Insights

GRAUNT KRUGER AND GRANT LOCKE: The age of debt is behind us

November 9, 2018
Insights

There is no more capacity to take on credit. The future is financial wellness

This article was first published in the Financial Mail.

If you think of the average financial services customer as a balance sheet, the past decade has been the age of liabilities. Banks and nonbank lenders have built their businesses on giving loans, particularly unsecured personal loans. But that era is coming to an end. There is no more capacity to take on credit.

So what will be the key theme of the next decade? We think the consumer balance sheet has to be rescued. And that suggests a different kind of business model for financial services companies.

It will be driven by consumer and political pressures — a backlash against the practices of the past, and a demand that financial services companies demonstrate that they are doing the right thing for consumers.

What does this approach look like? First, it is not about avoiding debt entirely. It is not about saving and never consuming. It is not about removing consumer choice. Rather, it is about giving consumers the kinds of products that ensure their balance sheets support a good life. This idea is often called “financial wellness”.

This is a paradigm shift for financial services companies, which need to shape their businesses to ensure that customers are financially well in the long run. That calls for a radical departure from the practices of the past decade that have left many customers financially distressed.

Financial wellness can be defined as doing well according to basic personal financial metrics such as positive cash flow, positive net worth, adequate risk coverage and high credit scores.

But it is also the subjective perception of personal wellbeing. Do clients feel well prepared for the future? Do they feel their financial situation allows them to live the life they want?

Subjective experience can also be misleading. Some think they are doing fine but underneath it their financial position is vulnerable to unexpected shocks.

We have to define some key metrics of financial wellness. First is positive cash flow — that is, having a surplus each month because your expenses are less than your income. A debt spiral is when customers do not have enough free cash flow to meet debt obligations and therefore borrow each month. Being able to put aside some money each month is key to removing financial uncertainty.

Next is net worth. This means that on balance their assets exceed liabilities. Within the balance sheet we should ask if the assets and liabilities are optimal — is the individual well invested in a diversified portfolio that matches their risk tolerance at a low cost, while their borrowing and other liabilities are well priced? Is there sufficient liquidity in those investments for emergencies? Borrowing should occur to support asset accumulation (such as property) or other investment, such as education. Third is having appropriate insurance for unexpected events that could devastate you financially.

Finally, financial wellness is about having a good credit score to enable you to get access to credit when you need it, at a good price.

A good example of bringing the subjective and objective dimensions together is from a recent study by Prudential Financial. It finds that only one-third of US consumers have a subjective sense of their financial wellness that is positive and aligned with reality; 37% feel bad about their finances, for good reason; 17% feel too positive relative to reality; and 12% are unnecessarily pessimistic.

A comprehensive definition of financial wellness must take account of an individual’s complete financial picture: income and expenses, assets and liabilities, insurance and credit — all of which operate in concert, after all.

The key for financial services companies is how to find the business model in a financial wellness approach. There are opportunities to develop products across the consumer balance sheet that support consumers with productive debt and healthy asset accumulation. Products can help consumers manage their risks and liquidity. Myopia on this issue is not good for consumers, and even worse for the financial services industry. The key for financial services companies is how to find the business model in a financial wellness approach. Adopting a comprehensive understanding of financial wellness helps to envision new products and services while guiding consumers to outcomes in their best interest.

• Kruger is head of strategy research at Intellidex, and Locke is head of OutVest