Mary Holm: The mortgage or the KiwiSaver?

When debt is low, paying down the mortgage might not be best bet. Photo / File

My husband and I are in our early 40s. I have a pension but he does not. In a few months we shall be $800 better off a month, so we are wondering whether to pay off our mortgage quicker, currently owing $240,000, or set up a KiwiSaver scheme for my husband.

It sounds as if neither of you is in KiwiSaver. I suggest you both join, even though you have another pension.

While paying off your mortgage is a great idea, KiwiSaver is probably even better. That's because it turbocharges your investments.

If you're on a low wage, the contributions from the government and your employer more than double your own contributions. It's not quite so good for those on higher wages, but still, even on $200,000 your contributions are multiplied by 1.8.

If you're self-employed and putting in up to $1043 a year, your contributions are multiplied by 1.5.

If 1.5 or twice as much goes into your savings, the total at retirement will be 1.5 or twice as big. That's huge. It means KiwiSaver beats any other investment, once you allow for risk.

Compared with debt repayment, contributing to KiwiSaver won't beat paying off credit card or other high-interest debt, but it's highly likely to beat paying off your mortgage.

What's more, you're diversified in KiwiSaver. Depending on your fund, you may be in cash, bonds, shares and commercial property, as well as your home. And you can learn something about investment markets.

In your particular case, it sounds as if you are an employee with your pension scheme. If you join KiwiSaver, you'll have to contribute 3 per cent of your pay for a year, and you probably won't receive employer contributions if your boss is putting money into your other scheme.

However, after a year you can take a contributions holiday of up to five years, and renew that until retirement. You can then contribute any amount to KiwiSaver, and I suggest you set up an automatic transfer of $87 a month to get the maximum $521 annual tax credit.

If your husband is self-employed, he should do the same. If he's an employee, there's all the more reason to be in KiwiSaver, to get the employer contributions.

What's more, employer contributions could rise if a recommendation from the Commission for Financial Capability (CFFC) released this week takes effect. It suggests minimum employer and employee contributions should gradually rise from 3 to 4 per cent of pay.

The commission has also recommended:

• Allowing people to set up automatic contribution increases, rising by 0.25, 0.5 or 1 percentage point a year, to a set maximum.

• Adding 6 per cent and 10 per cent of pay as employee options. Currently you can save 3, 4 or 8 per cent, although you can also make extra payments directly to your provider.

I like these two recommendations better than a compulsory rise to 4 per cent, because they give people choices. Still, 3 to 4 per cent is not a big increase, and long-term savers would end up with considerably more at retirement.

Another CFFC recommendation is to change the name from contributions holiday to savings suspension, a good idea. "Holiday" has happy connotations, whereas stopping KiwiSaver contributions is often not a good idea.

The commission also recommends changing the maximum contributions holiday from five years to one year. That means you would have to renew your holiday every year, but it shouldn't be a big deal.

One more point: Being in KiwiSaver may not use up all of your $800 a month. Put the rest into mortgage repayments.

Market threat?

I have read with interest your recent Q&As on passive funds. Although I agree that passive funds clearly have a cost advantage, I do wonder about what effect passive funds have on the functioning of the market.

Passive funds simply buy and sell individual companies in an index in proportion to their overall weight in that index. Without enough active managers setting the relevant price for individual companies, isn't there the potential that passive funds may be contributing to the mispricing of companies?

In an extreme case where there are no active managers, no individual company will ever change its overall market value relative to other companies within the index.

Obviously this is extreme, but I wonder what the risk is to the market as index funds grow. Surely passive funds are just free-riding on the work of active managers to accurately price companies?

I absolutely see the benefit of passive funds but would be interested in your thoughts.

For decades I've suggested readers put their long-term savings, including KiwiSaver, into index funds, also called passive funds.

As you say, these funds charge lower fees, usually considerably lower. Although many actively managed funds will perform better than an index fund in any one year, over the years the same ones don't tend to outperform. It's impossible to pick in advance the few that might. Given the fee difference, index funds are a better bet.

As the Economist magazine said recently: "In chasing performance, investors are pursuing a chimera. The FCA [the UK's Financial Conduct Authority] finds, like others before it, that active managers underperform the index after costs. And it finds little evidence of persistence in outperformance.

"It looked at the best-performing quartile of funds over the 2006-10 period and examined how they performed in the next five years. Just under a quarter stayed in the highest quartile, exactly what chance would suggest. More than one-third of the stars of 2006-10 slipped to a bottom-quartile ranking or were closed or merged."

Over 20 years, the FCA calculates, an active manager's charges can eat up a third of an investor's return.

It added: "Over 20 years, the FCA calculates, an active manager's charges can eat up a third of an investor's return."

On the strength of articles like that, passive funds around the world are becoming so popular that you and others, including Brian Gaynor in his column last week, are expressing concern that sharemarkets won't function properly.

It's true that the markets need active fund managers and other investors to research shares, buy the ones they think are underpriced, and sell the ones they think are overpriced. Although the total effect of all these decisions can misprice shares in the short term, over time the markets tend to efficiently price shares at what they are really worth.

Could active funds become so unpopular that this mechanism will no longer work?

There will always be some fund managers and individuals who believe they can outperform the market. If fewer people were trying to do that, the opportunities to find underpriced shares would surely increase.

Some active funds would start to consistently beat index funds, and some investors would decide it was worth paying higher fees and move back to those funds.

Supporting my argument is the UK's highly esteemed Financial Times in a recent editorial: "If too much money shifts to the passive side - free-riding on the work of a dwindling number of active managers - the market could become unstable. Bubbles could form as money moves indiscriminately into poor quality or mispriced assets.

"This is possible but we are a long way from there yet. The world is sloshing with capital looking for inefficiencies, and should the balance in performance shift back to the active side, the rush to passive products would reverse quickly.

"For now the best advice for most investors is to keep focusing on cost." To which I would add: If the balance did shift to where active funds are a better bet, a long shot, KiwiSaver and other investors could simply move funds then.

Passive funds

I read Brian Gaynor's column in the Herald last Saturday entitled "Perils of the passive strategy". Do you have any comments on his story? I thought it was quite conciliatory compared to recent stories on the topic.

I see that Gaynor is an active fund manager, and they charge higher fees than passive funds, so it is obvious where he is coming from.

It's probably fairer to say that Brian Gaynor's firm Milford Asset Management is an active fund manager because he believes his funds can perform better than index funds over the long term, so he thinks higher fees are justified.

But I do have some comments on what he said:

Gaynor seems to imply that we should support active-fund managers so they can stay in business to keep the markets operating well. I can't feel sympathy for fund managers. In 2006, Fred Schwed jnr wrote a book called Where are the customers' yachts?, after someone asked that question upon seeing the wealth of Wall Street bankers and brokers. Fund managers also appear to be doing okay in the current environment.

What's more, NZ fund managers have been handed a huge gift in the form of KiwiSaver.

Suddenly their funds became much better investments, courtesy of taxpayers and employers, whose contributions make KiwiSaver so attractive. Fund managers that can't make a buck these days don't deserve to.

Gaynor says I and others rely mainly on US research. But Bart Frijns, at the Auckland University of Technology, has said: "The evidence on fund performance in Australia and New Zealand is not very different," from US research.

The results of his and a colleague's research on KiwiSaver growth funds imply "that investors need to be prudent about fund fees and should not pay high fees for self-proclaimed superior investment skills," he says.

"A fund manager who mistakes his ability for talent (and charges a high fee), but in reality is doing nothing more than taking exposures to known risk sources (which can be achieved at a much lower fee), will not only be overcharging his customers for a skill that he or she does not possess but also exposing customers to risks that are not communicated to them, and are probably not well understood."

Frijns' papers are at here.

Here's a challenge: Can any New Zealand active fund manager refute his research?

Another point: When New Zealand fund managers say their funds outperform the index, many are not using an appropriate index. As a recent example in this column showed, when you make a fairer comparison, the fund underperforms significantly.

Gaynor says: "If a company represents 10 per cent of a benchmark index, then a passive fund will invest 10 per cent of its money in this company, regardless of its prospects."

True in theory. But I doubt if any passive fund uses an index with such big holdings.

Smartshares' big New Zealand Top 50 fund follows the NZX 50 Portfolio index, with all shareholdings capped at 5 per cent. And several index funds invest in a really wide range of companies.

Gaynor compares investing in passive share funds with investing in failed finance companies, because he says they also invested passively. The two types of investment are entirely different. Passive share funds are as safe, if not safer, than active funds. Failure of either in these days of increased regulation is highly unlikely.

A final comment: I'm not out to make enemies of active fund managers. My only motivation is to help readers get into the best investments for them.

Mary Holm is a freelance journalist, a director of the Financial Markets Authority and Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. Her website is www.maryholm.com. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com or Money Column, Business Herald, PO Box 32, Auckland. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice.