Recalling the generation
‘Generation Jones’ was not exactly spoilt for choice. Few owned cars and household appliances were still in their infancy. A suit or dress and a radio were all that were required to keep up with the Joneses. Life expectancy was such that defined benefit pension funds were a feasible prospect to secure pensioners.
The baby-boomer generation, post-World War II, witnessed the benefits of mass production. Consumer goods became affordable to many. But, very importantly, energy costs were miniscule. And the size of families exploded.
Generation X followed the same course as the baby-boomers. The 1974 oil crisis came and went. Rampant consumerism followed.
Generation Y brought technology into the home, at substantial additional costs. And when all could not be afforded, consumer credit was extended.
Generation X saw the extension of the progress in Generation Y, until the global credit crunch of 2009, and the world economy has bumped along ever since.
All of the above is general knowledge. However, few stop to consider five critical factors that emerged from Generation Y and have substantial effects on financial planning today:
The fantastic medical science developments since 1980 have increased life expectancy (excluding those affected by the HIV/Aids pandemic) by 15 to 20 years.
Risk-free returns have plummeted
Residential property, previously viewed as an investment, has, in some respects, become a liability.
Governments worldwide have jumped on the wave of rampant consumerism and resorted to stealth taxes to supplement income taxes.
Energy costs, driven by increased worldwide demand for resources, have increased at above the inflation rate.
The problem the world faces today is that we all are wishing for an economic comeback to provide the lifestyle and ideals we all enjoyed pre-2009. And the reality is quite simply that for most, this is not going to happen. The lifestyle created in Generation Y was not sustainable.
In formulating a financial plan one must take account of the above developments in more detail.
Increased life expectancy
Most now accept that increased life expectancy was behind the demise of the defined benefit pension fund. Today, the emphasis of the responsibility for financial planning has moved away from the employer (who now plays the role of a facilitator of retirement, medical and group life funds) to the employee (who now assumes the responsibility and risk).
The challenges of providing for a retirement of 15 to 25 years are aggravated still further by the following realities:
Gone are the days when the employer provided free medical aid to retired employees. Thus the progress achieved by the medical profession is only readily available if the patient can afford it. This is not limited to the enormous costs of private hospital care. The costs of preventive medicine needed pre- and post-retirement are also substantial.
Increased life expectancy affects both husband and wife. In the past the surviving spouse continued to receive a pension annuity from the defined benefit fund. Today the financial plan has to provide for the needs of both spouses.
Post the 1974 worldwide oil crisis, inflation rates became a major worldwide problem. Initially governments sought to control inflation by applying the monetary economic ideals of economist Milton Friedman. In short, monetary policy seeks to curb consumer demand by regulating money supply and increasing interest rates, resulting in a decline in inflation rates.
A benefit of monetary strategy is that high real interest rates can successfully underpin a financial plan.
The downside of monetary economic strategy is that it simply strangles the consumer and the economy. This potentially results in higher tax rates and increased government deficits.
Furthermore, monetary strategy places home ownership beyond the means of most, placing further strain on government resources.
Alan Greenspan, Chairman of the Federal Reserve of the United States from 1987 to 2006, made sure that harsh monetary strategy was largely abandoned during Generation Y. The resultant lower interest rates stimulated consumer spending and many economies benefited. But the casualty is undoubtedly the pensioner who can no longer exist on today’s substantially lower interest rates.
Post the global credit crunch, interest rates have declined to a level where it is simply not possible to create a financial plan based on risk-free interest rates. The investor has to assume a component of managed risk in a carefully considered portfolio of equity investments.
In any financial plan it is hard to justify an anticipated return exceeding 10%. This is a long way off the risk-free rates that exceeded 20% during the 1980s.
The above has a fundamental impact on financial planning that cannot be ignored. For most, the unavoidable result is quite simply a downsizing in lifestyle expectations.
Prior to 2009 residential property was viewed as an investment in a financial plan. Perhaps this has also changed.
In their paper ‘The Aftermath of Financial Crises’1 economists Reinhart and Rogoff predicted that it would take about seven years for residential property prices to recover after the global credit crunch. In the context of South African residential property this may take even longer as other factors will have to be considered:
There is a massive oversupply of residential property – created between 2000 and 2007.
Since the introduction of the Local Government: Municipal Property Rates Act of 2004 the holding costs of property have soared. This must be coupled with a 400% increase in the price of electricity over 10 years.
Prior to 2009 it was fashionable and feasible to own more than one property. ‘Recreational property’ was the all the rage.
In the past, many South Africans planned for a retirement where they ‘moved to their holiday home’. This trend is diminishing as holiday homes are (1) too expensive to maintain on a pension, (2) distant from comprehensive medical facilities and (3) distant from family. Retiring to the holiday home for 15 years before seeking refuge in an old age home has, for most financial plans, become unsustainable.
It is not surprising that the retirement complexes in urban areas are emerging as the new trend. However, some on offer are not financially viable and many do not offer appropriate frail care facilities. Great care needs to be taken in the selection of a financially secure retirement complex that provides all the required amenities.
South Africa was almost completely reliant on income taxes until 1978 when General Sales Tax was implemented, as a temporary measure, at the rate of 4%. Today, VAT at 14%, coupled with a range of other stealth taxes associated with expenditure, account for 45% of total taxes. This excludes property rates and taxes that have escalated substantially but are officially designated as service charges.
Worldwide, governments have moved towards stealth taxes in order to avoid increasing income taxes. Thus an income tax-efficient financial plan is achievable, however the tax burden increases substantially when the capital is spent.
This is not all bad news. Stealth taxes have allowed income tax rates to be reduced. Even the total tax exemption granted to retirement funds would never have been achievable were it not for stealth taxes.
Most accept that tax efficiency is an integral part of creating a sustainable financial plan to last a lifetime. And most contributions to retirement funds have some element of tax efficiency. But few financial plans factor in the double tax exposure inherent in all withdrawals from a retirement fund, ie (1) income tax on the retirement fund withdrawal and (2) stealth taxes on the after-tax withdrawal when spent.
There are many pensioners in South Africa today who have a far higher exposure to stealth taxes than income tax. They just do not know it.
The energy issue
During Generation Y, families dispersed as residential property ownership became more accessible to all. It became an uncommon phenomenon to find three generations living under one roof.
Multiple residential property ownership within one family may have been a proposition when residential property was an investment. But today, in addition to the vagaries of the residential property market, multiple property ownership represents an exposure to increased energy costs. And, with the looming introduction of carbon emission taxation, residential property now represents exposure to stealth taxes.
The futurists are now predicting the emergence of the ‘six parent family’, where grandparents, parents and children all live under one roof. The primary driver will be the increased energy costs associated with maintaining the larger family.
The global credit crunch was not the ‘blip on the radar screen’ many analysts took it to be. Perhaps it signalled the true end of the lifestyle ideals of Generation Y and the mass consumption that went with it.
The King III report of 2009 introduces the benchmark of ‘sustainable leadership’ in business. This means that profit alone does not make a successful business. The same applies to financial planning. Handsome returns alone are not going to keep most families safe.
There are 53 million South Africans. If it takes R1 million per annum in pre-tax income to fund a high net worth family, then there are only 60 000 South Africans who have what it takes to maintain the old lifestyle of Generation Y. There is work to be done.
1. ‘The Aftermath of Financial Crises’, 2009, Carmen M Reinhart, Kenneth S Rogoff, NBER Working Paper No 14656