A Simple Welfare Analysis of Borrowers and Savers

One of the missing piece in the discussion on CPF returns is the peg to HDB housing loan. This is an important point of consideration since any increase in CPF rates will have considerable welfare consequences on these net borrowers - people who took out a HDB loan which is larger than the available balances they have in their CPF accounts. I too was once a net borrower, when I first got married, emptied my OA, and took out a loan of almost $200K from HDB for my flat.

As we know, HDB loans are granted at a concessionary rate of 2.6 per cent, pegged at 0.1 per cent above ordinary accounts (before new changes are introduced). We do not need to know the details about the intra-government financial arrangements, but it suffices to note that for HDB to grant the loans, the money has got to come from somewhere.

I set out then to compare two sets of outcomes using highly simplified assumptions. These assumptions are meant to follow closely to how the current system operates, but I ignore some complicating rules where they occur (I will tell you where they are in the course of the post).

The Life Cycle of a Hypothetical Couple

A young couple starts working at age 25 with a combined income of $35k per annum. Every year, they get a wage increment of 2 per cent until they are 50, after which their wage stagnates. For simplicity, they are assumed to be continuously employed from 25 to 65 until they are retired. They save 33 per cent of their income and consume the rest. At age 30, they make a major decision of their lives to buy a HDB flat and in the process take out a 30-year $250k loan to finance that purchase. How would they fare with and without the CPF system?

With the CPF system, their savings (which is 33 per cent of income) is split between OA (which pays 2.5 per cent returns on net balances) and SMA (which pays 4 per cent). I ignore the changes in contribution rates for different age groups and contribution cap for convenience, and savings is split 65/35 between OA and SMA. The mortgage payment can only be deducted from the OA account. The interest on their mortgage is 2.6 per cent. The rules I applied here are a good approximate of how the current system functions.

Without the CPF system, they can invest their savings (again 33 per cent of their income). I posit several scenarios of long term returns (4 to 7 per cent). However, without the CPF system they can no longer borrow at 2.6 per cent for their property since the government can no longer supply that source of fund. The couple will have to borrow from the market at 4.5 per cent, which I believe is a fair estimate of long-term borrow cost. Of course, this parameter can be adjusted and the results re-evaluated in a sensitivity analysis.

Retirement Funds at Age 65

How would the couple fare under the two different systems at age 65? How much retirement funds would they have with the different systems? It turns out that the couple which starts out with $35k income is better off with the CPF system, mostly. Why is this so? In the earlier part of their life-cycle, they are net borrowers who take out a loan for their property. Since they have very little net balances in their OA account (because of mortgage deduction), any increase in CPF rates are not going to benefit them.

Conversely, they enjoy a 2.6 per cent interest rate on their property, which saves more than $3000 per year in mortgage payment each year over a 30-year period as compared to if they have to pay the assumed market rate of 4.5 per cent. Unless they are able to do very well with their investing their savings in the market, they are better off enjoying the concessionary housing rate that comes with the CPF scheme.

The High Income Couple

In the second spreadsheet, I change the couple's starting pay to $70k per annum. This is therefore a high income couple compared to the previous example. The high income couple is better off without the CPF system. Why? As they have high income, they become net savers much earlier in their life-cycle given the same loan they took out. As a result, the CPF accounts do not offer them a rate of return that matches the 4 - 7 per cent assumed to be offered by the market. They are better of without the CPF scheme - that is, to forego the concessionary loan rate and then be free to invest their savings in the market.

Winners and Losers

What does this whole exercise tell us? First, it confirms the simple microeconomics principle - borrowers lose when interest rate rises. On the other hand, the high income couple is mostly likely better off if their net savings is freed up to be invested in the market. The analysis between the two systems is sensitive to assumed rates of returns offered by the market, risks, income profiles and many other parameters. But within fairly reasonable estimates, the general result holds.

Second, if CPF has to increase its returns to members and at the same time passes on the cost of funds to other agencies including HDB, borrowers would have to fork out more for their mortgage. There is a real possibility of many poor families may end up net losers if that happens. The microeconomic consequences of pushing up CPF returns is therefore not clear cut. From whose perspective are we looking at when we say that CPF rates are too 'low', borrowers or savers? If indeed there is an element of welfare transfer, it is from the rich savers to the poor borrowers.

The fact that CPF has a net total balance of more than $120 billion may suggest to some that there are huge surplus savings. But remember, we have to knock off a couple of billions that belong to W Malaysians and not Singaporean households. And also that HDB obtains loan from the government at CPF rates in order to lend to purchasers (who borrow at 0.1 percentage point higher). How much does HDB 'owe' the government as a result of mortgage financing? $55 billion in total as of 2006. Let's assume all this is disbursed to borrowers. After accounting for all these, the net savings position falls significantly.

Furthermore, we are only talking about aggregate numbers and they mask the devils in the distributional details. How many net borrowing families are there? The number surely is not small. In fact, it is entirely possible that for every one rich net saver into the system, there are many more net borrowers. If that is indeed the case, and if rates of returns are pushed up, the number of losers will outnumber winners. Worse, the distribution will be in favour of the rich and against the poor.

It is really 'not so simple'.