Why a PhD in economics is not required to see the flaws of CPF

One of Singapore's greatest mystery is : The existence of people who actually believe that CPF is a good tool to provide for the retirement needs of Singaporeans.

If I'm not wrong, Bart must be the blogosphere's greatest proponent of the CPF scheme. Doing a PhD in economics sure clouds one's clarity of thought. He claimed that

1) CPF returns are not low

2) Pegging CPF returns to that of GIC will precipitate a motivational problem on GIC's part

On his first point that CPF returns are not low, let's examine the 100 year Dow Jones Industrial Average chart here.

From 1900 to 2007, the index has risen from 51.6 to 14,000. That is to say over a period of 107 years, the index has given a return of 270 times.

Compare this to the return of a sum of money invested in CPF at a return rate of 4%. Over the same period of 107 years, the return is only a misery 66.5 times. That's almost excatly 4 times less that what DJI has yielded. We are not talking about a 10% , 20% or even 50% difference. DJI has out performed this CPF fund by 400%. So much for "CPF returns are not low".

And we haven't even take into account that the 4% "bonus" rate is only applicable to the first $60,000 of each CPF member's account if i'm not wrong. This totally wipes out whatever compounding effect there is, which is the most important thing in a long-term investment.

Of course one could argue (a popular argument) that the stock market is risky and cannot guarantee that profits will always be made. What happens when an event like the Great Depression occurs? Doesn't that mean that one's retirement funds would be wiped out?

Far from it. From 1900 to 1929 (market low during Great Depression), the DJI fell from 51.6 to 41.2, a plunge of 20%. If CPF funds had been used to invest in an index fund tracking the DJI, an event like the Great Depression wouldn't be a big deal. Each year, assuming the working life-span of the average Singaporean was 40 years and that there's an equal number of people in each age group, only 2.5% of the workforce will retire in that 1 year.

Assuming the retiring batch of the CPF members had the most money in that fund, that the newest members had contributed nothing and that the variation in monetary contribution varies linearly between those 2 groups, the retiring batch has approximately a 5% stake of the total fund. Hardly enough to bankrupt the fund. All will be fine when the market recovers (as has always been the case). Perhaps in order to hedge such a risk, adjustments to the monthly payout can be made based on market conditions. Whatever the case, an index fund will surely outperform a CPF 4% fix rate fund.

As for Bart's second point that pegging CPF returns to that of GIC will precipitate a motivational problem on GIC's part, i quote him

" A Principal-Agent Problem

The difficulty here lies in the principal-agent problem. Consider a simple example. The boss (principal) pays the worker a fixed wage for the worker (agent) to put in effort to maximise profits for the company, but the boss does not observe the amount of effort which the worker puts in. The optimal response of the worker is always to shirk since the boss cannot tell. Because of the asymmetry of information, this contractual arrangement results in suboptimal outcomes. The worker will never put in effort for the company.

The only way to overcome this is to make the worker the residual claimant or the profit owner. That is, the boss collects a fixed rent and leaves the rest of the profits to the worker. Since the worker now gains the benefits, he puts in effort and this arrangement results in optimal outcomes. The economic principle is simple: whoever controls the amount of unobservable effort must be made the final claimant of the rewards that come from this effort. "

In his blog entry, he claims that "the only way to overcome this is to make the worker the residual claimant or the profit owner". His argument is fallacious right to the very core. What he said was either GIC get to keep the profits or they will not be motivated to act in the best interest of CPF members. GIC can be considered as a fund manager for CPF monies.There are plenty other methods to motivate the management of the CPF funds. Pegging remuneration to a small cut of the profits or something similar will suffice. Allowing the management to keep all the profits of the CPF fund would surely be an overkill. It has been frequently said that if GIC were not allowed to keep all the profits that were made, they would adopt a riskier investment approach which is detrimental to CPF members. However, by allowing GIC to keep all the profits, CPF members stand to lose even more. The main point is that allowing GIC to keep all the profits is not the only way to motivate them.

And if you are still unconvinced that CPF is an inferior tool to provide for the needs of the retiring citizens, consider this:

"Fifty-five percent of the 7,100 active CPF members who turned 62 last year managed to meet the Minimum Sum amount of S$60,000. "

This means that 45% of CPF members who turned 62 last year did not manage to meet the minimum sum of S$60,000. If after 4 decades of saving 34.5% of your effective salary still fails to enable you to retire comfortably, CPF must therefore be as lousy a retirement plan as can be.