Q&As
- Self insure only for the small stuff
- KiwiSaver not good for rainy day money — but diversification is important
- Can’t beat mortgage repayment after taking tax into account
- Mortgage versus KiwiSaver revisited
QI read with interest the Healthy Outlook item last week — a stimulating departure from regular topics, especially coming as it does from health professionals!
I agree with the writer’s opinion that “the public health system in New Zealand is actually pretty excellent.” But I share your view that health insurance brings fast relief to sometimes intolerable discomfort or risk of untimely death for the insured person.
There is one other option for covering the cost of unexpected medical intervention, namely self insurance. This requires putting away the equivalent of an insurance premium on a regular basis, as well as steely discipline to leave it untouched for anything but medical misadventure. It works better if started at a young age.
Meanwhile it earns interest if parked in the right (low-risk) place, and gets used only if required, unlike insurance premiums.
Interesting that your column appeared in the paper the same day as a news article about a man who was given six to eight weeks to live, and who was put on an eight-week waiting list for seeing a specialist. I rest my case.
AYes, that news story did strengthen the case for having health insurance. But not really self insurance.
Sure, your idea has lots of appeal. If your medical costs over your life are average or below average, you’ll come out ahead, as insurance premiums have to include the company’s admin costs and profit. And, as you say, your earmarked savings can be sitting in an account — or perhaps short-term deposits — earning interest.
But what if an expensive health problem — for which you don’t get prompt action from the public health system — emerges before you’ve saved much?
Of course you do have public health to fall back on. It would be much riskier to self insure your car, house, contents or loss of income. Picture your house burning down when you have just a few thousand in your self insurance account. Still for my money, health insurance is worth having.
Having said that, it can be a good idea to self insure for the little stuff.
You do this by: getting health cover just for major medical expenses; choosing higher excesses for house, contents and car; and choosing a longer stand-down period before you receive money for loss of income. Obviously that means you pay more yourself when things go wrong, but your premiums are much lower.
Hand in hand with this, build up a rainy day fund to cover what you have to pay, as well as other unexpected expenses. This is really important. So many people go off the rails financially when things go badly wrong and they have to borrow large amounts, often at high interest.
QThe question of saving for retirement versus paying the mortgage published last week, where the advice given was to pay the mortgage to reduce the term or payments, doesn’t diversify risk.
So many New Zealanders are investing in housing, including using our future retirement funds, and therefore continue to have a low level of savings and no rainy-day nest egg.
I believe we should not only consider financial risk, but other life events where a nest egg may come in very handy.
AFirstly, as I said above, I fully agree about the importance of rainy day money. It’s good to have a couple of months’ income easily accessible.
But both of the first two correspondents last week were talking about KiwiSaver savings versus a lower mortgage. Those savings are not available for emergency money except in dire circumstances. In fact, in many cases it would be easier to get emergency funds by adding to your mortgage than withdrawing from KiwiSaver.
Still, I take your point about diversification. Regular readers will know I go on and on about the importance of spreading risk, but perhaps I should have made that point again last week.
Diversification is actually one main reason I always suggest everyone with a mortgage takes part in KiwiSaver, contributing enough to receive the maximum tax credit and employer contributions.
Once you’ve done that, though — and I assumed last week’s correspondents were contributing to that extent — it’s hard to argue with the effective return you get from mortgage reduction, as our next correspondent points out.
QThere is one small but significant correction I think needs to be made in your “Save for Retirement or Tackle Mortgage” advice last week. You very correctly state that, “Reducing debt improves your wealth in the same way as an investment does.” But I think you’ve actually understated the benefit of doing so.
The second correspondent had a mortgage rate of 4.49 per cent. However, the “investment return” of this is significantly higher than that, as paying off a mortgage is of course a “tax-free investment”.
To find a similar return with increased KiwiSaver contributions, or any other investment, they’d need to earn 4.49 per cent after fees AND TAX.
Assuming the correspondent’s KiwiSaver is taxed at the top PIE fund rate of 28 per cent, they’d actually need an investment earning 6.24 per cent net of all fees. According to Canstar the average earning rate for a balanced fund for the year ending March 2018 was 6.26 per cent after fees and tax.
But of course paying off debt is as close to a 100 per cent safe investment as it gets. So it’s probably better compared to defensive funds — the lowest risk funds — that only earned 3.5 per cent average after fees and tax.
Balanced earnings at defensive risk levels — what’s not to like? And you can then potentially be a bit more aggressive with your KiwiSaver fund, knowing that you’ve got a solid base of “debt-repayment investment” to balance out the risk.
If I’ve got those number wrong, please tell me and I’ll have to seriously rethink my own investment strategy!
AYour numbers are spot on, but your reading skills are a bit of a worry! I said last week, “In your case, whacking back the mortgage is equal to having a risk-free investment that pays you 4.49 per cent after fees and tax. That’s a pretty good deal. You might get that return in KiwiSaver, but not without risk.”
But I’m running your letter because your calculations make the point more clearly.
What’s more, those returns for that period are unusually high. Normally you would have to be in a riskier fund to expect average returns of around 6 per cent after fees and tax.
QI’m sorry, but I really believe you should rethink your advice to the writer last week asking about using their KiwiSaver for a deposit, who said “I have finally bought my first piece of real estate — an apartment off the plans, for $870,000, and I move in in March”.
Firstly, you neglect to mention that owning property also comes with risk, especially buying an apartment off-plan when the property market looks like it is peaking and with what is currently happening to the property market in Australia.
There was also no mention of diversifying your assets. Kiwis have historically done well by putting all their eggs in their property basket, but that may not always be the case.
You also fail to mention anything about the liquidity of the investments. The writer is 48 years old, so let’s say 17 years away from retirement. You suggest they empty their savings to top up their deposit, which is already a hefty 48 per cent of purchase price. What money are they going to live on when they reach retirement? They are only buying an apartment, so it might be quite difficult to downsize.
Seventeen years isn’t long to build up another nest egg if they are only contributing 3 per cent of salary to KiwiSaver. Will their Super really be enough? Did you encourage them to save more in their KiwiSaver with lower payments to their mortgage? No, you encourage them to reduce the term of the loan.
Perhaps you don’t fully appreciate the effects of compounding over a 17-year period or the average long-run returns of the share market. In fact you could even take the time to show the writer the effects of different rates of return versus different mortgage rates to see how much better off they would be by actually continuing to invest.
I’m sorry, but this is quite an important decision in this person’s life and you seem to have only given it a passing thought.
ANope. Plenty of thought.
You’re right, of course, that property can be risky — especially buying off-plan given that sometimes places don’t turn out to be as good as the plans seem.
But the reader has already bought, and was not asking whether that was a good move. As for the Aussie situation, some experts are saying their price fall won’t be repeated here. Who knows?
In any case, when it comes to buying your own home, there are many other practical and psychological factors involved. I say, “Buy when you can. Don’t try to time the market. You can muck around on the sidelines forever.”
On diversification, see the second Q&A.
Money in retirement? I’m not sure that I’m the one not fully appreciating the situation.
The writer says that if he hasn’t paid off his mortgage by retirement, he could use his KiwiSaver money to do so. And I think that’s a good idea. Nobody wants to be making mortgage payments in retirement if they can help it.
Assuming he plans to go into retirement with the mortgage paid off, there are two scenarios:
- He doesn’t use his KiwiSaver money to reduce his mortgage when he buys the apartment. With the larger mortgage, he needs more in KiwiSaver to pay off the loan at retirement.
- But as you say, his savings are likely to grow considerably over 17 years, what with compounding and average share market returns. I write about such growth all the time.
- He puts the KiwiSaver money into his mortgage. That means lower KiwiSaver savings at retirement, but he has a smaller loan to pay off.
- The correspondent in the previous Q&A points out the high effective return of paying down a mortgage. In our reader’s case, it’s the high effective return of having a smaller mortgage in the first place. Same thing. Avoiding paying interest on debt improves your wealth in the same way as earning a return on an investment.
What we have to weigh up is the return on his KiwiSaver account, after fees and tax, against the mortgage interest rate. But — and this is a key point you seem to be missing — we also need to take risk into account.
We don’t know what KiwiSaver fund the reader is in. You seem to assume he is comfortable with the volatility of a high-risk fund — sticking with it through market ups and downs. But many people are not. And he also faces the risk of rising mortgage interest rates.
If he’s risk averse and in a lower-risk fund, mortgage repayment will almost certainly beat his KiwiSaver returns, after fees and tax. If he’s in a riskier fund, it might be the opposite. But it’s riskier.
That’s why I said last week, “Because of this uncertainty, if I were you I would put my KiwiSaver money into my deposit.”
In the end, it’s his choice. But it’s important he understands the risks of his two options.
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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to [email protected] or click here. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.