“Nothing ventured, nothing gained”. These words of folk wisdom passed down over the ages have direct relevance to the concept of investment returns and their associated risks. One might imagine these words playing in the mind of a pre-historic caveman before embarking on an expedition for food: “Will I be able to catch something for my dinner, or will I end up as prey for that sabre-toothed tiger prowling in the area?”
The relationship between return and risk is like the two sides of a coin: the upside to a caveman of successfully hunting a mammoth is that he may feed his family for a month (i.e., the return), or he may get trampled by his potential prey (i.e., the risk). He could decide to focus on catching rabbits instead (i.e., smaller returns), with considerably reduced risk of getting mauled by such a prey. The higher the return, the greater the risk, while lower returns come with less risk in a continuum that finance theory dubs as the efficient frontier.
A modern, global-city dweller has fewer life-or-death decisions to make on a daily basis, yet judging by the numerous investment scams screaming out the promise of “guaranteed double-digit returns” hitting our email inboxes every week, it remains a treacherous jungle out there, with any number of prowling predators waiting to pounce on the unwary or the unwise.
Amongst the lowest risk, highest investment returns available to Singaporean residents today for their retirement savings are those provided by the Central Provident Fund (CPF) to members’ Ordinary Accounts (OA) and Special Accounts, Medisave and Retirement Accounts (collectively called SMRA). All monies in one’s CPF balances are subject to a minimum interest rate of 2.5% per annum, well above current savings and deposit rates from our local banks. In addition, the SMRA earn additional interest of 1 percentage point above the 12-month average yield on Singapore government bonds, subject to a floor of 4%, and CPF members’ balances of up to $60,000 attract an additional 1% interest annually. Both principal and interest earned in the CPF accounts are backed by the creditworthiness of the Singapore Government, one of only nine sovereign nations in the world with the highest credit rating from all three major rating agencies.
An IPS working paper that I have published (together with Peter Ryan-Kane, Mark Whatley and Will Rainey from Towers Watson, a global financial services consultancy) calculates the boost to returns provided in CPF members’ accounts from the application of the minimum rates in the OA and SMRA, at a time when interest rates have been low globally.
As an illustration (table below), the first $100 held in a member’s OA as at 1 January 1993 would have earned compound interest amounting to $93 up to 30 September 2014, as compared with only $41 if the $100 had been held in a bank savings or deposit account over that period. Correspondingly, the first $100 held in one’s SA as at 1 January 1993 would have earned $154 of compound interest up to 30 September 2014 at the actual rates declared, as compared to $102 if the calculated market interest rates had applied instead. These calculations include the benefit of the additional 1% interest on balances up to $60,000 in the CPF (with $20,000 of funds in the OA), as well as the minimum rates on balances in the OA and SA.
The government can afford to boost the returns to CPF members like this by pooling its own resources with the funds raised through the issue of Special Singapore Government Securities to the CPF Board. The government can tap on this enlarged pool of funds to invest in a broader range of potential asset classes than may be available to an individual — and with its perpetual nature, the government can take extremely long-term views in the investments it does make to generate higher returns over time. If we continue to stretch our pre-historic analogy, this may be likened to our caveman joining a clan of hunter-gatherers to hunt collectively and to share resources to tide things over in lean times. The clan, with more skills and resources to call on, can tap a much greater set of hunting and gathering strategies to feed themselves.
Through the pooling process, investment risk has been passed from the individual to the collective (in this case the government, via the CPF Board). Individual CPF members still retain some choice to make investment decisions for themselves through withdrawals under approved housing and investment schemes from the CPF, but then takes on the risk of not meeting his/her retirement savings objectives.
There’s another well-known adage: “There’s no such thing as a free lunch”. The saying may well be valid, but for our core retirement savings, the government’s guaranteed returns on our CPF balances come quite close to a meal on the house, at least from an investment risk perspective.
Safe and happy hunting!
Christopher Gee is a Research Fellow at IPS. This is the first in a series of essays examining risks and returns in Singapore’s retirement financing system. The report on the IPS Forum on CPF and Retirement Adequacy, held on 22 July 2014, can be found here.
Top photo from here.