Wednesday, April 21, 2021

The CPF Conundrum Explained - Part 2

This is a continuation of the previous post on CPF

In the last post, we spoke about topping up 7k to get tax relief and also earn 4%pa. From an investment perspective, this 7k top up will earn 6-7% guaranteed IRR over time. This is damn good return which why it is capped at only 7k per year. There are also other things that we should do. Here's a recap of the three top ups.

1. We should top up $7,000 in our Special Account every year.
2. We should top up whatever we had withdrawn from our CPF (usually for mortgage) asap.
3. We should top up CPF for our loved ones to the extent possible.

We also explained CPF Life. For the benefit of new readers, let's just recap also. CPF Life is a scheme to make sure that everyone will have enough to draw out because some Singaporeans, unfortunately, actually don't have enough in their CPFs. We do not actually know how many percent, some blogs out there says like 75% of Singaporeans don't have enough while the Government says more than 50% have enough. Maybe the truth is somewhere in between but the impt angle is that whatever money that had been put away in the CPF, do not just disappear, the contributors or their nominees would eventually get them back. It won't be eaten up by the Govt. People go to legal courts to get this back from mistresses or illegitimate sons/daughters or domestic helpers. So no, the Singapore Gahmen, despite the many flaws, does not usurp our CPFs. 

Hence we are not discussing if the Gahmen would give us this money or not. It is a given that it would come back. For our purpose today, we would determine that the returns on the three types CPF top up are actually very lucrative. We have already done that for the first one in the last post.

Back to CPF Life, this is a scheme structured as an annuity that will pay out a fixed amount, usually three or four digits payout per month, until death. The amount that we have contributed will definitely come back to us, just not in one lump sum but over our remaining years. The interest earned does not belong us and this goes into the pool to benefit others. If we outlive our contributions, we benefit and take from the pool. If we do not, the remainder less interest earned goes to our kids, or our nominees. In short, CPF Life is a very sustainable scheme. It is not a way for the government to usurp our monies. 

The whole issue is being made complex bcos CPF is almost always used to buy properties. Trading real estate is a national pastime and huge fortunes had been made and lost. It gets even more complicated bcos whatever that we used from the CPF to buy properties had to be put back, with interest. This rule, while logical, really creates one problem which is also the crux of some of the arguments out there. Hence:

2. We should top up whatever we had withdrawn from our CPF (usually for mortgage) asap.

To put simply, when money is in our CPF, we earn interest on it, this is around 2.5-4% in 2021. But when we use this to buy property, we lose this interest and we have to top it up some day, supposedly. In reality, almost nobody tops this up bcos over time, due to the nature of compound interest, this amount explodes! Just a simple illustration, say we took out $100k to buy a property from CPF. If we have to top it up after 20 years, based on a compound interest of 2.5%, the full amount is $100k principal + $63k in interest! This is $163k. If we took out $200k, it would be around $326k to put back in CPF. These are no small sums. By taking this $100-200k in the first place, we "lost" the opportunity to earn $63-126k of interest. Shit right?

Again, in reality, we might not need to ever "pay" this. Since property bought using CPF can be pledged for many things, including the minimum sum that we talked about and when we hit 55, the government would also not dictate that we pay back this lost interest, since we are legally allowed to withdraw money out of CPF by that age.

So why the fuss of topping up?

Let's review from an investment angle here. When we draw money out of CPF to buy property, we are actually choosing between two alternatives: CPF or mortgage from the bank. The mortgage from the bank will actually cost us interest. Currently (2021), SIBOR is at 20-40bps plus spread of 60-80bps which means we pay 0.8-1.2% to the banks. This is quite low by historical standards but still it's money out of our pockets. CPF, in contrast, is 0%, since it's our money. And when we do need to "top up" back to CPF, it's still our money, so in essence it is a 0% borrow. So between borrowing at 0% or 1.4%. It is then logical to borrow at 0% right? Taking this one step further, since if money is left in CPF, it would earn 2.5% which is more than the 1.2% borrowing cost, in fact, we should borrow more and keep the CPF money and earn that 1.3% spread! Alas, the banks are not stupid and there is a limit as to how much we can borrow.

This banker and others won't let you borrow w/o emptying your CPF!

So this is the first part. Strike a balance, although somewhat up to the bank discretion, between CPF and mortgage. Then assuming everything goes well. At some point we need to decide between prepaying the mortgage or top up CPF or having cash in our hands. So here's the new decision tree:

i. Prepay mortgage
ii. Top up CPF
iii. Hold cash

To make it more obvious:

i. Prepay mortgage - save 1.2%
ii. Top up CPF - earn 2.5%
iii. Hold cash - earn 0%

Between saving and earning, it's actually the same, so the first option could also be read as "earn" 1.2%. The answer then becomes obvious right? We should top up our CPF! Again, this decision might be frown upon by the banks, so we need to tread carefully. And when the day comes that we are done with our mortgages, then between holding cash and topping up CPF, we should top up CPF. The caveat is of course we always want to have enough cash (around 12 months of expenses) to meet emergency needs. Of course if we have good opportunities to earn more than 2.5%, then we should go for it. But bear in mind that CPF's 2.5% interest is money from the government, we shouldn't waste this opportunity to earn it! In the last post, we also talked about Special Account, which gives 4%, hence all the more we should top up!

As alluded to above, these decisions should also be viewed against other means of allocating money i.e. buying stocks or bonds, but we must understand that investing while almost definitely means more return, usually 5-8% or even more, comes with risks and also less liquidity. We might lose 20% while trying to earn 8%. And once we are invested, like CPF, we cannot take this money out easily. So depending on our age, CPF could be more liquid! Esp for those already in their 40s and 50s.

Having said that, I would give more priority to first clear the mortgage and topping back up CPF as it gives a peace of mind. Sometimes in life, we need to clear some of these literally mind boggling issues to be able to think better and make better decisions. Although that doesn't mean totally not investing. If a good opportunity comes about, money has to be put to work!

3. We should top up CPF for our loved ones to the extent possible.

Finally, on to the last point. Yes we should also top up CPF for our loved ones, usually our parents. This is also limited to $7k per year and also tax-deductible but only to retirees or with some other conditions. Hence the same rules for the previous post applies. The good, or perhaps better thing is that we can also receive the money back in cash from our loved ones if they have enough to spare. 

As mentioned, the risk of doing all this is really regime change, which is a low probability event. The PAP should stay in power for the decade at least given the vote of confidence in 2015 winning almost 70% of the popular vote. Changes to the CPF system while possible would also be gradual and hence the 4% should stay high even if it is changed (maybe 3+%).

So, that's the moral of the story, do think about topping up CPF, especially for 1 and especially for those in the high income tax bracket. For 2 and 3, it should be done for those with spare cash. It will definitely make life easier in the future!

Huat ah!

Thursday, April 08, 2021