One of the most time consuming task I have to do for comprehensive financial planning is often related to the allocation of limited resources. Under comprehensive financial planning, there are a number of conflicting needs namely retirement planning, children's education and property purchases. For example, if one would to overcommit to a large property, it may jeopardise one's retirement as the interest paid for the mortgage over a long period would erode the retirement funding significantly.
To optimise and allocate resources, I would develop a modelling technique. I first learn about modelling when I attended a course on Financial Modelling in the context of stock valuation some time ago. Although financial planning and stock valuation are completely different matters altogether, I realised that financial modelling can be applied to financial planning in the context of resource optimisation. I would spent up to 10 hours to build the model for each comprehensive financial planning case.
But not all resource allocation requires a model to be built. Sometime, simple logic is sufficient. What is needed is a clear understanding of government rules. The following is an example of resource optimisation using logic and is adapted from one of the case I did (figures changed though):
Optimisation example using CPF Retirement Sum Topping-Up Scheme
John and Mary (not their real names) are in their early fifties. Resource to be optimise and allocated include property purchase, maximisation of returns from CPF and tax savings.
John's CPF Ordinary Account is $123,456 ; Special Account is $12,345.
Mary's CPF Ordinary Account is $543,210 ; Special Account is $321,000.
John is a house-husband while Mary is a Managing Director of a SME whose tax bracket is at 17%. Both are debt free.
FIRST: In the Financial Modelling input parameters for the purchase of a second property assumes utilising Mary's CPF-OA only. I did not take into consideration of John's CPF-OA. John's CPF-OA stands at $123,456. I did assumed that John will eventually use the $264,000 Enhanced Retirement Sum (ERS) from his CPF-OA/SA for CPF Life when he is age 55 under the Retirement Planning section. Hence, his shortfall in meeting that ERS target is $264,000 - $135,801 (current OA+SA) = $128,199.
SECOND: The maximum amount that can be transferred to John's CPF-SA is limited by the current Full Retirement Sum. Hence, the maximum allowed to be transferred is $161,000 (Full Retirement Sum) – $12,345 = $148,655.
THRID: the money to be transfer to John's CPF-SA will not be available for purchase of a property. However, money in his CPF-OA is always available for property purchase.
FOURTH: The source of money to top-up John's CPF-SA can either be in cash or Mary's CPF-OA or John's CPF-OA
- To use cash, Mary can enjoy a tax relief but capped at $7,000 tax relief per calendar year. The benefit of using cash is the marginal higher return of getting 4% when cash is only giving 0%. While using cash to top-up John's CPF-SA means less cash to purchase a property, it must be noted that entire's of John's OA can be used for property purchase.
- There is no tax relief if the source is CPF-OA. The marginal higher return is 4-2.5% = 1.5%. From this, we can safety assumed that using CPF-OA to top-up John's CPF-SA can be ruled out.
FIFTH: Since it is better to use cash, the question is whether is it better to top-up John's CPF-SA to the maximum allowed (capped at Full Retirement Sum) currently at $161,000 or leave "some room" in his CPF-SA for Mary to continue to top-up $7000 every year and enjoy a tax relief.
To answer this question, let's assume Mary marginal tax rate is 17% until she retires 12 years later. If John's uses $14,865 to maximise his CPF-SA to the Full Retirement Sum, the loss of tax relief in Mary's remaining working years is $7,000 x 17% x 11 = $13,090.
However, in two years the $148,655 in the CPF-SA grows to $160,785 (compounded at 4%). The interest earned over the two years is $12,130 which is almost equal to the loss of Mary's tax relief for her remaining 11 working years. The interest earned is realised in just two years whereas the tax savings of $13,090 could have earn is only realizable over 11 years. In view of the time value for money, it is better for John's CPF-SA to be top-up to the maximum permitted which is $148,655.
Conclusion: Mary should use cash of $148,655 to top up John's CPF-SA. Tax saving for Mary is a one-time $7000 x 17%.