Outrunning the debt cycle

Dominic McCormick

Albert Einstein was reportedly quoted as saying: “The most powerful force in the universe is compound interest”.

Veteran newsletter writer Richard Russell frequently refers to the power of regular compounding of returns over the long-term as the key to long-term wealth, especially in the short article “Rich Man, Poor Man”.

In that piece, Russell cites a simple study that shows that at age 65, someone who invested $2,000 a year for eight years from age 19, then left the money to compound, will still end up with more than someone who puts $2,000 in ever year (that is, 38 years) from age 26, just eight years later (both assuming a 10 per cent return).

In terms of the amount accumulated, the first investor makes an outstanding 66 times their money, while the second investor makes a still solid 11 times.

Obviously, tax and fees can complicate things in the real world, but the principle is clear. The key is making a start as early as possible, discipline, consistent positive returns and a long-term perspective.

However, today many don’t seem to understand this concept or perhaps are not in a position to maximise the awesome power of compounding.

Indeed, many individuals and households risk experiencing the opposite force for much of their lives, the compounding of debt, particularly non tax-deductible debt.

I am not just referring to the increasing number of low income earners facing bankruptcy from excessive credit card debt. Rather, a much larger part of the population risks being overwhelmed or heavily constrained by a range of debt obligations.

I suspect this will prevent or limit the ability of many individuals and households to undertake any serious compounding of returns and resultant wealth accumulation over the course of their lives.

Many take comfort in the average statistics across the Australian population as a whole that suggests our gross assets still far surpass liabilities.

However, this hides the current and growing inequality of this wealth, with the current and emerging generation of Australians increasingly struggling.

Unfortunately, the current relatively benign economic investment climate (and low unemployment and strong asset prices) is hiding much of this looming problem.

It is simply too easy to get on this debt treadmill these days. In the days when I came out of university we had no assets, but we didn’t have any significant debts, or even large expenses either. (Fortunately, this was pre-HECS.) It wasn’t even easy to get into debt then.

Banks were notoriously tight, especially with mortgages, requiring large deposits and a consistent savings record. The best you could expect once you had a job was a credit card with a $500 limit or a personal loan for a few thousand dollars.

There were no home equity loans, margin loans or interest-only finance for structured products. You could live relatively cheaply and going out did not cost a fortune (at least to the venues I frequented).

These days it is very different. Individuals start work or leave university with often large HECS debts (albeit at concessional interest rates), and a plethora of financial services companies are ready to hook them into the debt habit almost immediately through credit cards (with regularly increasing limits), personal loans, mortgages and even margin loans and structured products.

On top of this, they generally have high expenses — large mobile phone bills, a passion for expensive bars and restaurants (almost all the cheaper ones have disappeared) and a need to spend big each year for holidays.

All up, a recipe for saving little and accumulating expensive debt, which feeds on itself and, importantly, does not allow them to move into a position to benefit from compounding returns.

The commitment required to buy a house these days is enormous but, ironically, it is relatively easy to do, and the social pressure to do so is enormous.

Decades ago you needed a large deposit (perhaps 25 to 50 per cent) and an impeccable savings record to even qualify for a mortgage. However, buying a house then at least made economic as well as emotional sense.

The rental yield, which was avoided by owning a house rather than renting, was usually at least 6 to 7 per cent per annum, and you could be comfortable that wage inflation of as much as 10 per cent-plus would quickly deflate away the debt burden of monthly repayments.

As a result, many came to fully own their home much quicker than expected and could quickly move onto accumulating other investments and benefiting from compounding.

Not today.

Home prices relative to current income are much higher (and among the highest in the world). Net rental yields are at 2 to 3 per cent per annum, wage inflation is much lower and from current levels prices are less likely to keep appreciating.

What’s more, with much smaller (or in some cases no) deposits, the levels of debt being taken on are also much larger, even with lower nominal interest rates.

Many are therefore taking on enormous debts that they can expect to be paying off for decades, perhaps even at retirement.

There are two important tax advantages from owning one’s home. The first is that one is effectively receiving the imputed rent on the property tax free, and the second is that it is exempt from capital gains tax on sale.

However, the first advantage only really fully accrues when one has fully paid off the mortgage (since it is offset by having to earn pre-tax income to pay interest). It is also a lesser advantage in absolute terms when net rental yields are low, as is the case currently.

The second advantage may clearly not be an advantage at all if we get an extended period where prices fail to rise.

Buying a home is also a form of forced savings for some less disciplined individuals and there are clearly lifestyle and emotional benefits to owning a home.

However, for many households, the burden of buying a home in the current environment (in the capital cities at least) is going to ensure many are never in a position to benefit from compounding of returns (at least outside super). They risk being stuck in a debt straightjacket that seriously inhibits their financial flexibility. In this context, perhaps buying a house is not the cornerstone to financial security that many people think it is.

What about so called ‘good’ or tax-deductible debt? Aren’t those who only take debt to buy an investment property, gear into shares or invest in their business doing the right thing (perhaps secured by the equity in their home).

It certainly is better than non-deductible debt, but those that automatically assume that all deductible debt is ‘good’ debt may be missing the point when it comes to compounding returns.

The reason compounding works is that one is reinvesting returns on top of previous returns.

Ideally, that return is reasonably consistent in the form of income or at least reasonably reliable gains. If you have too much debt against such investments you risk there being no net returns after interest to reinvest. Negative gearing that relies only on capital gains can obviously be a poor strategy if the capital gains are not there.

I am certainly not against gearing to invest and do so myself. However, one of Richard Russell’s Rules (and Warren Buffet’s) is, “Do not lose money”.

One cannot get away from the fact that, all other things being equal, gearing increases your chances of losing money, simply because you need a higher return to cover your interest cost than if it was all your own money. I view gearing as an adjunct to an investment strategy, a tool to bolster your ability to back good investment ideas, not an investment strategy in itself.

I am not sure that all the gearing and structured ‘products’ offered today can be seen as a tool for enhancing an investment strategy.

Indeed, many of the structured products with as much as 100 per cent gearing have just become a bit of a tax-driven punt — where you are hoping your return will exceed the interest and fees you pay on an annual basis. Sometimes you will win, sometimes you will lose — but that’s not what compounding returns is all about. Typically, it is the financial services companies that are compounding profits out of these arrangements, not their investors.

Unless you have a really brilliant investment idea, starting an investment plan with no money and all debt is probably an unwise strategy. You are probably better off waiting until you have money to invest to get a more sensible (but lowly geared) investment plan going.

Why the downside to this debt treadmill is not obvious to many is that they have been continually bailed out to date by rising asset prices in recent decades.

The perception is that any debt taken on today, while it might seem large, will be much less significant as the assets rise in value. This is unlikely to continue indefinitely. It won’t be until the tide goes out that we see who has been swimming naked.

House prices are at levels where simple affordability will be a constraining factor to broad-based price rises for years.

At the very least, the debt won’t quickly depreciate in real terms as it did for purchases in previous decades, where inflation was higher or prices were being re-rated upwards as interest rates fell.

Shares are basking in an environment of still low interest rates and record profit margins, but this scenario is unlikely to be sustained. It is simply not reasonable to assume that the benign environment for being heavily indebted (even ‘good’ debt) will continue to be as well rewarded going forward.

Of course, part of the reason it is so easy to get into debt today is we have a much more sophisticated and flexible financial system. This has obviously brought some benefits as well. Margins for lenders have significantly reduced across a range of loans and borrowers are clearly benefiting from this.

Perhaps we have simply gone from a system that was overly restrictive to one that is overly loose. If people are beginning to get into trouble now after a few interest rate rises and a small fall in some property prices, what will happen in the much tougher environment that is inevitable at some point?

What about superannuation? Surely super is the answer, as it is the one vehicle where everyone can compound returns in a tax-advantaged manner, particularly with the changes in the last Budget. In theory this is partly true, but there are some practical problems.

Firstly, superannuation is about saving for retirement. Retirement is just one destination for the benefits of wealth accumulation.

I doubt most people would consider themselves successful in compounding wealth if they had access to a large sum beyond age 60, but had to live like a pauper until then to achieve that.

Secondly, there is still enormous scepticism over super, partly because of this lack of access and partly because of fears the Government will keep changing the rules. This scepticism is especially prominent among the young, who would otherwise be in the best position to benefit from super and maximising the long-term benefits of compounding.

Thirdly, while in theory a compulsory 9 per cent or more of one’s salary over the course of 40 years with reasonable returns will compound to a significant amount, in practice it doesn’t happen like this for many. People take time out from employed work to travel, have families and start their own business, all times when they are likely to make little or no contribution to super.

The low average balances in super currently reflect these issues, although it is also partly due to the relative newness of the system. However, even those that are building large balances in super may find they need to use a significant portion of it simply to pay off debts when it becomes available and tax-free at age 60.

Clearly, part of this widespread heavy indebtedness comes from an increasingly competitive society, where there is significant pressure to keep up with the neighbours.

Many people seem to be going into their 30s and 40s overloaded with debt from credit cards, personal loans and mortgages, but many are also under pressure to gear into investments at the same time.

Patience to wait to buy things until you can afford them has gone out the window.

Part of the solution is obviously to spend less, something hard for the current and emerging generation to come to terms with.

It is no surprise that considerable wealth is often built up by those who are very careful what they spend (that is, those who are somewhat ‘tight’ and do not have a significant income).

However, people mistakenly think this wealth comes directly from the savings they make because they spend less than they earn. This is not the case. Rather, the wealth comes from their ability to benefit from the compounding of returns very early, to avoid the debt treadmill, and to understand the real value of such compounding over the longer term.

The rules to generating wealth over the long term are therefore pretty simple.

Buy consumer and other depreciating assets only when you have the money, thereby avoiding or minimising non tax-deductible debt (especially outside owner occupied housing), and start an investment plan (not overly geared) early.

In simple terms, at least early on, live frugally to cover expenses and have enough left over to start investing as early as possible, both inside and out of superannuation.

Unfortunately, few people follow these simple principles.

Too many people risk ending up on the treadmill in the other direction — bulging debts (much of it non tax-deductible) and expensive, highly leveraged assets and financial products that fail to deliver more than the cost of debt in the future.

The nightmare scenario is the current and emerging generation gear themselves to the hilt in a quest to keep up in today’s consumer driven and competitive society.

Apart from borrowing for consumer items and ongoing expenditure such as school fees and holidays, they excessively leverage themselves into expensive property and shares in a quest to ‘get ahead’, only to watch as the value of these assets fall as the baby boomers sell them to finance their retirement.

And the further rub — many of these assets, including, ironically, their own debt packaged up, are widely held by the one savings pool they would then be relying on to bail them out (and possibly pay off debts) at their own retirement — compulsory superannuation, even though they probably will have insufficient funds there in any case.

All of this occurring at a time when the mounting pressure on social security would reduce its accessibility. For many people it could all turn very ugly.

Dominic McCormick is chief investment officer at SelectAsset Management .