In our cover story, the Sunday Business Guardian gives recipients of lump sum payments some advice and investment options to explore.Here, Brent Salvary of KSBM Asset Management Ltd and Ian Narine, general manager, Guardian Asset Management Ltd expound on the issue further.
Brent Salvary:
KSBM Asset Management Ltd
On an almost continuous basis, human beings engage in decision-making with regard to the pursuing of one choice to the detriment of another. These can range from watching television or exercising, eating healthy or not, to more complex decisions such as saving and investing as opposed to consuming goods and services such as discretionary items like a car or a new watch.
At the very core of such decisions lies the amount of enjoyment or benefit (or utility in economic terms) that is derived from making one decision over another. The concept of opportunity costs addresses these issues as a way of explaining the "cost" associated with making one decision over another.
In some instances, it is somewhat intuitive and sometimes intangible what one foregoes in order to pursue a particular decision. The cost of watching television over getting in some exercise is the lost opportunity to get to a healthier state.The cost of getting in some exercise as opposed to watching television is the loss of enjoyment from viewing one of your favourite programmes.
In financial matters, however, quantifying such decisions leads not only to better decision-making in the short-term, but also it can help determine what is important in the long run.Individuals are sometimes faced with a choice where, on the receipt of a lump sum of cash, they can either pay off major debt such as a mortgage or invest the funds over the long-term.
The decision in this case involves a consideration of the opportunity cost of each option available. The opportunity cost of paying off your debt is the loss of returns that could have been generated on your funds in the long-term, which may increase your consumption into the future. The opportunity cost of investing the funds is the lowering of your debt burden and the attendant relief from paying off that debt thereby allowing for more current consumption.
Some of key factors that must come into the mix in making such a choice include:
�2 The interest paid on your debt, for example, your mortgage rate
�2 The level of returns available in the market, taking into consideration the level of risk one is willing and able to take
�2 Expectations of future interest rates, investment returns, inflation etc
�2 Your general financial condition, future expenses such as educational pursuits etc
�2 Your appetite for risk.
If we take this example to a local setting, we have the following conditions presently:
�2 Relatively low rates of interest on loans such as mortgages with the average available mortgage rate clocking around 7.0 per cent, give or take.
�2 Historically low rates on savings, fixed deposits and bonds off all types, a rising stock market and area-specific property market where some regions continue to see appreciating property values and others in a state of stagnancy.
�2 Historical average inflation of around 8.0 per cent over the past 10 years although it is reported to be on a downward trend post April 2012 to currently below 5.0 per cent.
Making the choice to pay off your debt or not will depend on:
1. The level of risk one is willing and able to take with regard to the investment of funds
2. Immediate and short-term objectives, expenses etc.
Given that the second set of factors can vary widely, to simplify the analysis, we will focus on making the decision based on the consideration of risk. For a conservative investor who is unwilling or unable to put their funds at risk, the returns on the funds if invested would most likely be very low and generate anything south of 2.0 per cent, at least in the short to medium-term.
Therefore, the opportunity cost of paying off their debt for this individual is low and this option may not be the most beneficial one. On the other hand, for a more aggressive individual who is willing and able to put their funds at risk, whether through investing in traded securities, real estate or establishing a business of their own, the opportunity cost of paying off their debt can be quite high and thus the decision may tend to lean more towards the choice of not paying off their debt but rather investing the funds to generate a higher return.
At the very heart of this dilemma is the answer to this question: if I invest the funds according to my tolerance for risk and not pay off my debt, can I earn a rate of return above and beyond the cost of my debt?If the answer is yes then, with due consideration, individuals should invest the lump sum and forego paying off their debt. If, however, the answer is no, then investors should pay off their debt before investing for the long term.
The ability to quantify the opportunity cost in this situation allows for a more vivid and tangible illustration of the situation thus facilitating a better discussion of the options at hand. As, in most instances, the answer may lie in somewhere in the middle, but through an exercise such as this, one may find an ideal mix of how much to pay off and how much can be invested according to their unique set of circumstances and profile.
Should the source of the lump sum be from voluntary separation or early retirement, other considerations would have to be factored in the decision.If the individual would be dependent on the lump sum for an income to cover expenses, for example, he/she would have no choice but to invest some or all of it to realise that income. Should the individual be able to secure another source of income, then the considerations noted above in terms of mortgage cost versus investment returns would assume greater weight.
Ian Narine
Guardian Asset Management Ltd
The fundamental issue in this question is whether one expects the current low interest rates and moderately high inflation rates to continue. The best case scenario is that the status quo remains. However, one has to consider the implications of rising interest rates.A mortgage is typically a variable rate instrument and, if interest rates rise consistently going forward, it can impact the cost of servicing the mortgage. That means that if interest rates rise, the mortgage payments of tomorrow may be higher than it is today.
If inflation were to also rise into the future, one's purchasing power will decrease. This means that, at the same time, your mortgage payment is increasing, the disposable income needed to meet that increased payment is decreasing.If one is comfortably able to meet one's mortgage payments today then it may not be an issue. If, however, one is challenged, then this is a risk that must be considered.
In addition, for the past 12 years, T&T has been facing what is known as "financial repression." That is where the rate of return on fixed-income investments is typically below the rate of inflation.This situation is likely to continue for the foreseeable future and is now the norm in the developed economies of the world. Investing a lump sum today–especially if it is invested in a predominantly fixed-income product–may not produce a rate of return that is higher than the rate of inflation.
I know the typical response to questions such as this is to suggest that one leave the mortgage in tact and take the lump sum and invest it for retirement. However, given the considerations, I would go against the "standard" view and suggest that one should pay off the mortgage and any other high cost debt, for example, credit card debt, that one may have.
The next step does require some discipline.I would further suggest that the cash flow that was previously associated with the mortgage payments be invested consistently each month under a concept known as "dollar-cost averaging" and allow the power of compounding to work for you.
Consistently investing amounts over time has been proven to outperform investing a lump sum at a point in time. This is because the lump sum takes on all the risk of the market at that point in time. You could be investing at the top of the stock market or when interest rates is at its lowest point.However, with dollar-cost averaging, the environment does not matter as you will be investment a smaller amount every month regardless of the circumstances.
The above advice is predicated on the person receiving the lump sum and still having a source of monthly income going forward. This is the case if the lump sum is in the form of an inheritance or a voluntary separation, where the person goes to work elsewhere.In the case of early retirement where there is no future source of income, then, the consideration would be different and one may be inclined to leave the mortgage intact and invest the lump sum.
This should be done specially with the objective of generating investment cash flows that go some way towards servicing the mortgage payments.