A UBS survey among high networth individuals in Singapore and Hong Kong revealed interesting findings:
- 62% of investors admitted that they did not know how much to save for retirement
- Only 1% claimed to have begun to plan for retirement
- Asset allocation is the same regardless of the difference phases of retirement planning. Asset allocation is something like:
- 60% in stocks
- 40% in real estate
- 32% in cash
The asset allocation adds up to more than 100% because more than one asset classes would be used for retirement planning.
The first thing that come to my mind is whether is it even necessary to plan for retirement. While only 1% of high networth have begun to plan for retirement, it does not mean that the remaining 99% did not plan. In fact, the 99% already have their ‘retirement’ pot planned for by their private bankers.
Among the high networth cases I’ve seen, there are basically two kind of clients.
The first type is the first generation high networths. This means they are rich because of their own effort. Typically, they are business persons. Majority of the wealth is in their business. They do not have a significant sum of money in the bank. So they may not be private banking clients. But I also have met high networth individuals who are professionals. They are the senior civil servants, medical specialists and CEOs. Typically, majority of their wealth is in properties. Again, they may not be private banking clients because their investments and cash in the bank is limited.
The second type of client is the second generation high networth individuals . These individuals were given or inherited a large sum of money from their parents. Widows who inherited large sum of money from the deceased spouse also count as second generation. These second generation are usually financial illiterate. They are unable to appreciate basic concepts such as time value for money, cash flows and credit risk. The reason is because they did not have to work hard. Managing money is unimportant in the sense that there is a perception that the investment pot is so large that there will always be sufficient money for retirement.
Frankly speaking, the asset allocation done by private bank is always the same:
- There will always be a Universal Life
- Premium financing to support Universal Life.
- Structured notes & products of all types including foreign currencies.
- Junk bonds
- Loans to buy junk bond.
- Unit trusts (also known as favor of the month).
- Usually there will be very little cash left in the account as majority are invested.
I will write on Universal Life and junk bonds.
How Universal Life is mis-sold to high networth individuals
To me, Universal Life is often mis-sold. All sort of reasons is used for Universal Life such as:
- Coverage for short-term liabilities such as mortgage and dependents. I know of an individual who told me that his private bank proposed Universal Life as the insurance to cover his mortgage! Yes, it is unbelievable. This will be considered as major infraction under the Balance Score Card. As Accredited Investors, the client is not entitled to any protection under the Financial Advisers Act. The client cannot complain to FiDREC and to MAS. A more suitable product is term insurance or mortgage reducing term. But commission is insignificant compared to a Universal Life.
- Retirement planning whereby the cash value is withdrawn over a period of time. This is the worst type of proposition. When cash value is withdrawn from the Universal Life, there is a high chance that the Universal Life will lapse due to the inability to pay for the escalating insurance charges. Moreover, the returns are terrible. By the way, withdrawal of cash value from a Universal Life is not possible without the approval from the bank if there is premium financing. A more suitable type of products is to purchase actual retirement products manufactured by insurance companies. These retirement products do not have coverage unlike Universal Life and it offers better returns.
- Legacy planning. Legacy planning is also known as estate planning. But to the private bank, legacy planning means leaving behind a large sum of money to family members. This is done by buying insurance using Universal Life. Frankly speaking, the high networth individual is already so rich, legacy planning is not necessary. Estate planning is critical importantly though.
Whenever there is a Universal Life, there will always be premium financing. I have never seen anyone who buys Universal Life without premium financing.
The client is often told that since the crediting rate of the Universal Life is higher than the interest, the interest in the Universal Life can pay for the loan interest and the client can earn a profit. This is totally nonsense and very misleading. The crediting rate on the Universal Life is applied on the Account Value (also known as the notional value). The interest cannot be withdrawn. If it is withdrawn, there will be a surrender penalty. Thus, during the penalty period (usually 15 years), the interest in the Universal Life cannot be used to pay for the loan interest. This means the client will be negative cash flow for 15 years before he is able to use the interest in the Universal Life to pay for the loan. This kind of misleading loan advice is not governed by any regulatory statues. Hence, the private banker can say anything he likes without infringing on any laws.
It is also a very bad idea to do premium financing using the Universal Life as a collateral. The benefit of instant liquidity creation is lost once the Universal Life is used as a collateral because the Universal Life has to be assigned to the bank. The bank will only pay the proceeds after deducting money owed. Universal Life that is used as a collateral cannot have insurance nomination. Another reason why it is a bad idea to use Universal Life as a collateral is because the client will be at the mercy of the bank as the bank can charge exorbitant loan interest. Typically the loan interest is based on some proprietary floating rate plus a spread. A better idea is to apply for home equity loan using existing properties as collateral. Home equity loans have been commoditized because there are many mortgage brokers in the market place. The advantage of using housing loans to leverage is because you can shop around for the best terms and conditions and the ability to refinance with other banks after the lock-in period. There is no such thing as refinancing if the Universal Life is held as a collateral with the bank.
Why junk bonds are often recommended
Junk bonds are common asset classes in a high networth’s portfolio. There are two primary reasons.
First, these high networth individuals are usually second generation who are financially illiterate. They expect a high amount of income from the products they buy from the banks without any appreciation of the risks involved. To meet such unrealistic expectations, private banks are pressured to recommend junk bonds. They face huge competitions from other banks and so it is important that they keep their client happy.
It is no big deal if the junk bonds are just 10% or 20% of the bond portion of the portfolio. But what can be shocking is I’ve seen cases which 100% of the entire bond portion of the portfolio is in junk bonds. The bond portion supposed to provide some level of safety while the remaining portfolio of the portfolio is typically invested in high risk investments such as structured notes and hedge funds.
If 100% of the bond portfolio is in junk bonds, it implies 100% of the entire customer’s networth is in high risk investments! What kind of asset allocation is this? I think monkeys can do better.
The second reason why junk bonds are often recommended is because it is used to pay for loans. Typically, these bonds are leveraged. The income from these bonds are used to pay for the interests of these loans. Obviously there must be some meaningful income from these bonds to pay for the loan otherwise the proposition is not enticing.
Not all bond can be leveraged. In order to leverage bonds, it must fulfill two criterions:
- High coupon rate / high yield - sufficient to pay the loan’s interest and have a meaningful money left over for the client.
- Low duration risk. This is to avoid margin calls if interest rate increase. The necessity for low duration risk means the years to maturity cannot be too long.
What has high yield and has a short number of years to maturity? Junk bonds!
But not all private bankers know how to manage duration risk. Last year, I met an individual who invested in bond funds (i.e. unit trusts). The bond funds produce regular dividends. The bond funds are leveraged. As I was in discussion with the client, her private bank called telling her that her bond funds may have a margin call. She got shocked and almost fainted as she thought the bond funds were safe. She cannot afford to top-up cash if the margin call would to occur because majority of her cash is invested. I checked and found that the unit trusts were invested in junk bonds. The unit trusts declined in value probably due to the raising interest rate environment and perhaps due to widening of credit spread. What was for sure is that it is impossible to calculate the precise duration risk of a unit trust bond fund.
Why high networth need to plan for their retirement?
Only 1% of high neworth plan for their retirement because 99% already have their retirement planned for them by their bankers. Yet, 62% of investors admitted that they did not know how much to save for retirement.
The asset allocation recommended by the typical private bankers is often nonsense consisting of the usual leveraged Universal Life, junk bonds and structured notes.
The UBS Survey shows that a typical high networth intend to use stocks (60%), real estate (40%) and cash (32%) to fund for their retirement.
In reality, majority of the so-called second generation high networths are not in stocks because they are financial illiterate. They may have real estate but that is because of inheritance. And of course they have no cash because majority are invested in junk bonds. To get cash, they need to further leverage.
Personally I don’t like these second generation high networths. They are one of my worst clients because their lack of financial knowledge means they cannot differentiate between good and bad advice. So they tend to listen to the persons who shouts the loudest and has the gift of the gap. See this article on Case study of a typical 2nd generation high networth portfolio for further reading.
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