CPD: Investment lessons for the next generation

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Help your clients teach important financial lessons to their children and grandchildren.

The importance of financial literacy is recognised worldwide, with programs in most OECD countries and many developing nations, to help people better manage their financial circumstances.

In this article, Centuria examines financial literacy in Australia and discusses strategies to help your clients teach these important lessons to their children and grandchildren.

What is financial literacy?

Financial literacy is taken seriously in Australia and there are a wide range of programs available; in fact, ASIC did an audit in 2013 and found 112 financial literacy programs in operation, conducted by 64 different organisations[1].

What is financial literacy and why does it have so much importance? According to Financial Literacy Australia, a not-for-profit organisation with a focus on advancing financial literacy, it can be defined as:

“…the ability to make informed judgements and to take effective decisions regarding the use and management of money.”

Financial literacy is a combination of a person’s skills, knowledge and behaviours in relation to decision making with respect to money.

In 2014, ASIC launched its National Financial Literacy Strategy (2014-17) with a vision to “improve the financial wellbeing of Australians by advancing their financial literacy.”

The strategy sets out a national direction for financial literacy and a framework for action under five strategic priority areas[2], primarily focused on training and providing resources to teaching, and integrating financial literacy across the curriculum to ensure students are equipped with basic knowledge and skills to make good financial decisions. It is an essential everyday life skill; arguably more important than algebra, correct grammar or understanding plate tectonics.

This is not uniquely Australian – it has been internationally recognised that building the financial literacy of young people is critical. Research confirms that most children form money habits by the time they are seven years old and that parents can play a powerful role in influencing the attitudes and habits of their children around money.[3]

Since the GFC there has international recognition of the need to ensure at least basic financial literacy concepts are understood – things like budgeting and the use of credit, to longer-term retirement planning and an understanding of investment concepts including asset classes, diversification, and the risk and return trade-off.

ASIC is currently undertaking a consultation process to update the strategy for 2018 and beyond; it released a consultation paper in October 2017 and has embarked on the process to garner feedback to refine and update the National Strategy for 2018.

Financial literacy in Australia

Whether looking to save money for a home deposit or an overseas trip, choosing between bank accounts or credit cards, deciding on a mortgage provider or a super fund, it’s important to have a fundamental understanding of a variety of factors that drive the decision-making process.

Despite the focus on financial literacy, 42% of Australians do not feel confident about managing their money on a day-to-day basis. Add to that, 36% find dealing with money stressful and overwhelming, and 21% have difficulty understanding financial matters.[4] While literacy programs start in schools, not everyone has had the benefit of that educational focus.

Despite this lack of confidence in matters financial, every Australian holds one or more financial products – mortgages, super accounts, bank and savings accounts, credit cards. At end August 2017, there were 16,717,777 credit cards in Australia, accruing a massive interest bill of $31,470,071,044.[5]

That leads into one of the biggest issues for Australians – managing debt. Around 20% say they are struggling to meet their mortgage repayment obligations.[6] This is at a time of record low interest rates and a record high ratio of household debt to household income.[7] It’s evident that Australians need support to understand their finances and manage financial risk – once interest rates start to rise, there could be many people under financial stress.

Is financial literacy in education working?

The approach adopted by the National Financial Literacy Strategy (2014-17) draws on similar programs adopted in other countries within the Organisation for Economic Cooperation and Development (OECD). Unfortunately, its research suggests that thus far, it is not enough. According to an OECD report[8] released earlier this year, one in five 15-year-old Australians do not have basic financial literacy and as illustrated in figure one, only 15% of students are ‘top performers’ in financial literacy, marginally ahead of the OECD average.

 

 

Some of the report’s findings include:

  • Students who hold a bank account perform 20 points better in financial literacy
  • Students who receive money as gifts perform 13 points better in financial literacy
  • At least 50% of students state they would save if there was something they really wanted to buy; not surprisingly, the savers perform better
  • In several countries, including Australia, the top performers were 70% or more likely to expect to complete university education.

Given that school curriculums are full, and teachers are busy getting through the mandated education requirements, is relying on schools to produce a financially literate cohort going to be sufficient?

The OECD report provides evidence of a positive relationship between financial literacy and holding a bank account or receiving gifts of money. This suggests that experience with money or financial products can provide ‘real life’ opportunity to reinforce the basic tenants of financial literacy. How can your clients support their children or grandchildren in their financial literacy journey?

Investment bonds and financial literacy

While gifting money into a savings account obviously aids financial literacy, taking it one step further and using a slightly more complex financial product – with a range of features and benefits – could further enhance financial literacy. Using investment bonds, a tax efficient savings vehicle, can provide a range of lessons as follows.

#1 A savings and investment discipline

An investment bond can be used to develop a savings and investment discipline. With an initial investment as low as $500, regular investments of up to a total of 125% of the initial investment, per year, can be made.

#2 All about asset classes

Unlike a bank account, investment bonds can teach future investors about the characteristics of different asset classes. With a choice of investment options, the owner of the investment bond can learn about Australian and global shares, fixed income, property, as well as cash. A multi-asset investment bond provides an excellent snapshot of each asset class and can become a springboard for discussion about the importance of diversification. There is, after all, more to investing than cash.

#3 The risk/reward trade off (aka if it’s too good to be true, it probably isn’t!)

One of the disturbing findings of a several studies into financial literacy, including the OECD’s PISA study, is that many people do not understand the trade-off between risk and return. Consequently, the financially illiterate have more trouble discerning between a genuine investment and a scam. According to the ACCC’s Scamwatch website[9], 138,291 Australians have lost just shy of $73 million to scams so far in 2017; approximately one third ($23.5 million) of this resulted from investment scams. A sound understanding of risk and return should help all investors avoid losing money to ‘get rich quick’ schemes that are too good to be true.

#4 Tax effective investment

Interest earned on bank accounts is subject to tax which, in the current low rate environment, results in little growth over time. Although minor’s generally pay no tax unless earning more than a certain amount; if this threshold is breached, the tax can be highly punitive.

On the other hand, an investment bond is a tax effective structure; tax is paid within the investment bond rather than personally by the investor. The maximum tax paid on the earnings and capital gains within an investment bond is 30%, although franking credits and tax deductions can reduce this effective tax rate.

There is no tax liability on maturation after 10 years, and no capital gains tax liability when switching between investment options.

#5 A long term view – and the power of compounding

Because the ideal term of an investment bond is 10 years, it can teach young investors to take a long-term view. Behavioural finance studies have shown that a tendency to make short term decisions on investments that have a longer-term time horizon often end badly for the investor. The power of compounding is best illustrated over the longer term; figure one in the following case study demonstrates the potential outcome of a relatively small initial investment and ongoing savings plan.

Case study

Eight-year-old Susie’s parents and grandparents want to teach her the value of money and the power of investing, so they gift her $1,000 to start an investment bond regular investment plan that can’t be accessed after she turns 18.

Her grandparents and parents together also provide her with a monthly amount of $100 to invest into the investment bond through a regular savings plan. Each year, the regular savings amount is increased by 25%. When Susie gets her first job, she is encouraged to contribute to the monthly savings.

 

Source: Centuria – figures assume investment returns of 4% income (70% franked) and 3% growth, and that the investment is held for 10 years. This example is for illustration purposed only and does not purport to represent the return achievable in any particular investment bond. Investments are subject to risk, including the risk of negative return.

 

If the assumptions in the illustrative example above are achieved, Susie’s investment would grow to just over $49,000 tax paid by her 18th birthday…whether she uses it to buy a car, pay university fees or towards a deposit on her first home or apartment, that’s a terrific way to start adulthood!

Saving and investing regularly over the medium to long term can translate into a growing nest egg. Your clients’ children and grandchildren can benefit from the power of compounding returns and learn some valuable lessons along the way, lessons that will stand them well throughout their financial journey. While financial literacy may form part of their curriculum, real life experience is always the best teacher – and a positive real life experience the best lesson.

 

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[1] Source: http://finlit.org.au
[2] http://www.financialliteracy.gov.au/strategy-and-action-plan
[3] Money Advice Service (UK), Habit formation and learning in young children, 2013
[4] ASIC, Report 541 Australian Financial Attitudes and Behaviour Tracker: Wave 5 Key Findings
[5] https://www.finder.com.au/credit-cards/credit-card-statistics
[6] Australian National University, ‘Attitudes to house and affordability: Pressures, Problems and Solutions’, May 2017
[7] Reserve Bank of Australia, ‘Household debt, housing prices and resilience’, speech, 4 May 2017
[8] OECD The Programme for International Student Assessment (PISA) Test, Financial Literacy, 2015
[9] https://www.scamwatch.gov.au/about-scamwatch/scam-statistics

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