to invest manually at minimum $250.
Use SuperLife if you already have a portfolio with SuperLife and want to have all funds under one flexible service with great functions.
Use Sharesies if you like their interface. Check out my comparison here.
For other ETFs, you should use SuperLife, here is why.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.

August 4, 2017 Investing, KiwiSaver Fees, Simplicity, Superlife Leave a comment

How to Check Your Investment Fund and KiwiSaver Fund’s Admin Fee

by Alpha

A reader asked me about their Superlife fund charges. She notices something funny on her transaction list: Instead of charging $1/month on admin fee, she got charged $1/day.

After checking my transaction, I believe those charges are incorrect and she contacted Superlife. Superlife immediately said the charges were wrong and reversed them straight away.

This is a good reminder for all investors to a take look at their transaction once in a while. I am all for ‘set and forget’ method to invest but we should look at those charges maybe once or twice a year. Not only to Superlife but all of your investments including your KiwiSaver.

I have account with Superlife and KiwiSaver with Simplicity, here is how to check those transactions

Superlife

Go to superlife.co.nz and click on “Log in”

Click “Transaction history” on the left

Select ‘last 12 months’ on period, select ‘All’ on Funds, select ‘Administration Fees’ on Transaction types.

They should charge $1/month. (The $2.75 charges was before the admin fee price drop)

Simplicity KiwiSaver

Go to Simplicity.kiwi and Log in.

Click ‘My transaction’ on the menu.

There will be a list of transactions and Simplicity should charge $2.5/month on member fee.

If you are with a different fund or service and don’t know how to check transactions, call the service provider and ask them.

If there is anything out of the ordinary, you should contact the fund manager and get them to correct that as soon as possible.

August 2, 2017 Personal Ffinance, Personal Finance Basic Personal Ffinance, saving Leave a comment

Quickly Work Out How Much You (Roughly) Saved

by Alpha

Wealth is not about how much you make, it’s how much you saved.

Most people have a pretty good idea of their income every week/fortnight/month. However, in personal finance, the important number is not the amount you made but how much you managed to save. This figure is calculated by your income minus your expenses. It sounds easy, but you will be surprised as lots of people have no idea what their expenses are. Hence they don’t know how much they saved. They may be doing alright, or they may over spend every month. Without working out those numbers, you simply don’t know.

No worries, there is a simple way to work it out.

To work out how much you save, you will need to make a profit and loss statement on your finances, just like the financial report for the company. Yes, it may seem time-consuming and lots of hard work, especially for those people who are not good with numbers. So for those lazy Kiwis out there, here is a quick way to roughly work out your saving amount, expense and saving rate in about five minutes.

What Numbers Will You Need?

To do this lazy version of profit and loss statement, you will need three sets of numbers.

Bank Balance this month: Go and gather the balance of ALL bank account, including cheque, saving, serious saver, term deposit and credit card. You can get this number from internet banking or bank statement. For example, today is 28/7, so I need to find out the account balance of 1/7. Make sure you record the credit card balance as negative. Add them all up to get your current cash balance.

Bank Balance 12 months ago: We need another set of account balance (cheque, saving, serious saver, term deposit, and credit card) to compare the numbers. Try to get the balance from 12 months ago, so we cover the income and spending for a full year. You can get that from internet banking (search the balance history) and old bank statement. Add them all up to get your cash balance 12 months ago.

Check out the example above. In July 2016, we have a $2000 term deposit, and it matured during the year. So in July 2017, the term deposit is $0. On the other hand, we opened up a new serious saver account during the year, so in July 2017 we have a second serious saver account with $2800.

Your income after tax and KiwiSaver: We will need to get the income for your last 12 months.

If you are employed, you can get your gross pay on your pay slip.Also, you can log on to MyIR at IRD to check your gross pay.
If your income hasn’t changed much during the year, you can use one income to estimate a full year income. You just need to multiply your weekly pay by 52, fortnightly pay by 26 and monthly pay by 12.
If you know your annual income before tax, put that number into paye.net.nz, and they will calculate your take home pay.
If you have another source of income outside employment, you will need to add those in as well. (Like Investment income, rental property income)
If you have uneven income or self-employed, you will need to sit down and review your bank transaction to work out your income.

If you can’t get the bank balance 12 months ago, you will need to adjust your income for the same period. For example, you can only get the balance 6 months ago, then you will need to calculate your income during this 6 months period.

Saving Amount

We can work out your saving amount with those two bank balances. Let’s look at our previous example.

In July 2016, the total balance was $17,220 and in July 2017 was $20,596. During the year, the balance increased 20596 – 17220 = $3376. So our annual saving amount is $3,376, average is 3376/12 = $281.33/month.

Expenses

To work out the expenses, you will need the annual income amount with those two bank balances. The logic behind the math is very simple. You started with your Bank balance 12 months ago: During that year, you made some money, you spent some money and you ended up with the current bank balance.

To turn that statement into a formula will be :

Bank Balance 12 months ago + Income (after tax) – Expense = Currently Bank Balance

We move around that formula, we will get:

Expenses = Bank Balance 12 months ago + Income – Currently Bank Balance

Using our example with a 55K income ($43,065.5 after tax and KiwiSaver). The expense will be

17200 + 43065.5 – 20596 = $39,669.5/Year, $3,305.79/month

Saving Rate

Saving rate is the percentage of income you managed to save after expenses. The math is:

Saving Amount / Income Amount = Saving Rate

Using our example with a 55K income ($43,065.5 after tax and KiwiSaver). The saving rate will be

$3376 / 43065.5 = 7.84%

Why do it over a 12 months period?

The main reason we try to get the bank balance and income for a 12 months period is that our spendings are uneven through out the year. Most people will spend more toward the end of the year because of Christmas and new year. If you only cover 6 months from March to September, you may under estimate your spending. If you cover November to May, you may over estimate. So it best to cover a full year.

What If you buy or sell something big during the year?

For example, if you purchase a Car during the year for $10,000 and you are not the kind of people buy car every year, you should exclude that in your bank balance.

On the other hand, If you sold your car for $10,000 during the year and you are not doing that every year, exclude that as well.

Basically, we are trying to work out the saving from your typical day to day income and expenses while ignoring one-time big event.

Should you exclude investment contribution?

Some people may use their savings to do some investing like KiwiSaver contribution, Index fund investing, top-up mortgage payment on rental property or pay extra on your own mortgage. If we calculate the saving with our previous formula, we will treat those transactions as expenses.

Bank Balance 12 months ago + Income (after tax) – Expense – Investment Contribution = Currently Bank Balance,

We turn it around

Expense + Investment Contribution = Bank Balance 12 months ago + Income – Currently Bank Balance

You can see investment contribution inflated the expenses amount. In my opinion, the reason we calculate the saving amount and saving rate is to work out how much money we could invest for our future. Therefore, I will include some investment contribution into all calculation.

I will categorize those investment contributions into two group, Voluntary and Involuntary. Voluntary investment is those you can stop contribution anytime if you choose, like your Superlife/SmartShares contribution, KiwiSaver top-up or you made a lump sum repayment on your home mortgage. Involuntary investment is the one you are obligated to pay, like mortgage top up on your negative cash flow rental property. You have to top up those mortgage payment every month. Otherwise, the mortgage will be in arrears.

Here is an example, during the year, you have the following amount went to investment.

Voluntary:
SmartShares Conrtibution – $1,200
P2P Lending – $500
KiwiSaver Top up – $1,043
Own home mortgage voluntary repayment – $500
Total: $3,234

Involunary:
Rental home mortgage top-up – $3,500

Here is the Saving amount after invesment exclusion on voluntary invesment.

The adjusted saving amount will be 23839 – 17220 = $6,619/year, $551.58/month

Adjusted Saving rate will be 6619 / 43065.5 = 15.37%

The adjusted expenses will be 17200 + 43065.5 – 20596 – 3243 = $36,426.5/Year, $3,035.54/month

What’s the Limitation with this method

This lazy method will give you a rough idea on much you saved, but it comes with limitation and flaws.

Rough figures: The bank balance will be accurate, but your income amount may not be. It depends on how you collect and calculate your income amount. If there is any error in income, the expenses amount will be off.
No expenses break down: You will have a rough figure on your expense, but there is no break down on where you spent the money. You simply don’t know where you spent your money without a line by line breakdown.
Ignore interest income: This method ignores interest you made on your deposit. If you have $20K in the bank with 2.5% interest, it will generate about $330 after tax interest. It is not that much compared to average income, but if you have $200K in the bank, that will be $3300.
Ignore seasonal fluctuation: This method worked out the income and expenses throughout the year and divided by 12 to get the monthly average. However, in reality, our spending fluctuate every month. In winter, we will spend more on power and gas, we shop more during Christmas and new year and, we may travel during the summer. All those factors will affect your month-to-month expenses and saving amount. You may overspend in some months while saving a lot in others.

Without knowing your saving amount is like driving down a country road at night with headlights off, you may be driving into a hole without knowing. Hopes this straightforward and lazy method will provide a rough idea of your saving amount and shed some light on your financial situation.

If you want to get into the details of your finances, you will have to spend time and do a detail report. We will get into that in the future.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.

July 21, 2017 Mortgage Interest & Principal, New Zealand, Personal Ffinance 5 Comments

Understand Interest & Principal on Your Mortgage Payment

by Alpha

Do you know how much interest you are paying on your mortgage? No, I am not talking about the interest rate. How much interest in the dollar amount you are paying on your mortgage? Also, what proportion of your mortgage payment goes to interest? Do you know how many years it will take to pay off half of your mortgage? (spoiler: more than 20 years with 5% interest rate)

Most home owners know their mortgage payment like the back of their hand, but not all of them can tell you how much interest is in the payment. Some new house owner is surprised when they read the mortgage statement and found out how little money went to mortgage repayment. Let’s look at the interest and principal on our mortgage payment. I will be focus on the simple interest mortgage with a fixed interest rate and fixed payment amount for 30 years.

Interest and Principal

Every mortgage payment in New Zealand will contain Interest and Principal.

The principal is the part of your mortgage payment that goes to repay the amount you borrowed. It starts out with a small amount and increases on every payment. Eventually, the total principal paid will be equal to the amount you borrowed.

The lender (usually Bank) took up risk to borrow you money on a house purchase. Interest is the reward for taking that risk. They are profit for the lender and expense for the borrower. Interest rate could be different for each different borrower. Usually, a low-risk borrower will have a lower interest rate compared to a high-risk borrower. At the lender’s point of view, to take a higher risk borrower, they will charge higher interest to compensate that risk. A significant amount of mortgage payment will go to interest payment at the beginning of the mortgage and decrease on every payment.

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Proportion of interest and principal on a 5% interest, 30 years mortgage

How Much Interest you are paying?

We will use the following simple interest mortgage as an example.

Mortgage size: $500,000
Term: 30 years, pay monthly
Interest rate: 5%
Monthly payment: $2,684.11

For your first payment, $2083.33 will go to interest and only $600.77 will go to principal payment. That’s 77.6% of your monthly payment go to interest expenses.

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Breakdown on your mortgage payment during the first year

For the first year, you will pay $32,209.30 in mortgage payment, $24,832.47 will go to interest, and you only reduce your mortgage by $7,376.83.

Why most of your payment went to interest in the beginning?

You may be surprised only 23% of your mortgage went to principal payment and wonder why most of your payment went to interest in the beginning. I was angry and thought it wasn’t fair. So I dug in and worked out how the banks come up with that amount.

First, under the terms of the mortgage, interest is calculated daily and compounded monthly. What it meant was the bank will charge interest on the mortgage every day and recalculate the mortgage amount and interest every month. The interest rate (5% here) is an annual rate, so one day of a 5% interest will be 5% / 365 = 0.013699%. Bank will apply that one-day interest rate to your current mortgage amount $500k. At your first month, you will be paying $500000 x 0.01369% = $68.49 every day on interest. Here is the daily breakdown on the first month of the mortgage.

You may notice on 31/7, the interest amount is only $28.54. The reason is that when we calculate the monthly mortgage payment, we are not calculated based on how many days in a month. We just divided the full year (365 days) by 12, so every payment got 30.41667 days. That’s why I have to re-adjust the 31st day of July interest by 0.41667. $68.49 x 0.41667 = $28.54.

On 31/7, you pay $2684.11 for your mortgage. At this point, the total interest is $2083.33, only $2684.11 – 2083.33 = $600.77 go to reduce the $500K mortgage. At 1/8, your new mortgage amount will be $499,399.89 and you daily interest will be $499,399.89 x 5% / 365 = $68.41. At the end of the month, we will accumulate $2080.83 in interest. By paying the same amount of mortgage payment ($2684.11), you will reduce the mortgage by $2684.11 – 2080.83 = $603.28.

When you compare the numbers on both months, your monthly payment amount is the same. Since you reduce the mortgage amount by a little bit in your first payment, the interest on the mortgage at the 2nd month will be reduced. That explains the interest payment will keep decreasing and principal payment keeps increasing. The reason we why most of your payment went to interest payment is because your mortgage amount is high in the beginning. Lots of interest was charged and most your payment went to pay off those interest.

How does pay extra on your mortgage reduce the interest calculation

In my last post, I said one thing you can do to reduce the interest paid on your mortgage is by paying extra on the mortgage. Let put that in our example and see how $100/month extra can reduce the interest.

The first month will be the same as we haven’t made any payment. We will still have $2083.33 interest needs to pay. However, if we increase the monthly payment to $2183.33, we will reduce the mortgage amount by $2183.33 – 2083.33 = $700.78. On your second month, the new mortgage balance is $499,299.22 and the daily interest will be $499299.22 x 5% / 365 = $68.40. At the end of the month, we will accumulate $2080.41 in interest, $0.42 less.

You may think that just $0.42, hardly make any difference. However, that is the saving on the second month only. You will save more and more each month. Paying extra on the mortgage will have a knock on effect on the mortgage amount reduced. You will end up pay off your mortgage in 27.6 years and saved $42.6K on interest.

Breakdown interest paid by years

Now we took the $500K mortgage break it down by years. Here is what you will pay over 30 years.

Some interesting facts here:

77% of your first-year payment went to interest.
By the end of the mortgage, you will pay $500K on principal and $466.3K on interest. You almost paid twice on your mortgage.
For the first 16 years, over 50% of your payment will go the interest.
You will pay almost half of the total interest on the mortgage in your first 10 years. Therefore, lenders make half of their profit in 1/3 of the time.
After paying 20 years, you still owe over 50% on your mortgage.
You will pay off $253K in the last 10 years of the mortgage.

That’s why Bank love mortgages, and it’s their bread and butter. I personally feel angry reading those facts. I put reducing mortgage as my top financial priority. On the other hand, inflation is another factor helping to reduce the ‘real’ cost of the mortgage, we will get into that in another post.

If you want to find out the breakdown on your mortgage payment, you can check out this mortgage calculator on mortgagerates.co.nz.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.

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July 13, 2017 Mortgage New Zealand, Personal Ffinance, property, Reducing Mortgage 1 Comment

Understand the Math of Mortgage

by Alpha

I spent a lot of time here talking about investing in New Zealand. However, if I put my money where my mouth is, I spent more money on reducing my mortgage compares to investing. So let’s take a break from investing and talk about the mortgage, which is one the top three investment options in New Zealand.

We are one of the lucky ones who luck into a house before house price went batshit crazy between 2013-2016. However, since we brought Auckland, the mortgage amount is still huge dispute we put down more than 20% deposit. So reducing that mortgage have been my top priority and I spent a lot of time to research and study on mortgages. It turns out the mortgage is just a mathematical formula. If we understand the factor of that formula, how to pay off the mortgage early is not a secret at all.

The Formula of Mortgage

A mortgage is a loan to buy a property. You borrow money from the lender (usually a bank), and you are obliged to pay back with interest. The lender uses the property as security. Here is the formula of Mortage.

A is the payment on each term.

L is the mortgage amount (or Principal)

r is the interest rate

n is the term

So the mortgage formula based on those four factors and they are interconnected. If you follow the mortgage plan and make the payment each term (usually every fortnight or month), by the end of the term, you will pay off the mortgage and plus interest.

(You don’t need to calculate the mortgage on your own. There are hundreds of mortgage calculator online, I recommend the Mortgage Calculator on Sorted)

Interest and Principle

Each mortgage payment will have interest payment and principal payment. The principal is to repay the amount you borrowed, and interest is profit for the lender. At the beginning the mortgage term, most of the payment went to interest, and only a small part of the payment went to the principal.

To work out the total interest paid on the mortgage, you will need to:

Payment amount X No. of Terms = Total amount paid

Total amount paid – Mortgage Amount = Total Interest Paid

The Game of Mortgage

The mortgage is a game with four controls.

For me, the mortgage is just a game. It’s a game with 4 controls. The goal of the mortgage game is to minimise Total interest paid by changing payment amount, mortgage amount, interest rate and terms within your abilities. In New Zealand, the size of the mortgage can be range from $100k to $1mil or more. Total interest paid on the mortgage can be 30% – 130% of the size mortgage. This is a high stake game with $30k to $1.3mil of interest to be saved. Yet, the rule of the game is surprisingly simple!

We are going look into each factor and see how they affect our goal to minimise our total interest paid. We will be using the following mortgage as our default example. To keep it simple, I assume interest rate will stay the same during the whole period.

Mortgage size: $500,000

Term: 30 years, pay monthly

Interest rate: 5%

Monthly payment: $2,684.11

Total Interest Paid: $466,278.92 (93% of mortgage size)

Mortgage Amount

The mortgage amount is the main deciding factor in a mortgage. The amount you borrowed is in direct proportion to your monthly payment and total interest paid. More you borrow, more you pay every term and more paid on interest. However, the size of total interest paid compared to mortgage amount reminds the same. In our example, no matter the size of the mortgage, you are still paying 93% more on interest.

In most case, you want to borrow as little as possible.

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5% interest rate and 30 years term, pay monthly

Interest rate

Interest is charged by the lender to the borrower to offset the risk of lending money. It calculated based on interest rate. Interest rate change from time to time due to multiple factors, including official cash rate change by RBNZ, the cost of borrowing at the lender, the length of the fixed term, demand of mortgage at each lender and more.

Increase interest rate in a mortgage formula will affect mortgage payment and total interest paid. If you took a 5% interest rate and increased that by 0.5% to 5.5%, the mortgage payment will increase by 5.8% but the total interest paid to mortgage ratio jump from 93% to 104%. So you want your interest rate as low as possible.

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$500,000 Mortgage, 30 years term, pay monthly

Terms & Payment

The term is how long the mortgage supposes to last and payment is how much you will pay each time. I put them together because they are closely connected in a mortgage. If we increase the mortgage terms, the payment amount will be lower but you will pay more on interest. On the other hand, if we increase the payment amount, we will shorten the mortgage terms.

In the table below, you can see if we shorten the mortgage by increase our payment amount, we will be paying a lot less on interest.

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$500,000 Mortgage, 5% Interest Rate

In Reality, What can you Change?

Now we understand those four factors of a mortgage and how they will affect the end game (a.k.a total interest paid). Let’s put them into a real world situation and see how we can change them to our favour. (There are many ways to improve those factors, I only covered the obvious one here)

Reduce Mortgage Amount

Since the mortgage amount decides your term payment and total interest paid, it’s better to have a smaller mortgage. With small mortgage amount, it will come with a small monthly payment amount. You can increase the monthly payment amount without adding pressure to your living budget.

To reduce the mortgage amount for potential house buyer, you will have to put down a larger down payment or choose a cheaper house.

For existing homeowner, you can reduce the mortgage amount when you mortgage terms are up for review by transfer some of your saving to repay that mortgage. (if you have the spare cash)

To be honest, it is difficult for both potential buyer and house owner to reduce their borrowing amount. With those crazy house price these days, most of the potential buyers are stretching to the maximum on what they can borrow and get onto the property ladder. Existing homeowners are already stuck with that mortgage and lender don’t like you pay them back early. So in reality, you don’t have much control on that.

(There are some tricks to reduce that mortgage with right mortgage set up. We will get into that in an upcoming blog post)

Get a Better Interest Rate

Bad news, you don’t have much control on interest rate either. The Interest rate set by the lender and each lender will have the identical interest rate. What you can do is make yourself a better borrower.

Banks love mortgages as this is their bread and butter. If you are a good borrower in their eyes, they will offer you a discounted interest rate to get your mortgage business. What consider a good customer from the Bank:

Owner Occupied Property, mean the mortgagor live in that property
Work full time with a stable income
Employed by established company for a long time
Clean credit history
No other debt
DINK (Double income, no kids)
New Customer
Willing to change your ‘Main Bank’
Have 20% or more equity in the house
A good quality house in a good location (not leaky home or potential leaky home)

Bank will consider that as a low-risk lending and happy to offer a small discount on the interest rate.

However, the free-market is still the primary deciding factor on the interest rate so there is not much we can do about that. Kiwis used to pay 18% interest rate in 1985. Before GFC in 2008, the mortgage rate was around 8.4%. We are experiencing a historic low in interest rate at 2017.

Increase Payment Amount & Shorten the Terms

Payment and terms are the most important factor in the game of mortgage because we have control over it. When the bank says you need to pay $2684.11 for your $500K mortgage, it’s not the absolute amount! It’s just the minimum amount you’ll need to pay. You can always tell the bank you what to pay more. Let’s see how the term and total interest paid change when we pay more on our mortgage.

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$500,000 Mortgage, 5% interest rate. Minimum monthly payment at $2684.11.

By simply put $1/day extra into your mortgage payment ($30/month), you will shorten the mortgage by 9.6 months and save $13.8K on interest. If you can add $10/day extra into your payment, you can pay off your 30 years mortgage in 24 years and saved $106,644 in interest.

It may be hard to do in the first couple of years, but your income will likely to be increased while the mortgage payment stays the same. Combine that with careful budgeting and frugal living; you can put more and more into your mortgage and reduce the interest paid.

The Secret of Paying off Mortgage

Now you understand the four factors of the mortgage and how you can improve them. The secret of paying off mortgage fast and win the game of mortgage is very simple.

Get the smallest amount of mortgage with the best interest rate discount, pay it off with the biggest payment amount you can afford.

That’s the fundamental principle of getting out of debt; it does not only apply to the mortgage but other consumer debt as well. Every single tips and trick that help you pay off mortgage fast will always chase back to this principle. We will cover lots of them in the coming months. Stay tuned.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.