Introductory Personal Finance Lecture 2 2024 PDF

FNCE20003 Introductory Personal Finance Lecture 2 Consumption and saving Financial planning life cycle Lecturer – Tony Cusack July 2024  Lecture 2 topics Consumption and Saving Financial planning life cycle July 2024 FNCE20003 Lecture 2 2 ...

FNCE20003 Introductory Personal Finance Lecture 2 Consumption and saving Financial planning life cycle Lecturer – Tony Cusack July 2024  Lecture 2 topics Consumption and Saving Financial planning life cycle July 2024 FNCE20003 Lecture 2 2  Optimising financial wellbeing decisions regarding spending and saving are fundamental in the context of the goal of optimising financial wellbeing recall that we defined financial wellbeing as relating to financial outcomes, freedom, control, and security “now, in the future, and under possible adverse circumstances” i.e. there is a time element as considerations relating to the future are included, and the future brings uncertainty we also noted that many people suffer financial anxiety, the key drivers of which include the financing of retirement and providing for the family’s future financial weaknesses are common, mostly related to inadequate savings July 2024 FNCE20003 Lecture 2 3  Financial anxiety and financial weaknesses July 2024 FNCE20003 Lecture 2 4  Lecture 2 topics Consumption and Saving July 2024 FNCE20003 Lecture 2 5  Consumption and Saving relevant literature in this area is known as the theory of intertemporal choice, referring to a choice relating to different time periods – in basic terms, the theory is based on the obvious proposition that if we consume more today, we will have less resources to consume in the future this theory has been addressed by many academics and economists over the years, i.e. they have sought to explain the relationship between income and consumption / saving over time – for example, using a function such as: Y = C + S it is studied because the relationship is significant to national economies – historically, C has accounted for ~60% of national expenditure in many countries July 2024 FNCE20003 Lecture 2 6  Consumption function the first formal work in this area was by Keynes (1936) – addressed in his General Theory of Employment, Interest and Money the theoretical basis of his work was that consumption expenditure comprises both variable and fixed portions – Keynes posited that as income increases, so will consumption expenditure, but on less than a 1:1 basis – it is also posited that there is a specific (minimum) amount that an individual will consume, regardless of the level of income (implying negative saving is possible) this became known as the consumption function July 2024 FNCE20003 Lecture 2 7  Consumption function the Keynesian consumption function was: C =  + c.YD  S = YD - C where: C = consumption expenditure S = saving YD = disposable income c = MPC (1 > c > 0) (‘multiplier’)  > 0 July 2024 FNCE20003 Lecture 2 8  Revised theories the model generated much interest, but early testing found that the it was not supported by empirical evidence these findings led to a revision of thinking, and to the development of alternative theories of consumption and saving – life-cycle hypothesis [Modigliani & Brumberg (1954)] – permanent income hypothesis [Friedman (1957)] we will briefly examine the former, as both have similar theoretical bases in that they both draw on the notion that consumption is related to a measure of income that is broader than current period income July 2024 FNCE20003 Lecture 2 9  The life cycle hypothesis the life-cycle hypothesis describes the link between the savings and consumption decisions of individuals and those individuals’ stages of progress from childhood, through years of work participation years, and finally into retirement the foundation of the model is the saving decision, which directs the trade-off between consuming and saving the saving decision reflects an individual’s relative preferences between present and future consumption (as measured by utility) at different times of life the life-cycle hypothesis is firmly grounded in expected utility theory and assumes rational behaviour, leading to the proposition that an entire lifetime’s succession of optimal saving decisions can be computed given only an individual’s projected household income stream, vis-à-vis the utility function July 2024 FNCE20003 Lecture 2 10  The life cycle hypothesis specifically, two common (and reasonable) characteristics of individuals are assumed by the theory 1. individuals prefer a higher standard of living, i.e. they want to maximise current consumption 2. most individuals want a relatively constant standard of living throughout their lives – they dislike volatility and want to avoid ‘feast followed by famine’ the foregoing implies ‘consumption smoothing’ and it follows that savings rates should on average be low or negative early in life, high in midlife, and negative during retirement accordingly, the main prediction is a life-time of savings, which results in a hump-shaped savings curve July 2024 FNCE20003 Lecture 2 11  Theoretical life cycle model July 2024 FNCE20003 Lecture 2 12  Irrational decision-making we previously noted that finance theories generally assume rational financial decision making, but in practice we find that it is not always the case, e.g. – choosing sub-optimal short-term payoffs – repaying low interest loans quickly – regular deposits to low interest special purpose savings accounts – buying low cost, energy inefficient appliances, etc. a key reference in this area is Lowenstein and Thaler (1989), in which the authors describe irrational behaviour in relation to financial decision making by individuals – they refer to this phenomenon as anomalous ‘internal’ discount rates July 2024 FNCE20003 Lecture 2 13  Anomalous discount rates The marshmallow test (see: Stanford marshmallow experiment – Wikipedia) Exercises: – would you prefer $100 today, or $110 in 3 months? – would you prefer $100 today, or $150 in one year? – would you prefer $10 today, or $15 in one year? – would you prefer $100 today, or $220 in 4 years? July 2024 FNCE20003 Lecture 2 14  Smoothing savings instead of consumption an alternative to the emphasis on smoothing consumption that has become more popular in recent years, is to instead focus on smoothing savings rates (or maintaining relatively constant savings rates), motivated as follows: – the usefulness of establishing saving consistently as a discipline – simple savings rules that have the virtue of requiring minimal computation (why?) – the power of compound interest (Futurama example) current popular authors also champion rules that seek to address cognitive biases such as anomalous discount rates, mental accounting and framing we will see that the superannuation system in Australia effectively forces the “smoothing savings” outcome July 2024 FNCE20003 Lecture 2 15  Interest – a key determinant of savings Savings all gone? You're not alone and it's intentional, says economist Interest Rates | Chart Pack | RBA July 2024 FNCE20003 Lecture 2 17  Recent savings experience historically, savings rates have been sensitive to interest rates the graphs on the previous slide show a ‘de-coupling’ of interest rates and savings at the time of the Covid pandemic (savings ratio spiked) there are many reason for this, including (1) the fact that many items that people spent money on, e.g. travel, were no longer available; and (2) reaction to dramatically increased uncertainty, i.e. precautionary savings however, in the March quarter 2024, the household savings ratio fell to 1.1%, a 17-year low and continuing the post-Covid trend – this is largely related to significantly rising living costs in Australia, in particular home mortgage repayments, which have risen by 52% in the past two years July 2024 FNCE20003 Lecture 2 18  Reasons for saving by age 60% 50% 40% 30% 20% 10% 0% 18-2 4 25-34 35-44 45-54 55-64 6 5 - 74 75+ Saving for a deposit on a home Travel Saving for a ‘rainy day’ Accumulating wealth Planning for retirement Supplementing current or future income Sources: Deloitte Access Economics July 2024 FNCE20003 Lecture 2 19  Importance of savings savings not only provide critical financial functions to Australian households (related to financial wellbeing), they are also vital for the Australian economy most savings are deposited with banks, superannuation funds and other financial institutions, and are invested either directly (by the saver) or indirectly (by the financial institution) the total value of household deposits is currently $1.46 trillion (source), and the total value of superannuation assets is about $3.9 trillion (up from $3.5t a year earlier) deposits are the primary source of funding of large Australian banks and hence are the main source of funding of loans, and superannuation savings represent a large portion of investments in Australian public companies and also in infrastructure, commercial real estate (e.g. office buildings) and other important investments July 2024 FNCE20003 Lecture 2 20  Lecture 2 topics Consumption and Saving Financial planning life cycle July 2024 FNCE20003 Lecture 2 21  Theoretical life cycle model July 2024 FNCE20003 Lecture 2 22  Theory v. practice whilst the life cycle model is unrepresentative of practice, it would be wrong to say that it has no relevance to personal financial decision making it is useful in a number of areas, e.g. to examine the theory in terms of what is the basic objective of financial planning – i.e. the objective of financial planning is to maximise financial wellbeing by ensuring that there is adequate lifetime income to meet lifetime consumption we can conclude that, informally, the objective of personal financial planning is to enable achievement of the life cycle model so, the theory and model are therefore relevant, at least as a starting point for examining financial decision-making July 2024 FNCE20003 Lecture 2 23  Some empirical observations unsurprisingly, the savings ratio is higher for higher-income households evidence indicates that many people only start saving for retirement later in life – leading to the insufficient savings problem there is gender disparity (proposed policy) the theory predicts full ‘dis-saving’ of savings, but many people don’t run down (all of their) assets in retirement – bequest motive, ‘longevity’ risk mode of payment (payment products used) affects consumption behaviour – studies show that the easier it is to pay, more consumption expenditure occurs cash flow management (e.g. budgeting) is useful for encouraging saving, and can also help to avoid financial hardship July 2024 FNCE20003 Lecture 2 24  Funding life consumption Net Consolidation phase Worth Long term: Retirement Short term: Children’s education Accumulation phase Vacations Long term: Consolidation Retirement Children’s education Short term: Spending phase House Gift phase Car Long term: Growth-oriented Estate planning Short term: Lifestyle needs Gifts Income-oriented Age 25 35 45 55 65 75 July 2024 FNCE20003 Lecture 2 25  Income over the life cycle Retirement Labour market entry Training July 2024 FNCE20003 Lecture 2 26  Life cycle ‘phases’ one approach is to apply principals of the life cycle model, modified for practical realities by explicit recognition of different ‘phases’ of the life cycle this involves saving and investment strategies designed to meet varying preferences, needs and resources in the different phases, e.g. i. young, single, no commitments ii. younger couple, two incomes, no children iii. one-income family, young children, tight budget iv. one- or two-income family, older children v. retired, living off private income and/or government pension July 2024 FNCE20003 Lecture 2 27  Financial life cycle phases July 2024 FNCE20003 Lecture 2 28  Relevance to personal finance in the context of the life cycle model, collectively phases (i)-(iv) represent the accumulation phase, where a capital sum is built up (v) is the retirement phase, where the accumulated sum is converted to a Retirement Income Stream (RIS) for consumption over remaining lifetime the obvious difficulty in applying a theoretical model to practice is the existence of uncertainty in the real world practical issues that have an impact on personal financial decision making include risky income flows and assets, age and life expectancy, portfolio allocation choices, inheritances and bequests, changes in preferences over time, family circumstances, taxation and other government transfers, etc. July 2024 FNCE20003 Lecture 2 29  Traditional life cycle phases (post uni) i. No children, perhaps partnered or newly married, perhaps two incomes, saving for a home deposit, paying off student and other loans ii. Starting a family, pregnancy, arrival of a baby, paying off a home mortgage, may have dropped one income (short or long term) iii. Raising a young family, paying education fees, starting to make headway with mortgage, homemaker may or may not return to workforce, perhaps upgrade residence iv. Empty-nesters, children start to leave home, mortgage well under control v. Retirement – relying on super, income from investments (and possibly social security, e.g. Age Pension), major debts repaid July 2024 FNCE20003 Lecture 2 30  Considerations – life cycle phases in (v) above, the retirement phase, the issues are notionally simpler than for the first four phases – retirees need a reliable (preferably indexed) income stream (RIS), generated by the assets accumulated over a life of working, i.e. savings – ideally, also maintaining a cash reserve to meet unexpected expenses phase (i) is characterised by low earning capacity phases (ii) and (iii) in particular, can represent times of financial stress and taken together these stages are relatively long term note: demographics and shifts in preferences are also relevant to the discussion July 2024 FNCE20003 Lecture 2 31  Phase (i) – issues to consider in phase (i) – single or newly married, one or two incomes, no children financial issues to be considered include the following: – new job, travel plans, further education, repayment of debts (e.g. HELP), managing credit cards or similar, saving for a home, furnishing a house, deciding when and if to start a family (financial implications) – other expenditure based on specific circumstances (e.g. special needs, hobbies, family commitments) – one recommended financial strategy in this phase is that a couple should try to live on one income and save the other before starting a family July 2024 FNCE20003 Lecture 2 32  Phase (ii) – issues to consider phase (ii) (partnering, starting a family) issues: – cost of having a baby, hospital costs, out-of-pocket medical expenses – what government payments are available? Do the couple qualify? – do(es) either or both partner(s) plan to take time off work? For how long? – costs of a baby: obstetrician, hospital / birthing suite, medications, prams, cots, car seats, clothing, etc. in this phase, it is likely that debt will be taken on (personal loans, credit cards, home mortgage, other) July 2024 FNCE20003 Lecture 2 33  Phase (iii) – issues to consider issues in phase (iii) (raising a young family): – will the homemaker parent return to work? if so, part-time or full-time? – paying off debt – cost of child-care, education costs – private or public? – child’s living expenses including clothing, entertainment, food, holidays, sport and activity participation costs (e.g. music) as well as petrol / transportation costs studies have found that the cost of raising a child to the age of 18 is in the range of ~$200,000 to $548,500 (The cost of raising children in Australia) – education costs will be significantly higher for privately educated children – the weekly cost of an older child is 3-4 times that of a younger child July 2024 FNCE20003 Lecture 2 34  Children’s education other issues to consider include: – the earlier you can start making provision for these costs, the better – it may be possible to save/invest in a tax-free environment note: punitive tax rules relating to child unearned income apply ($416 limit), but there are structures that avoid these rules – choice of investment product (cash on deposit / bonds, bank shares, property for negative gearing?) in whose name should such investments be held? July 2024 FNCE20003 Lecture 2 35  Government assistance – university education higher education fees are payable each year, either in part (if attending under a Commonwealth Supported Place, CSP) or in full (e.g. overseas students) assistance by the government for paying these fees is available to resident Australian and NZ students through the HELP loan scheme – HECS-HELP, FEE-HELP, OS-HELP and SA-HELP are the current schemes available to assist students to pay the cost of tertiary education – from 1 January 2022, the HELP loan limit is $121,844 for most students, and $174,998 for students studying medicine, dentistry and veterinary science courses – these loans are repaid when income is earned (via the taxation system), starting once a certain level of income is earned July 2024 FNCE20003 Lecture 2 36  HELP repayment levels ATO specifies HELP Repayment Income (RI), essentially an adjusted Taxable Income, which is called the compulsory repayment threshold – RI = Taxable Income + any total net investment loss (which includes net rental losses) from 1 July 2024, HELP repayments are required at RI levels above $54,435 between $51,551 and $159,664 the rate scales up from 1% of RI to 10% (repayment income thresholds) in 0.5% increments note: employers are required to withhold extra tax (PAYG) at these rates from employee remuneration variations to compulsory payments are possible (e.g. Low Family Income) July 2024 FNCE20003 Lecture 2 37  Other HELP matters in theory, HECS-HELP loans are the least important debt to pay off, as they do not accrue interest like most other loans however, the loan amount is adjusted each year by the indexation rate to account for inflation – the annual increase was 4.7% in June 2024, resulting in an increase of $1175 on the average $25,000 debt (it was 7.1% in 2023) – voluntary HELP repayments can be made at any time on an accumulated debt, which could be advantageous in times of high inflation HELP debts are not wiped on becoming bankrupt – however, outstanding HELP debts are cancelled on death, although a payment might be due on the deceased’s last tax return (i.e. up to date of death) July 2024 FNCE20003 Lecture 2 38  Government family payments the government provides a number of benefits to families to assist with family costs, subject to the meeting of eligibility criteria, such as: – Newborn Upfront Payment and Newborn Supplement (previously ‘Baby Bonus’) – paid parental leave up to 22 weeks, benefit payment of $915.80/week some eligibility criteria apply – Family Tax Benefit (Part A and B) both subject to an income test – childcare benefits – where the Government pays part of child day care cost, or makes payments for carers or in relation to disabilities July 2024 FNCE20003 Lecture 2 39  Family ‘life cycle’ realities phase (iv) is typically one of consolidation of course, one’s life cycle plan can be interrupted by numerous contingencies such as absence from work force (e.g. travel, child raising), divorce, death/incapacity of a partner, retrenchment, pandemics, etc. the (financial) impact of these contingencies can be serious and most will typically result in a savings shortfall, but some planning mechanisms exist – binding financial agreements (BFAs) are useful in relation to divorce – most employees will be covered by life insurance, often (but not exclusively) under superannuation arrangements – in addition, it may be advisable at certain times (e.g. when starting a family / during early child-rearing years) to invest in term life insurance July 2024 FNCE20003 Lecture 2 40  The road to retirement in summary, there are numerous issues, risks and opportunities arising in phases (i) to (iv) for phase (v) – retirement – the key issue is that there is an adequate RIS we will see that by making reasonable assumptions about superannuation, i.e. – commencing superannuation contributions in mid-20s – contributing at least the compulsory 11.5% (increasing to 12% from 1/7/2025) – long-term historical investment earnings are stable and doing nothing else to provide for retirement, then s/he is likely to end up with at least $800,000 lump sum in today’s dollars leading back to the key question: is that enough? July 2024 FNCE20003 Lecture 2 41