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Self Managed Super Fund (SMSF) Article
Generating money is still a modeller's minefield
By Tony Negline.
This article may be out of date.
29th April 2009
When a financial adviser compares different financial planning strategies they generally use various modelling tools.
Anyone who has tried to do this modelling will know it's not easy work.
Hugh Bannister of Optimo Financial has spent most of his working life building computer software modelling tools for the energy and finance leasing industries. Over the years Bannister has also received personal financial advice which has not served him well. As a result his business decided to develop a prototype to see if it could build better financial planning modelling tools than what is commonly available to advisers.
"As we started researching for this development, it became abundantly clear that the rules are really complicated". In fact when combined as a whole, all the financial planning rules represent an "impressive labyrinth and lead to what mathematicians call non-convexities," he said.
This means that "near enough is not good enough. The right strategy is not obvious and fundamentally difficult to find and to be sure you've actually found it."
He believes that you won't find the best strategy "by just fiddling with a few numbers and looking at the outcome."
He says that he and his colleagues have a profound respect for the challenge of what financial planners are supposed to do. But "we retain some doubts as to how many actually do it properly," he said.
He has a number of examples to back up his claims. One of them involves looking at Jim a middle income earning 51 year old who has dependant children and what he should do with a $200,000windfall.
One obvious strategy is to consider using the proceeds to repay some or all of any outstanding mortgage. But what should happen if this is not a valid strategy (suppose Jim doesn't have a home mortgage)?
Most financial planners would probably recommend putting all of the money into superannuation as an after-tax (or "non-concessional") contribution because of its tax concessions. Optimo Financial's modelling system found that this is probably not the best strategy.
Instead Jim will pay less tax and have greater individual wealth by sacrificing most of his salary into super whilst living off some of the windfall and the interest earned on it whilst it's put into cash investments and also using a Transition to Retirement (TTR) pension when he becomes eligible.
I asked Optimo Financial to run the numbers taking into account the Family Tax Benefit which can play havoc with some salary sacrifice strategies. Their salary sacrifice, living off some of the windfall and TTR pension strategies still come out on top.
Now even this strategy analysis is fraught with danger for at least two reasons. Firstly, what happens if Jim's conditions of employment don't allow him to salary sacrifice? According to Australian Bureau of Statistics data only a small proportion of employees actually use salary sacrifice. The real reasons for this aren't crystal clear but one of the reasons is that many businesses don't make it available.
Secondly, will Optimo's preferred strategy still be the best when salary sacrifice super becomes less tax effective because of tax changes that start on 1 July 2009? From this date, salary sacrifice contributions will become part of "income" for various government benefits such as Family Tax Benefit.
Optimo Financial ran their system taking into account these new rules. The salary sacrifice, living off the windfall strategies and TTR pension are still number one but some of the tax efficiency is lost.
In the Weekend Australian of 18-19 April, my colleague Christopher Pearson reviewed a book by University of Adelaide geologist, Dr Ian Plimer, which contains the following quote, "It is very easy for the modeller to produce the predestined outcome before the model can be run. This is a common flaw in mathematical modelling. A model is not real. Models are not evidence. Models with simulations, projections and predictions prove nothing. All a model shows is something about the model itself and the modellers … As the Talmud states: 'We do not see things as they are. We see them as we are." '
Plimer's book is actually about modelling the impact of human induced climate change. This quote could be applied to financial planning modelling.
The above modelling doesn't take into account any asset allocation issues. It assumes flat earning rates for various different types of investments categories.
Further it doesn't take into account gearing. For example suppose Jim wanted to use his windfall to borrow to invest into a rental property and earn some of the tax concessions that attach to this such as the 2.5 per cent building allowance or various depreciation allowances. The Optimo Financial system could have done these calculations if required.
These new modelling tools that Optimo Financial has created are an important evolution in financial planning.
That said we should keep financial planning modelling in perspective. No one can predict will full accuracy many potential inputs into financial planning modelling especially the outcome of financial markets or the likely shape and operation of the tax and super systems.
John Henry Newman, writer, poet, Oxford don and later a cardinal of the Catholic Church once wrote, "Quarry the granite rock with razors, or moor the vessel with a thread of silk; then you may hope with such keen and delicate instruments as human knowledge and human reason to contend against those giants, the passion and the pride of man."
Newman wrote this about how to run a university but he could have just as easily said it about the bewildering workings of financial markets and those who participate in it.
Jim's super account balance after 10 years
July 2009 rules
Typical Contribution to Super Strategy
Source: Optimo Financial; Assumed earning rates: cash - 6.0%, super – 8.0% and pension – 9.2%
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