Many Singaporeans wonder, given the state-mandated 2.5% interest rate of the CPF Ordinary Account and 4% interest rate of the Special Account, why should anyone take on risk and invest their CPF money into the financial markets and index funds?

2.5% and 4% guaranteed interest rate seems rather alluring. However, we ought to put that number into perspective and understand how financial markets and the economy-at-large works. Before anything, let us answer why bother exposing ourselves to risk at all, and how to be fairly rewarded for the risks undertaken.

This might be a long one so take a seat, get cosy but stay till the end. We hope this leaves you with a better idea on how to make better financial planning decisions, particularly with your CPF.

How our government determines our OA rate

As per the CPF Board, “OA monies earn either the legislated minimum interest of 2.5% per annum or the 3-month average of major local banks’ interest rates, whichever is higher. The OA interest rate will be maintained at 2.5% per annum from 1 January 2020 to 31 March 2020, as the computed rate of 0.64% for bank rates is lower than the legislated minimum interest rate.”

We might say that the government is doing Singaporeans a service by according 1.86% more than the 3-month average interest rate offered by our major local banks. When the bank interest rates were higher in the past, our OA rate was higher too – peaking at 4.69% back in 1991. Since the 2000s, as interest rates have stabilised at roughly the current rate, the OA rate has stayed at the legislative minimum of 2.5% too.

CPF OA Rate vs Savings deposit rate

CPF OA rates versus stock and bond market returns

We compared CPF OA rates with the SGD returns of the MSCI ALL Country World Index (large-caps developed markets and emerging markets), MSCI World (large-caps developed markets only), S&P 500 (US large-caps) and Bloomberg Barclays Global Aggregate Bond Index (SGD-hedged) since 1990.

Annual returns comparison chart

Understanding the characteristical return of varying asset classes is crucial. Particularly, one should consider the success rate in beating the CPF OA interest rate by taking on risk. The time horizon (length of time invested) required to stay invested to be reasonably certain of success.

Periodic success rate over CPF OA

As observed, generally as the time horizon increases, the likelihood in outperforming the CPF OA rate increases. If we diversify our investments into global stocks (Global Equity for example), you might expect that in 8 out of 10 of the years invested, you would have beaten the CPF OA. Over a 20 year period, that number goes up to 10/10 (historically speaking).

It’s about your time horizon. The longer your time invested in the market, the better your chance at success

This presents a rather compelling argument to take on risk given a relatively long enough investment horizon. However, our behaviour and emotions often get the better of us in capturing long-term market returns. Let us explain

The chart below presents the historical returns of stock indices. Pay attention to the worst outcomes for shorter time horizons

Periodic annualised returns: average, best, worst

For you finance guys: If the stock index appears low. Kindly note that all figures have been converted to SGD, while the industry typically presents figures in USD. USD: SGD rate has climbed 1.87 in 1990 to 1.38 in February 2020 as this is written, a 36% appreciation. BBGA also appears high as it is SGD-hedged, following institutional best practices when a portfolio is constructed.

Could you live on 40% loss on investment value as stay invested?

If your answer is no, it presents a tamer risk appetite, of which 100% investment of your CPF into high-risk funds of any length of time might be a bad idea as short-term shocks would throw you off course. Sadly, figuring out how to steer around sharp downturns to a significant degree of certainty is impossible, thus a lower risk portfolio might be recommended. If you invest into a globally diversified 60% MSCI World Index & 40% FTSE World Government Bond Index portfolio (“60-40”), your maximum loss drops to ~28%.

Generally, why do stocks return more than bonds and compensates more than the CPF rate?

This is structural as opposed to sporadic. Stocks are structurally riskier than bonds as in the event of a company’s bankruptcy, bondholders get paid back before company stockholders receive their first penny. The market thus generally compensates stockholders more for undertaking greater risks. We call this equity and credit risk premium.

How to be more confident in capturing significantly better returns?

  1. Diversify globally

The S&P 500 has proven itself to be a generally superior way to have invested your money. While the S&P 500 (representative of US large-cap equities) is great and makes up a significant portion of the portfolios we are invested into, it too can have extended periods of underperformance, such as a -9% return in the decade of 2000 to 2010 while emerging markets, on the other hand, boomed 162%. The future remains uncertain and we recommend our clients to stay diversified globally, across developed and emerging markets.

2. Be strategic. Not tactical

A strategic asset allocation implies an investment and rebalances towards an asset allocations representative of your needs, while at a risk tolerance suitable for yourself. Tactical asset allocations are attempts at beating the market by timing your entry and exit into funds, changing your asset allocation based on how you or the “expert analyst” might perceive the financial markets and global economies. Unfortunately, a tactical approach has proven to hardly work as the average investor returned 1.9% over the last 20 years, likely due to high fund management fees involved in active trading.

Be patient. Humble. Stay invested

We hope this article sheds some light on the importance of investing your CPF and its importance. Millennial Finance’s process begins with reviewing your financial circumstances, concerns and goals before recommending a suitable plan for you. Contact us today to schedule an appointment. 

Something about this article that was not clear or do you have a question pertaining to CPF investments? Let us know below or drop us a message.

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