Knowing how to invest for your child's future can often feel overwhelming. But it doesn't need to be...
March 17, 2022
November 26, 2021
For those that have crossed into the world of parenthood, you know that life instantly and significantly changes forever. These changes are wonderful yet challenging at the same time.
Financially, even for the most frugal and money savvy, there are many additions to the budget when we have kids. We need to spend more on food, childcare/education, clothing and toys, not to mention the nappy budget! We might also want a larger emergency fund or consider buying life insurance to provide for our children in case something bad happens to us.
At the same time, we are torn and start thinking about their future: education, hobbies and adventures, and even savings for their big moments that are decades away However, these choices do come at the cost of the amount that we can set aside for our own financial security. So, we thought we would explore some of these tradeoffs and how to navigate them as well as how to introduce and provide an understanding of money to the next generation.
As parents, our priorities also change. We might no longer be able to flit off on an adventure with no second thought. An even greater luxury would be creating brain space to learn about investing if our financial knowledge or investment experience is limited. Not knowing how and when to start investing for kids are among the most common reasons why many parents are reluctant to build the nest egg for their loved ones’ future.
As the number one and most important rule before pursuing investing for kids, you’d better clear all consumer debt (e.g., credit cards, car loans, hire purchases). Plus ensure you are contributing to retirement savings plans (e.g., KiwiSaver or an equivalent) and have an emergency fund of ideally three months income. Pay yourself first so you can find yourself in a better position to aid everyone’s future.
Second, a journey of a thousand miles (or a decade or two) can begin by just opening a Kids account and putting it in the child’s name. Why? Because anything you save this investment account for their benefit will usually be taxed at the lowest PIR rate (10.5%).
With rising household bills and living expenses, it might be difficult to have much to put aside and invest for the kids. Nonetheless, just regularly contributing $10 a week to a well-diversified index fund can accumulate $16,000 by the time a newborn turns 18 years old from savings of $9,000 if the fund yields an average annual net return of 6% per annum.
As you can see, it’s not just about how much you are putting into your investment every week. The point is that making a good investing habit will go a long way!
While it might take up to 18 years from when your kids are born to when you can celebrate their first big moments in life, such as leaving home for university and buying their first home, the earlier you start investing for your kids, the more compound interest you can earn.
Take Jane and Simon, for example. They decide to open an investment account for their daughter’s university education and regularly contribute $50 per week into a well-diversified index fund. If they start the investment from the day their daughter was born, upon reaching her 18th birthday, they will have $80,355, given an average net annual return of 6% p.a.
Whereas, if Jane and Simon delay starting by 8 years, when their daughter reaches 18 years old, the amount is only $38,926. That’s the benefit of compounding.
Average net return
Accumulated nest egg by age 18
When investing for your children’s education or deposit for their first home, the impact of fees and hidden tax advantages should not be overlooked.
You might’ve seen us mention previously that compounding interest can be a double-edged sword. Not only does compounding interest accelerate your growth (or conversely your debts) it also can be seen in the impact of fees. Why? Because any fees that you pay compound to eat up your returns over time.
How you intend on investing on behalf of your child(ren) is a consideration to make as this directly relates to the amount of fees that you are likely to be charged. If we’re thinking about ETFs specifically, there are fund management fees to consider, plus other trading costs such as brokerage commissions, bid/ask spreads and foreign exchange fees. When investing in unlisted index funds, on the other hand, there are no transaction fees. Regularly contributing to a portfolio for children can become more cost effective when investing in unlisted index funds.
Fun fact: A recent research by European Securities and Markets Authority (ESMA) shows that net of costs, index funds consistently outperform actively managed funds and those fees and costs can reduce investors’ returns by 25% on average. That’s a big chunk of your potential returns!
Whilst there is a lot of data that shows over the long-term index funds consistently outperform actively managed funds, a common cost overlooked by investors is the tax advantages that come with investing in index funds in comparison to ETFs in NZ. This is particularly important for children who are usually taxed 10.5%.
When investing in an NZ ETF (classified as listed PIE funds), each distribution from the fund is automatically taxed at 28% – the highest rate. Any investor with a lower Prescribed Investor Rate (PIR) pays too much tax, which can only be refunded the following May via a tax return. Comparatively, any distributions paid from unlisted index funds are taxed at the individual’s PIR, which in the case of kids is 10.5%. You can read more about the tax disadvantages of ETFs vs index funds here.
First, make sure you know the investment time horizon you’re working with and what the money is invested for.
If your time horizon is short and you will need the money you invest in the near future – for instance, you are finding a suitable investment option for kids’ money that they want for a car in a year – there are a couple of things that should be considered.
Overall there’s not much time for your money to grow and take advantage of the compounding effect. Second, all investments – either conservative/balanced/growth funds or individual stocks – are associated with some degree of fluctuation, meaning that you need to accept the possibility of the value falling below what you invested, sometimes for a period of time. Even if diversification significantly reduces the chance that is a permanent loss. Simply what if the stock market suffers an unexpected large drop just before you need the invested money?
As such, it makes sense to have a conservative investment strategy when the length of time that you can wait for the potential losses to recoup is less than two years. Despite the low returns, bank savings accounts can mean that you do not have less than you invested, and that might be the most important thing when you need the money within the next one year or two.
Other investment options can be short-dated high-quality bond funds. In general, stocks should not be an ideal option for the money that you want to tap within one or two years. Betting on a positive stock market movement in any given year is a gamble that you should avoid doing with money you and your kids absolutely need.
By contrast, when you have a longer time horizon of at least three years before spending large amounts of your portfolio, you have more options for investing. With time on your side, you can seek out better capital appreciation potential from stock markets with an increasing portion of your money that you are comfortable fluctuating. But remember to diversify your portfolio across markets, sectors and stocks as diversification helps reduce the risk of making a loss overall. If you are still wondering how, investing in a well-diversified index fund can be a good starting point. When there is 3 years or less to go until you require the money, don’t get greedy and start to de-risk the portfolio back to savings accounts for the same reason as above.
You can also consider using a core-satellite strategy to add more direct shares and thematic funds. These are “satellites”; higher risk and more volatile, but you believe to have great prospects for the future. The core portfolio holding should comprise of well-diversified broad market index funds.
Moreover, if you have a long time horizon of 10 years and above– – you can consider the majority into high-growth funds because you are in a good position to be able to weather the stock market’s volatility and stay the course. However, it is still a good idea to have emergency savings.
Having the nest egg ready for big moments in life doesn’t necessarily mean you (or your kids) have the skills for handling it. Therefore, it remains essential that we help our kids develop good money habits and financial literacy so they know how to save and manage money.
The answer is the sooner, the better. It’s a lifelong skill, an ongoing process that covers many years of life experience and unfortunately hardly part of the NZ school curriculum. Parents can start teaching children some basic concepts such as “money as a medium of exchange” and “needs vs wants” in early childhood.
As they grow up and can absorb more complex information, you can have more in-depth conversations about financial matters. Setting a positive example or acting as a good role model is also a very good way to help your children establish good financial habits and behaviours along the journey.
While it is hard for small kids to understand the concepts like saving and budgeting, practising the habits of self-control and delayed gratification is financially beneficial in the future.
By following a cohort of 1,000 children from birth to the age of 32 years old, a 2011 University of Chicago study shows that childhood self-control can predict future success in many key areas, such as saving, investing, homeownership and debt management. So the time spent building these habits with your kids can really pay off!
Here are some ideas to teach small kids skills that will help them with better financial futures:
Involve your kids in long-term projects: Getting your child involved in any activities that require patience and take place over a certain amount of time, such as baking, gardening and solving puzzles, helps them foster the ability to wait.
The “list” rule: You can start introducing the concept of “sticking to a plan” to your kids from an early age. For instance, together with kids, we can write a list of what we need to buy before going to the grocery store and keep it handy. The point here is to make the rule clear “ if something is not on the list, we aren’t going to buy it”.
Play games: playing is not passive like watching TV. Watching TV brings instant gratification because kids don’t have to do anything to be entertained. When kids play, they actively engage the parts of their brain that are responsible for problem-solving and critical thinking skills. We can help kids practice “self-control” with fun games like “Red Light, Green Light” or “Simon Says”.
Talk it over and plan ahead: Planning skill is one of the most important determinants of future financial success. And even a soft and regular reminder to think and plan before doing any task can help children form and establish their planning skills. Talking through problems and helping them answer questions like “What are you going to do now? How about after that?”
As kids understand more about the world around them through activities and knowledge acquired in schools and other social environments, you can start talking about financial matters in the family. Sharing the attitude and beliefs about wealth and money, as parents, can have a huge impact on kids’ perspectives at this stage.
Some of the money lessons that are suitable for middle-school-age children include:
Giving an allowance and teaching kids to spend, save and share. A framework that has been found successful in many families is to teach kids that money should go into three categories: (i) spending now, (ii) saving or investing with big-ticket items and; (iii) sharing with others/good causes.
(i) spending now,
(ii) saving or investing with big-ticket items and;
(iii) sharing with others/good causes.
Kids can learn how to use the money they receive as gifts or allowance wisely through the concept of “trade-offs” – buying now vs saving for later: You can start having a conversation about whether they want to buy something small today or wait until they have enough money for bigger items – a valuable lesson about saving.
At this stage of life, kids start getting involved in some of their first “real” financial decisions – like how to earn money from part-time jobs or how to save up for their first car. All of the habits and attitudes towards money acquired from earlier years start to come into play.
Here are some of the skills that we believe kids should have as teenagers or young adults.
Teach kids about savings account or KiwiSaver account: In fact, you can apply for your child’s IRD number any time after they are born and open a KiwiSaver account or any other investment (savings) accounts on their behalf. However, the teen years can be a good time to educate your children about KiwiSaver, emergency savings and how compound interest works both in savings and borrowings.
Discuss the university plan: Being financially realistic about university education is very important for both parents and kids. At this stage, you might have started saving and investing for their university education for years. But letting your kids understand how it will cost them to study, how much they need to save and how long they will need to wait for their initial savings to grow if they can earn an average market return does help foster their sense of responsibility. You should also be upfront about how much you are able to contribute to their university education and how much they will need to finance via scholarships or loans.
It’s easy to think that as soon as your child takes over the amount of money you have saved for them or looks at starting to invest for the first time, that the way they invest should be different to how you do it. But this isn’t necessarily the case. Investing, regardless of your life stage or how much experience you have with it, simply comes back to the investment horizon, goals and appetite for risk you’re working with.
For example, if your child doesn’t plan on using their money in the next 5+ years, then investing could be a great option for them. If they have a short term goal in mind, such as buying their first car, then perhaps their money is better in a savings account that is easily accessible if and when needed.
Nobody ever said that helping our kids get off on the right foot with their financial futures was going to be easy. While building financial literacy and good money habits for kids is a lifelong journey, one step that we can do today is to open a Kid’s account to take advantage of a more favourable PIR rate, stay the course with your index investment strategy and let the compounding do its job!
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