Last week we discussed how the Governor of the Reserve Bank Phillip Lowe recently recommended that home borrowers ensure that they have a ‘buffer’ against the time when interest rates inevitably rise. This buffer usually takes the form of making extra repayments now while interest rates are low, so as to be better able to cope when interest rates start to rise.
Interest rate buffers are not the only type of buffer in good financial planning. Buffers are used in many areas, but the need for buffers always comes from the same source: understanding that the way things are now is not likely to be the way things are in the future. Of course, in the future, things might be better. But they might also be ‘worse,’ and so good financial planning always ensures that there are contingency plans for a future that turns out less well than we hope.
The most basic form of buffer is savings. We used to refer to ‘saving for a rainy day,’ alluding to the time back in the distant past when rain might mean we lose our crops or our chance to earn our living. These days, few of us lose income when it rains, but the principle still exists: there might come a time when we do not have income flowing in, so it makes sense to save some of what we earn today to tide us over. Some money in the bank does this job for us.
Life insurance is an extension of this thinking. The basic idea is that we save some of what we are earning today (that is, we do not spend it). We then pool this saved money with the same type of saving made by other people. If one or more of us is unable to work due to illness, injury or death, we draw from this pool so that the financial consequences of our misfortune can be minimized. Of course, we have to ‘give over’ this saving to whoever is running the pool (‘the insurer’) in the form of a premium. But paying this premium usually brings great peace of mind that we and our loved ones will be able to cope if we become unwell or die unexpectedly.
Buffers can also be built into investment portfolios. This is seen most easily when people are relying on their investments to fund their lifestyle – for example, in retirement. Consider a basic example of a person with $1 million in their super fund and who wants to withdraw $50,000 a year to live on from this point forward. If the person was being very conservative, they would keep the whole $1 million in cash form. This would guarantee that the money is there when they need it and also that it lasts at least 20 years – but it also means that the value of the investment cannot really grow, so that the money will not last much longer than 20 years. It also leaves the person with little ‘wriggle room’ if the cost of living increases.
So, most self-funded retirees would invest at least some of that money into growth assets such as shares. How much they invest depends on how large a buffer they want. A simple example might be to keep five years’ worth of living expenses in cash form (in this example, $250,000), and allowing the rest to be exposed to a growth market like the share market. If the share market falls, the retiree can draw their living expenses from the $250,000 in cash, avoiding the need to sell shares at the precise time that the market is down, which would ‘lock-in’ a loss. In this case, in the event of a share market fall, the retiree would have five years for the market to recover before they needed to sell any shares.
This logic is often extended/inverted when it comes to younger people and their super. Because a younger person cannot normally access their super, they generally need less of a cash buffer within their super funds’ investment portfolio. This often allows them to have a larger percentage of their super exposed to growth markets. That percentage is then reduced as they approach retirement age and become more likely to need to withdraw cash from the fund.
The deposit that home buyers pay for their home can also be thought of as a buffer. The larger the deposit, the less chance there is that the buyer will suffer if the value of the home falls. This is because if the loan taken out to buy the property is relatively small, then it would take a larger fall in the value of the property before the loan came under pressure.
It always pays to remember that buffers are like fences: they can keep bad things out but they can also prevent things from expanding. As a simple example, if a person holds too much of their wealth as cash, then they miss out on the chance to grow that wealth through exposure to growth assets such as shares or property. Over time, the purchasing power of cash generally reduces. If inflation is running at 3% per year (which is the top end of the RBA target for inflation), then we would expect prices to double every 24 years. For a 65 year old person just starting retirement, this means prices would be twice what they are now before they turn 90. Too much of a buffer can create longer-term risks.
That is why good financial planning involves the sensible use of buffers. It is also why buffers need to be tailored to everyone’s unique situation. So, next time we meet, listen out for our thoughts about how you can best use buffers in your own financial planning. Our goal is to have you singing in all kinds of weather.