Personal Finance PDF

Personal Finance Financial Wellbeing Why Personal Finance Matters ● Personal finance is directly linked to one quality of life and it is a common source of anxiety. ● Only about one in five people rate their financial wellbeing as either ‘very high’ or ‘high’, and many suffer from “financial anxiety...

Personal Finance Financial Wellbeing Why Personal Finance Matters ● Personal finance is directly linked to one quality of life and it is a common source of anxiety. ● Only about one in five people rate their financial wellbeing as either ‘very high’ or ‘high’, and many suffer from “financial anxiety” Drivers of Financial Anxiety ● Main driver of financial anxiety is saving for ones retirement and providing for you’re family Financial Wellbeing ● Financial Wellbeing- The extent to which people both perceive and have each of the below now, in the future, and under possible adverse circumstances 1. financial outcomes in which they meet their financial obligations 2. financial freedom to make choices that allow them to enjoy life 3. control of their finances 4. financial security Objective vs Subjective Well Being ● This definition has a subjective and objective component. People’s overall financial wellbeing consists of both outcomes as they perceive and experience them and outcomes as they can be objectively and independently observed: ➔ Subjective- The first component involves financial outcomes that people experience and interpret through a personal, subjective lens and that they can report ➔ Objective- The second component involves financial outcomes that can be objectively observed in people’s financial records, accounts, and transactions Financial Wellbeing Conceptual Model ● Assumptions: Measuring Reported Financial Wellbeing Measuring Observed Financial Wellbeing Health and Reported/Observed Financial Wellbeing ● Health, especially in relation to reported financial wellbeing seems to be very correlated ● The same is true for financial literacy and wealth Financial Decision Making Consumption vs Savings – Buy a new smartphone, bike or car, eat smashed avocado, take a holiday – Put an amount (say, $100 per week) into a long-term saving account – Increase contributions to superannuation Financing – Pay by cash or credit cards or personal loan or other deferral methods (BNPL)? – Rent or own, with a home loan? – How much should I borrow? – How do I pay off my borrowings? – Can I make decisions that will mean expenses are tax deductible? Investment – Should I invest my savings in a term deposit? – Which stock should I add to my portfolio? – Is now the right time to invest in equities / property / art? – How do I know if a managed fund is suitable for me? Asset Protection – Should I buy life insurance? Car insurance? How much? – How would family breakdown affect my finances and wealth? – What will happen to my wealth / family if I die? Retirement Decisions – What are appropriate retirement funding strategies? – Will I have enough money? (How much money do I need?) – Do I need to keep earning in retirement? How? – Will I qualify for an age pension? How much? How does age pension and other social security interact with my assets and income? Regrets about Financial Choices and Barriers from Improving Finances ● Most financial decision making models assume that consumers are rational decision makers that logically rank and choose their choices appropriately ● however, rationality faces a major challenge: in most real-life situations, acting rationally requires enormous cognitive / computational resources to determine optimal actions ● Another challenge, of course, is that almost all financial decisions are about the future and hence involve uncertainty The “Complexity” Barrier ● One aspect that encompasses both the different barriers listed and the effect of uncertainty, is the existence of complexity in financial markets and products ➔ – complexity of products (e.g. managed investment funds, insurance policies) ➔ – complexity of contracts (e.g. ‘boilerplate’ aka standard-form contracts, product disclosure statements) ➔ – complexity of distribution (e.g. marketing, data/algo ‘biases’, ‘dark patterns’) ➔ – size of search space (e.g. private health insurance, superannuation investment options) The “Choice Overload” Problem ● There are simply too many choices now when it comes to ones financial products, this is overwhelming Savings/Consumption and the Consumption Life Cycle Consumption ● Consumption is important as it often accounts for around 60% of countries GDP Consumption Function - Keynes ● Consumption Function- 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) ● Function Equation: ● Early testing found that Keynes consumption function was not supported by empirical evidence. These findings let to different theories Life-cycle hypothesis [Modigliani & Brumberg (1954)] ● 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 Assumptions: ➔ 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 don’t want feast followed by famine ❖ 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 Life Cycle Model: Assumptions of Rational Decision Making Within Consumption Models ● finance theories generally assume rational financial decision making, but in practice we find that it is not always the case, ➔ Choosing sub-optimal short-term payoffs ➔ Repaying low interest loans quickly ● An example of irrational behaviour in relation to finance comes from Lowenstein and Thaler (1989) where they describe anomalous internal discount rates: ➔ ➔ As time/events change we tend to make irrational decisions, discounting the future rational goal e.g. we tend to discount smaller numbers with higher rates Savings ● If consumers are irrational and discount using anomalous internal rates than some argue you should simply focus on having a consistent savings rate Interest and Savings During Covid ● Saving rates are usually highly correlated to interest rates (higher interest = more savings). However during COVID this relationship decoupled: ● 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 a number of 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 2023, household spending moderated and the household savings ratio fell to 3.7%, its lowest level since June quarter 2008 – “This was driven by higher income tax payable and interest payable on dwellings, and increased spending due to the rising cost of living pressures” 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 almost $1.4 trillion, and the total value of superannuation assets is about $3.5 trillion ● 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 Theory vs Practise ● Whilst the model is unrepresentative of practice, it would be wrong to say that it has no relevance to personal financial decision making ● 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 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 • 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 in encouraging saving, and can also help to avoid financial hardship Life Cycle Trends Funding Life Consumption Income Life Consumption Life Cycle Phases ● Family Life Cycle Categories: ➔ 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 ● Family Life Cycle Categories and 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 that sum is converted to a 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. ● Uni Life Cycle Categories: ➔ I. No children, perhaps partnered or newly married, perhaps two incomes, saving for a home deposit, paying off student and other loans ❖ • 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 ➔ ii. Starting a family, pregnancy, arrival of a baby, paying off a home mortgage, may have dropped one income (short or long term) ❖ – 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. ➔ 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 ❖ – will the homemaker parent return to work? – if so, part-time or full-time? – paying off debt – cost of child-care, nanny ➔ 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 ● Uni Life Cycle Categories and Personal Finance: ➔ 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 Costs of Raising a Child Hex Loans ● University 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 2023, the HELP loan limit is $113,028 for most students, and $162,336 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 HELP Repayment Levels ● ATO specifies HELP Repayment Income (RI), essentially an adjusted Taxable Income, which is called the compulsory repayment threshold ● From 1 July 2023, HELP repayments are required at RI levels above $51,550 ● Between $51,551 and $151,200 the rate scales up from 1% of RI to 10% (repayment income thresholds) ● 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) ● 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 increase was 7.1% on 1 June 2023, resulting in an increase of approximately $1500 to the average $25,000 debt ➔ – 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) Government Family Payments Family Life Cycle Realities The Road to Retirement Income, Wealth and Taxes Money and Income Defining Money 1. Medium of Exchange: ● Eliminated previously inefficient barter system and facilitates easier financial transactions 2. Store of Value: ● Money can be stored and used for future consumption. Because of this its a store of value 3. Unit of Account: ● Money allows you to value a variety of different assets using a common unit The Value of Money ● Historically, money was backed by a physical asset (typically gold, therefore the “gold standard”) meaning that each unit of currency had a specific (intrinsic) value in the backing asset (e.g. $1 bought ‘x’ units of gold) ● However, the world has now moved to a system of ‘fiat’ currencies, whereby the currency is declared by government as ‘legal tender’, meaning it can be used to acquire goods and services, and meet financial obligations ● In that sense, money derives its value from the trust people place in it, as there is very little intrinsic value in physical notes and coins Digital vs Physical Money ● Today, most money is in digital (electronic) form, such as bank account balances, and an increasing number of payments are made digitally ● So, there is a declining use of banknotes and increasing use of electronic forms of payment, such as Buy Now Pay Later programs – only approximately 8% of ‘regulated’ money exists in physical form, and many people no longer use cash in any form ● Other observed trends relating to the payments system include greater use of digital wallets, growing involvement of the ‘big techs’ in payments, and growing community and political interest in the security, reliability and cost of payments Defining Income ● Income- For individuals, income is in the form of earnings in the form of salary / wages, the return on investments, pension distributions, and some other receipts Salary/Wages ● For most people their main source of income is salary/wages from employment. ➔ Salary- Agreed upon yearly amount ➔ Wages- Money received from job through payments ● The life cycle mode explained previously assumes regular growth of earned income. Historically this has been the case as experience of an individual increases ● Income growth is best measured through real growth not nominal growth as a result of inflation Annual Wage Growth, Real Wages, Inflation ● Nominal annual wage growth ● Real wages are set to fall back 15 years when taking into account current rises in inflation Credit and Debt ● Credit is the money loaned which is spent and debt is the total owed on that money with interest: ● Credit is broadly categorised into fixed payment loans repaid in instalments (car loans) and revolving credit (credit cards, overdrafts) ● Most common types of credit: 1. Personal Loans ● – personal loans are individual borrowings that can be used to fund purchases of items such as cars; they can be secured and unsecured, short or longer term ● typically require repayment of principal and interest as fixed monthly payments 2. Home Loans ● borrowing by individuals or couples to finance the purchase of a home ● the property acquired forms security for the loan (mortgage) ● they generally require repayment of principal and interest for terms between 10 and 30 years 3. Credit Cards ● – there are different types of credit cards available (branded, advance cards, store cards, line of credit cards), at varying – but high – rates of interest ● – the use of credit cards can be appropriate, yet they are often used inappropriately (funding excessive consumption) 4. Buy now, Pay Later ● – interest-free finance, commonly referred to as “Buy Now, Pay Later (BNPL)”, has become an increasingly popular way to pay for purchases ● – platforms such as Afterpay, Zip, Openpay and others allow you to spread the cost of a purchase over time without having to pay interest ● Recently there has been a strong push towards more buy now pay later schemes of credit with a strong call for more regulation of the sector. There are also rising costs of living Millenials and Credit Cards vs Buy now Pay Later ● 90% of millennials avoid paying credit cards and do so out of choice as a result of the various factors above ● In comparison BNPL schemes such as afterpay are cheaper than credit cards Debt and Funding Consumption Debt Funding Consumption ● Debt is often used to fund lifestyle consumption. Doing so to fund short term consumption such as eating out is considered financially irrational, this is because: ➔ There is no asset purchased ➔ The interest paid is not tax deductible ➔ Once spent there are no tangible benefits gained from debt ● Funding long term consumption such as cars is considered not as bad Debt Funding Assets ● Borrowing debt to fund consumption is generally considered a good investment, people commonly do so for two reasons: ➔ The first in this category is borrowing to fund non-investment appreciating assets (such as a home, vintage car, boat, holiday home or renovations, etc.), where the asset is expected to increase in value ➔ The other is funding of investments, i.e. where the borrowing is used to fund appreciating assets in the expectation of returns that will pay the costs associated with the borrowing, to provide a positive net investment return Paying off Non-Deductible Debt ● Investing by paying off home mortgage loans can be considered a low risk strategy that delivers a relatively high effective return (get more from saving on interest than cash interest in savings account) ● Home Mortgage Example - Motivations behind being deductible debt first: ➔ E.g. at the top marginal tax rate of 45%+2%, you would need to achieve a rate of return of 11.3% to better the ‘return’ from paying off mortgage at 6% p.a. – i.e. 11.3% * (1 - 0.47) = 6% ➔ Achieving this increased return is unlikely without taking on significantly more investment risk ➔ Note also that paying off the mortgage is not subject to market volatility, although there is some variability of return with variable rate loans, so in a sense the saving of mortgage interest is a risk-free return Personal Loan Examples ● 25,000 loan to be repaid in 12 equal monthly instalments at the end of each month. Annual interest of 10% that compounds monthly on the loan. ● This is essentially an annuity but you owe the payments. Thus use the annuity formula: ➔ Solving for the monthly payments gives the below: ➔ Repayment Schedule: ● Home Loan Example- Borrowing 550,000 from the bank to be repaid in equal monthly instalments over 25 years at the end of each month. Variable interest rate of 7% applies and interest is compounded monthly: ➔ Once again annuity formula can be used to solve for hte monthly amount: ➔ Repayment Schedule: ➔ What happens if the variable interest rate changes to 8% after 6 months: ❖ Determine amount owing after 6 months before rate change: ❖ Use this new PV to determine new A at new interest rate 8%: ➔ Changes in monthly payment illustrate interest rate risk that comes with a variable loan Refinancing and Debt Consolidation Refinance Example 1 ● Five years ago, you purchased a small apartment for $385,000. You paid a 20% deposit ($77,000), so the original loan amount was $308,000 and therefore the original loan-to-value ratio (LVR) was 80% ● Mortgage was for 25 years so you have 20 years remaining. You are paying the current standard variable rate of 5.88%, giving current monthly payments $1,962 . ● Your property is now valued at $517,500 and the mortgage balance (i.e. the amount still owed by you) = $276,526 (how is this calculated?) ● You consult a mortgage broker to find a suitable current deal and find you can now get a fixed rate of 4.69% ● It is possible to revert to a 25-year term again, but to reduce the repayment time (and thus, save interest), you decide on a 20-year term on the new loan, paying monthly as before ● At the new interest rate of 4.69% and given the remaining term of mortgage of 20 years, your new monthly repayments will be $1,778 ● The end result is that you will be paying off your mortgage over exactly the same time period as before, except you now pay $184 per month less (equating to $2,208 less per year and $44,160 less over the life of the loan) Refinance Example 2 ● Assume the interest rate for the car loan is 7.5% and the credit cards average 19.9% ● The total amount you owe on the car loan plus the credit card is $25,000 and your monthly repayments are $550 for the car and $200 for the credit card ● If you were to consolidate, this extra loan amount of $25,000 is added to the mortgage, meaning the mortgage balance outstanding becomes $301,526 ● With the house valued at $550,000 the LVR is now 301,526/517,500 = 58.3% – i.e. still well below the 80% compulsory mortgage insurance level, which is effectively the upper limit on these home equity loans Credit Traps 1. Hidden costs – fees, charges and taxation can change a positive outcome into a negative one (e.g. low interest, but up-front fee); note this for BNPL alternatives 2. Credit cards with interest free periods – can be effective, but this depends upon the holder’s payment discipline 3. Low introductory credit offers – banks often offer low introductory rates on credit cards (say 8%) that last for six months or so and then revert to the current market rate (currently near 20%) The Impact of Taxation Taxation of Income ● In Australia, income tax is levied on taxable income in m arginal manner: ● Taxable income = Accessible income - Allowable deductions ● Assessable income of individuals includes (but is not limited to) the following amounts received: – earned income (salary, wages, fees, etc.) – interest income – dividends and distributions – rental income – royalties – short- and long-term capital gains Treatment of Expenses ● Allowable deductions include losses and outgoings (expenses) incurred in gaining or producing assessable income or in carrying on a business – e.g. protective clothing, home office, travel* ● Expenses that are not tax deductible include those of a private or domestic nature, i.e. not incurred in producing assessable income or in a business – e.g. housing costs, living expenses, personal travel (including to and from work) ● There are also specific inclusions and exclusions of both income and expenses under tax laws – in addition, special rules can apply (e.g. higher deduction for R&D expense) Income Tax Calculation Example After Tax Investment Returns Dividends and Capital Gains Financial Planning Industry in Australia Financial Planning Industry ● the financial planning (FP) industry exists due to the need of individuals investors to access expert advice to build ‘portfolios’ tailored to their personal situation. SItuations may differ due to: ➔ – inadequate financial knowledge in some (many) cases ➔ – differing expectations of earned or investment income, tax situations, family circumstances, investment horizons, etc. ➔ – insufficient or illiquid assets Change in the FP Industry ● the prevalent poor practice in the industry indicates that the fiduciary duty was not being met, so the industry has been subject to substantial reform ● in the past two decades, much data was gathered and analysed by ASIC as a basis for introducing reform by way of stronger legislation ● ASIC ‘shadow shopping’ surveys of 2003, 2006 and 2012 found unequivocally that Financial Planners were not in general working in the best interests of their clients ● they identified numerous cases of consumers who have been given bad advice, but thought it was good advice – i.e. they didn’t know enough to perceive the difference Evidence from ASIC Surveys ● The 2012 survey assessed many examples of advice, finding: ➔ – 39% of the advice was not reasonable given the client’s needs (as required by existing regulation) ➔ – 58% of the advice was ‘adequate’ ➔ – only 3% of advice was considered ‘good’ ➔ – a switch of advisers would have resulted in higher fees in 62% of cases ● In a survey undertaken in cases where ASIC judged that the advice by AFSL* representatives clearly lacked a reasonable basis, 86% of consumers were still satisfied with the advice Conclusion ● Due to the specialised and complex nature of financial planning the conclusion was that people need to be protected much like medical patients ● As a result, there is now a statutory, as well as general law and ethical*, fiduciary duty on financial advisers to act in the best interests of the client ● the legal duty was introduced into the Corporations Law under the Future Of Financial Advice (FOFA) reform program introduced in 2011 General and Statue Financial Planner Regulation Best Interest Statutory Duty ➔ Duty does not apply to wholesale clients who are expected to have some financial prowess e.g. a bank “Best Interest” Fiduciary Duty (general fiduciary duty not specific statutory) ● financial advisers have always been subject to a general law fiduciary duty (also referred to as the ‘best interest’ duty), which requires an adviser to act objectively and solely in their client’s best interest ● the following factors apply to assess whether the adviser has met the duty: ➔ 1. The planner must have acted with a reasonable level of expertise in the subject matter advised on ➔ 2. The planner must have exercised reasonable care ➔ 3. The planner must have objectively assessed the client’s relevant circumstances ➔ 4. The planner must have regarded any action implemented as being in the client’s best interest in the circumstances Meeting Statutory and General Law Rules ● In order to meet the fiduciary / best interest duty, it is necessary for FPs to: ➔ 1. Perform a detailed investigation of the client and research the client’s needs ➔ 2. Carefully record all relevant aspects of the client ➔ 3. Formulate clear advice for the client ➔ 4. Obtain the client’s decision and implement it ● Two key principles: 1. Know your client (KYC) ❖ The KYC principle requires advisers to be aware of their client’s circumstances to a degree that ensures they have a reasonable basis for their advice. KYC imposes a strong onus on FPs to do sufficient information gathering 2. Know your product ❖ ‘know your product’ is based on similar principles, in that it requires advisers to have an appropriate level of understanding of financial products ❖ the FP is required to be aware of the available products in the areas in which they advise, and have some expertise in their application ❖ In this context, ‘products’ covers investment strategies and assets, insurance policies, superannuation alternatives, estate planning tools, etc. ❖ e.g. if an FP is to recommend a specific equity investment, such as company shares, s/he must understand the company, share market and inherent risks ● The KYC principle requires advisers to be aware of their client’s circumstances to a degree that ensures they have a reasonable basis for their advice. KYC imposes a strong onus on FPs to do sufficient information gathering Asic Regulatory Guides Legal Definitions of the Financial Planning INdustry When is a Financial Service Provided ● An advisor is providing financial service when: ➔ Providing Financial Advice (general and personal advice distinction) ➔ Dealing in a financial product ➔ Making a market in a financial product ➔ Operating a registered scheme ➔ Providing a custodial ro depository service Who is an Advisor ● under the legislation, advisers (to whom the fiduciary duty applies) comprise principals, authorised representatives and ‘paraplanners’ ● when a principal is referred to, it is any one of: ➔ – the holder of a dealer’s or adviser’s licence (AFSL – next slide) ➔ – any person who obtains a licence under FSRA ➔ – a registered life insurance broker – a life insurance company ● Principals employ or appoint both authorised representatives (qualified) and paraplanners (unqualified or partly qualified) Australian Financial Services Licence ● ASFL– it is the licence that covers those who carry on the business of providing financial services. ➔ ‘carrying on a business’ refers to activities that are systematic, continuous and repetitive ➔ Once you have an ASFL you can sell your services as a financial planner ● As soon as you have an ASFL you need ot abide by several key reporting obligations: ➔ Audit financial statements ➔ Report if you've breached rules/events ➔ Let asic know in changes of your authorised representatives ● who needs to hold an AFSL? ➔ – any person providing financial advisory services ➔ – any person who issues or deals in financial products ➔ – i.e. the principals in a financial services business ● who is exempt from holding an AFSL? ➔ – authorised representatives ➔ – directors and employees of the business ➔ – any other person acting on behalf of the principal Types of Advice within Financial Planning General Advice ● When general advice is given to a retail client, the adviser must: ➔ Warn that the advice is not based on knowledge of client circumstances and objectives ➔ Indicate that the client must consider the advice in this light if inclined to act Suggest that a Product Disclosure Statement should be considered (if applicable) before acting ● ASIC has stated that the following warning is sufficient: “This advice is general; it may not be right for you” ● When general advice is given, the aforementioned personal advice legislation does ont apply to you Personal Advice ● Personal advice is subject to the regulations as it does take into account knowledge of client circumstances and objectives ➔ in RG 175, ASIC notes that advice may be regarded as ‘personal’ even when: ❖ it is not given face-to-face ❖ there is no direct contact with the client ❖ it relates to only one product ❖ the client is a body corporate ❖ the adviser (subjectively) did not intend to provide personal advice ● Asic Guidelines on personal advice: ➔ The adviser explicitly offered to provide advice (and, for example, provided appropriate documentation) ➔ The adviser had an existing financial relationship with the client ➔ The client requested personal advice ➔ The adviser requested details about the client’s personal circumstances ➔ Personal circumstances are referenced in a recommendation ➔ The adviser had received or already possessed information about the client’s personal circumstances Quality of Advice ● There are two key elements of quality advice 1. The suitability Rule: ● – again, this is effectively the practical outcome of ‘know your client, know your product’ rules ● – it includes consideration of products alternative to those suggested i.e. clients should not have a product presented as the only available solution ● How to assess Risk Tolerance: ➔ By examination of previous investments made by the client(s) – this is ok if the client has a long history of investment (though in this case, the client probably doesn’t need advice from a FP); and ➔ By use of a questionnaire – many FP firms provide one of these for clients 2. Informed Consent: ● advice to the client must be communicated in a clear and concise manner ● in particular, this requires that the advice is not misleading, deceptive, incomplete or provided in a pressured environment ● if the adviser is responsible for implementation of the plan, a written signed statement to the effect that the client understands the projected course of action and agrees to the adviser’s implementation of it, should be obtained and kept Acting Efficiently, Honestly and Fairly ● Best practice also requires advisers to act efficiently, honestly and fairly ● These terms are not legally defined, but in the context of financial advice, they are: ➔ – ‘efficiency’ in conducting business, e.g. providing a plan and documentation in a timely manner ➔ – ‘honesty’ relates to ethics, conduct and fiduciary principles ➔ – ‘fairly’ requires advisers to treat clients equally, i.e. not discriminate between clients Disclosure to the client Experience, Competency and Training ● principals must ensure their advisers have proper experience and training and keep up to date; there are three types of training: ➔ – training in investment principles, preparation and formulation of suitable personal advice, knowledge of how the business operates ➔ – ongoing learning: keeping up-to-date with economy, financial markets, legislative and regulatory environments and changes ➔ – product training: provided by the principal if the principal is the issuer, otherwise (usually) by the issuer ● Any adviser must be adequately supervised by the principal, who should provide advisers with written directions that they are bound to implement Documentation of Financial Advice ● when providing financial services to a client, an adviser must operate under an AFSL and provide: – a Financial Services Guide (FSG) – a Statement of Advice (SoA) – the financial plan – a Record of Advice (RoA) – Product Disclosure Statements (if applicable) ● in addition, the complaints resolution process must be explained to the client ● a 14-day cooling-off period applies in some circumstances FSG ● a financial services guide discloses the services offered to the client and must be offered to a client at commencement of negotiations ● • contents of FSG (9 points): i. on the cover it must be called: a “Financial Services Guide” but can be referred to as an FSG (note for assignment) and must be dated ii. name and contact details of the adviser; any special instructions (e.g. feel free to email, etc.) iii. similar information about the authorising principals, or each of them iv. the kinds of financial services provided and the financial products to which they relate FSG Contents iv. who the adviser acts for when services are provided v. the remuneration and other benefits that the principal, the adviser or any other associated person will receive for providing the financial services vi. information about any business relationships or associations between principal and issuers of any products vii. details of internal and external complaints resolution mechanisms (one page may be sufficient) viii. a statement that the FSG has been authorised by the principal Statement of Advice (SoA) ● an SoA sets out the advice provided to the client by the adviser • it must be given to a retail client when providing personal advice, prior to any action required to be taken to implement the advice • SoA obligations and example provided by RG 90 ● an SoA must contain: i. the title ‘Statement of Advice’ on the cover ii. the advice iii. the basis on which it was given iv. the adviser’s name and contact details v. the name and details of the authorising principal, stating that the adviser is an authorised representative of the principal vi. information on remuneration and benefits anyone may receive; i.e. fees, charges and how and to whom they are distributed vii. information about any associations which might reasonably by construed as influencing the advice given viii. a warning if the advice is based on inaccurate or insufficient information ix. information on replacing one product with another Presentation of SOA ● ASIC has provided guidance in relation to preparation of an SoA in RG 90, including an example SoA in Appendix 2 – it is only 12 pages long, is written in plain English, makes clear disclosures, and explains the limitations of the advice ● • ASIC’s surveys had found that previously: – SoAs were too lengthy and too complex – key information was often located in an appendix to the advice document – SoAs were not tailored to client’s financial literacy – content was repetitive – there was no cross check with FSG for consistency with the SoA SOA Documentation Requirements ● • the rules (e.g. RG 175) set out specific items that must be included in any SoA, i.e. the type of detail that must be addressed / included i. Information elicited from client – assets, family circumstances, expectations, existing cash flows, projected cash flows, objectives, special needs, investment preferences (and aversions), risk profile and any other relevant information • this information should be recorded, agreed upon and signed by the client(s) • it forms the basis of the resulting financial plan • the adviser should notify the client of this at the outset ● ii. Information on fees – the amount and nature of fees for the service (SoA) should be disclosed in the first meeting with the client, as part of the Financial Services Guide • fees may, for instance, be divided into progressive parts – any products in which the adviser has a financial interest (e.g. he/she receives a commission from the fund manager, is employed by CBA to market its products, etc.) must by law be disclosed to the client iii. Recommendations made by the adviser that address client needs in the four main areas, or as limited by agreement When is an SoA not Required ● a SoA need not be provided in some circumstances, e.g. – advice consists solely of an offer to sell a product – client makes it clear that they do not intend to buy – no issue or sale results from the offer – advice relates to a CMT where the client is not retail – a basic deposit product, or traveller’s cheques – where the advice relates to general insurance – advice over the telephone on traded products, subject to client’s approval Product Switching ● when advice includes a recommendation that a client disposes of or reduces interest in one product, and replaces it with another, the SoA must contain additional information, including: – that the client’s existing product has been considered – costs and charges payable on reduction or disposal – benefits the client may lose as a result of disposal or reduction – entry or ongoing fees attaching to the replacement product – any other significant consequences of the switch Record of Advice (RoA) ● • a RoA may be provided rather than an SoA in specific and limited circumstances: – a SoA has previously been provided with client circumstances – the relevant circumstances have not changed significantly – the relevant basis has not changed significantly • note: neither a SoA nor RoA is required when the advice given relates to investments of less than $15,000 Product Disclosure Statements (PDS)] ● a PDS is designed by an issuer of a product to provide clients with sufficient information to make an informed decision about whether or not to buy (invest in) a financial product ● • what must be included? – it must be entitled ‘Product Disclosure Statement’ on the cover, but PDS can be used elsewhere – details of significant risks of the product – fees, expenses, charges and taxation implications – any other information that would influence a client Penalties ● • jail sentences and fines apply when advisers fail to give FSGs, written SoAs, PDSs, or provide defective documents that: – do not comply with Corporations Act – have not been authorised by the principal – have unauthorised alterations, or – have not been prepared by a proper person • defence: the FP provides proof of having taken reasonable steps (e.g. to ensure a document was compliant) – this emphasises the importance of documenting compliance Consumer Protection ● • there are four elements to consumer protection provisions (Corporations Law, TPA, FSRA, etc.) – misleading and deceptive conduct – restrictive trade practices – Corporations Act 2001 requires advisers to provide services ‘efficiently, honestly, fairly’ – other miscellaneous relevant laws ● • ACCC administers the TPA generally • ASIC administers provisions in relation to financial services Misleading and Deceptive Conduct ● • refers to conduct that either does mislead or is likely to mislead and may involve: – making or writing a statement – doing something, or – failing to say or do something which is needed to prevent someone from being mislead ● note: conduct misleads when it leads someone to believe something that is false ● penalties up to $1.1m for a company and $220,000 for an individual (that was in 2020, now the numbers are $15.65m and $1.565m, respectively) ● • misleading conduct may be either intentional or inadvertent • and … it is not necessary that someone is actually misled • rather, it is only necessary that there is a real chance that they might be – the test is not what you think (as adviser), it is the impression that people get from the advice – it is enough that a gullible, not-so-intelligent or poorly educated person is misled • an accurate statement can be misleading because of context • a disclaimer does not absolve responsibility when the conduct as a whole is misleading Complaints Procedures ● • the FP (principal) should implement a system to allow mistakes to be rectified speedily, practically and without resort to high risk, high cost litigation • ● there is an 8-step process for identifying complaints and resolving disputes: 1. Is there a complaint? If so, assist the client to put it in writing 2. Can the adviser satisfy the client immediately? 3. If the complaint cannot be resolved immediately: i. Internal system: adviser and client state their case ii. Decision by principal 4. Make decision and advise the client 5. If the complaint is justified: amend procedures, apologise in writing, and pay compensation if applicable 6. If client not satisfied with decision. Advise client of external procedures 7. If client not satisfied with external (industry) procedures? Client may need to go to court 8. Court or regulator action ● at all times, the adviser must keep the client fully informed in writing of what is happening, in particular disclosing the likely timetable of activities Financial Ombudsman Service (FOS) ● the FOS is an independent body existing to handle complaints: – in relation to investment advice to a retail client, or insurance contracts; – on handling of a complaint by a member; and – about the operation of managed investment or superannuation schemes sold to retail investors • it also aims to conciliate any dispute between members, but if necessary, can then move to arbitration and adjudication where it has powers to make decisions Asset Allocation and Investment Choices I Investment Risk Pyramid Return on Assets HIstorically ● numerous empirical studies provide evidence that different investments performed as you would expect, given their relative risk, i.e. – shares/equity > real property > bonds ● In Australia, studies have shown that long-term returns on equities have averaged 10-11.5% p.a. (but much short-term volatility) ● The equity (risk) premium has historically been in the vicinity of around 4-6% ● This illustrates a basic principle of corporate finance, i.e. expected return is a function of risk ● There is also evidence that ‘real’ (inflation-adjusted) rates of return have remained relatively constant over time Investment Portfolio Construction ● Broadly speaking, constructing a diversified investment portfolio is a two-step process: 1. Asset Allocation (the ‘macro’ decision) – refers to the percentage of available funds invested in the different asset classes (i.e. equity, cash / fixed interest, and property) 2. Security Selection (micro decision) – refers to selection of, and investment in, individual securities within each asset class ● Each step depends on investor risk tolerance, so there is currently no standard model for either Investment Strategies ● Due to differing risk profiles, a number of alternative investment strategies arise as variations of the above – e.g. there are different types of asset allocation strategies, e.g. strategic, tactical and dynamic – also, there are active v. passive management styles • empirical studies have consistently shown that around 90% of portfolio return arises from asset allocation ● this implies that there is little value added in the second category, i.e. selection of specific assets (individual stocks, property) within the asset classes – is this consistent with theoretical diversification principles? Strategic Asset Allocation ● strategic asset allocation (SAA) is based on setting target (%) allocations amongst asset classes ● the objective is to identify efficient allocation amongst the classes, then “buy and hold” ● it can be viewed as the allocation that managers would choose if they believed that aggregate asset classes are efficiently priced – i.e. they are of the belief that no abnormal profits are to earned from switching investments between asset classes ● most managers will periodically rebalance the portfolio back to those targets as investment returns skew the original asset allocation percentages Tactical Asset Allocation ● tactical asset allocation (TAA), on the other hand, represents the asset allocation that managers would choose if they believed that certain asset classes are (relatively) mispriced – generally, this refers to temporary mispricing – it is relative mispricing in the sense that, for example, the equities market is ‘overheated’ vis-a-vis the bond market ● under this strategy, managers attempt to outperform a passive benchmark by engaging in market timing ● this is an active (or aggressive) application of the asset allocation decision ● empirical evidence suggests that most managers are poor at market timing Dynamic Asset Allocation ● a third category is often identified – dynamic asset allocation (DAA) – but different users apply the label in different ways ● DAA is the term most often applied to the periodic rebalancing of portfolio weights under SAA and TAA strategies ● in other cases, DAA is used to describe market timing motivated switches under a TAA strategy ● finally, sometimes DAA refers to replicating return distributions; in effect, switching funds between asset classes to replicate an option payoff – also called portfolio insurance or stop-loss strategies – this would be a defensive rather than aggressive type of asset allocation Asset Allocation Example ● assume an investment fund manager with $100 million to invest on behalf of personal investors – the first decision is to determine the proportions of available funds to be allocated to each asset class – this decision will be based on the risk-return profile of investors, market conditions and research / forecasts ● assume it is decided to allocate the funds as follows: Property 20%; Equities 50%; Cash 30% – Is this consistent with the Mutual Fund Separation Theorem? Does it matter? ● the fund’s investment philosophy will determine subsequent actions ● if it has adopted a passive investment strategy, then the initial asset allocation (strategic) will remain in place over the investment horizon (subject to minor re-balancing alterations) ● alternatively, the managers may follow an active management strategy, which would mean reacting to updated market sector forecasts, in an attempt to profit from timing aggregate market movements ● either way, the next step is to allocate the funds to the different asset management teams (e.g. $50m will be allocated to the equities team for them to determine the appropriate specific equities investments) Investment Assets - Cash/Bonds ● We now focus on the first specific class of investment asset: cash (on deposit) and fixed interest securities, or bonds – hereafter, we focus on bonds in discussing this asset class ● A bond may be defined as “a contract between the issuer (borrower) and the investor (lender), evidencing the issuer’s obligation to make specified cash payments to the investor on specified future dates” ● The specified cash payment obligations are principal (amount borrowed), plus payment for use of the funds, i.e. interest ● Note that differences in regularity of interest payments leads to two broad categories of bonds: coupon-paying bonds, and zero-coupon bonds Coupon Paying Bonds ● Coupon-paying bonds comprise a regular fixed payment of interest (i.e. the “coupon”, C), plus repayment of principal at maturity (F) ● The coupon rate is not necessarily the market interest rate (although they are usually close at issue date – why?) ● Cash flows to investor: Zero Coupon Bonds (ZCB) ● interest rates are conventionally quoted on a nominal, per annum basis ● coupon payments are also determined on this basis, on the face value of the bond ● However, payments are often made more frequently than annually (usually six-monthly) e.g. bonds with quoted rate of 7.75% p.a. payable half-yearly; FV = $100,000 – coupons = 7.75%/2 x 100,000 = $3,850 ● The valuation of coupon-paying bonds clearly needs to take into account timing and amount of coupons ● ZCB make no payment of interest over the life of the bond, just a once-only payment of principal (par or face value) at maturity ● ZCB are issued at a discount to par, so the effective interest = F – P ● the most common types are commercial (including bank-accepted) bills and treasury notes – bank-accepted bills are those that have been issued by a corporate entity to raise short-term funds, and have obtained a bank guarantee for creditworthiness ● ZCB are also known as pure discount securities Bond Valuation ● as with other financial assets, the valuation of bonds is based on present value principles ● the key variables are therefore cash flows, time to maturity, and yield – then simply discount to determine PV ● note that as the day-to-day changes in interest rates are typically small, yield changes are typically referred to in terms of basis points – a basis point is usually 0.01 of 1% (i.e. 100 basis points = 1%) – sometimes referred to as ‘pips’ Zero Coupon Bond Valuation Investment in Bonds ● Whether or not bonds are coupon paying, in each case there will be a final (capital) payment at maturity ● bonds are typically of a short- to medium-term life ● in terms of diversification and portfolio selection, bonds are obviously an important asset class ● Are bonds a high risk or low risk investment? – Low risk: hold to maturity, fixed return that ranks before return on equity – High risk: trade bonds on the basis of interest rate forecasts; buy and sell prior to maturity leading to profits or losses on capital Risks of Bonds Convertible Bonds Australian Bond Market 10 Year Government Bond Yields Cash Management Trusts Equity Investment ● debt, represented by bonds as an investment class, imposes a contractual obligation on the firm to make regular payments of interest and principal to the lenders ● equity therefore represents a residual claim on the cashflows generated by the assets of the firm – dividends are paid after interest, and capital is returned only after borrowings (and all other obligations) are repaid – this is the reason for an equity risk premium ● equity may be generated from both internal (retained earnings) and external (new issues) sources (e.g. IPO listing of a company’s shares) ● Principal methods of equity capital raising: – flotation, i.e. Initial Public Offering (IPO) (see recent ones) – rights issue – private placement – dividend reinvestment plan ● These methods differ with respect to cost, time to implement and the potential for a transfer of wealth from old shareholders to new shareholders ● Investors in equity may participate in any of these capital raising methods ● In addition, an investment in equity can be direct (purchase shares) or indirect (e.g. purchase units in managed funds) How Risky are shares ● as noted, long-term returns on equities typically been stable and higher than other assets (many studies have verified this) ● on the other hand, short-term investment in equities can lead to losses due to volatility in markets (see a chart) ● many investors lost significant amounts of investment asset value in the Covid pandemic, and before that, the Global Financial Crisis ● for instance, in 2008 the S&P/ASX200 Index dropped from a level of nearly 7000 to below 3500 points – i.e. in 2008, about half of the value of equities in the market was lost – this obviously had severe consequences for retirees Investing in Shares in Australia ● • in relation to public companies, shares are listed and traded on the Australian Stock Exchange (ASX) – you can buy and sell listed shares by contacting a broker and setting up an account – the ASX provides a detailed education service to assist people who are new to investing, see video on investing first steps ● it is also possible to invest in shares in private companies, typically referred to as unlisted companies – the problem is identifying such shares; usually this will involve some personal relationship with the company principles / owners Share Analysis Fundamental ANalysis ● Many professional investment advisers build their practice on performing detailed fundamental analysis, involving the following: – examination of available company data (e.g. annual reports, information releases, profit/loss, balance sheet, generate financial ratios, etc.) – evaluate current management – compare with similar companies in same line of business ● to be efficient, the market requires that fundamental analysis is undertaken ● yet the Efficient Markets Hypothesis (EMH) assumes that information has already been impounded into share prices – this is the ‘paradox’ of the EMH Technical Analysis ● Technical analysis, or charting, is a ‘time series’ prediction technique – it uses price history charts and other indicators ● Chartists take the view that there is additional information contained in the behaviour (movement) of the price over time – and sometimes, in the volume of trade (e.g. Japanese Candlesticks) ● three sources of information are therefore required: 1. price 2. volume of trade 3. open interest ● technical analysts do not examine why a price moves; instead, they: – study charts of financial time series – evaluate patterns – evaluate indicators derived from time series – analyse trends – evaluate bull/bear dominance ● the problem with charting is that it implicitly refutes the weak-form EMH, which is the easiest form to prove Getting Share Information ● Share prices for ASX-listed companies are quoted in real time on the ASX website (along with other listed securities, e.g. rights, options and futures) ● the daily financial press also provides price listings ● In addition, both the ASX and financial press also provide research in relation to individual companies and sectors ● Most overseas stock exchanges have similar services ● Brokers also play a role in this area – in addition to using a broker to transact (buy, sell) on your behalf, they also provide research on equities – many brokers have dedicated teams of analysts that produce regular reports with buy/sell/hold recommendations Transaction Costs and Documentation ● as is the case with most things in life, transactions prices vary according to service offered, e.g. – transacting online is usually cheapest – company/sector advice and research most expensive ● the following are the forms of documentation that relate to a shareholding: – contract note, to evidence purchase – Holding Statement (there are longer any share certificates for ASX companies) ● Holder Identification Number (HIN) ● specifies company and number of shares held – dividend or distribution statement, where relevant Asset Allocation and Investment Choices II Why do Share Prices Move ● S Diversification ● As more assets is added we diversify away unsystematic risk. 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