Life Cycle Financial Planning

Looking around me, I see quite a few semi-old gits pumping money into their pensions, and lots of it. I’m one of them. We’ve all got it horribly wrong, you should start saving when you’re young.

Optimum pension contribution rate from the paper referenced by the FT. There is some similarity with my AVC contribution rate.

I was tickled to read in the FT that maybe we’re not so daft after all. Why Starting a Pension Early Could Be a Mistake originally appeared in the Financial Times  Merryn Somerset Webb puts far more accurately succinctly what I’ve been driving at with Compound interest is Overrated.

I was probably wrong – compound interest is all very well. Why it doesn’t work as well as people like to make out is that in your twenties you can’t put any decent amount of money into a pension, because of where you are in your financial lifecycle. You’re not earning much, so the basics of life are a higher proportion of your outgoings. And you’re starting out in life, so you aren’t as financially savvy as you may get, plus you have to buy lots of stuff to establish life as an independent adult. Merryn gets to the heart of the matter

We all think that we should start saving into our pensions from the moment our first paycheque hits. But it turns out that if we were “rational life-cycle financial planners”, we would wait until we are into our mid-thirties to save.

Everything we do financially should be to maximise our standard of living over our life cycles. In our early career years, when our earnings are low, we compromise our living standards if we save.

So we should consume our initial incomes and then step up savings as we earn more: with the percentage rising from zero before age 35, to 30-35% as we head towards 60.

Now I haven’t followed that exactly, but there has been a huge increase as I’ve got older. And as Merryn intimated, it gets so much easier to save as you get older, though with the caveat that having children and aspiring to help them with university costs can put the kibosh on that. Previous generations  became financially independent of their parents as they came of age, making saving easier for the parents once they got into their 50s.

The takeaway isn’t that you should blow it all in your 20s – you should still be saving or building capital. Either in house equity if that is your bag, and you expect house prices to continue rising (why?) or in financial instruments to give you a passive income, which is equivalent to home ownership reducing your housing costs.

It’s hard to know the benefit of not having housing costs until you experience it. In my twenties I perpetrated the biggest misallocation of financial resources in my whole life by buying a house at the peak of the market, signing a mortgage document that was to be discharged in February 2014.

That screw-up was redeemed by paying down that mortgage about six years early. Not having to pay the mortgage means I can save much faster, for the simple reason that I need access to far less of my salary. Using salary sacrifice I can stop the Government stealing a lot of my pay, allowing me to save two year’s gross salary in three years by booting much of my salary into pension AVCs.

I don’t have to live on thin air :) I live on an annual expenditure of less than the national minimum wage, but I have a standard of living that is much higher than you’d expect from that because I am using the accumulated capital from earlier years.

That is why compound interest doesn’t benefit me much in investment, I haven’t got the 40 years it takes to do anything useful at a 5% compounding rate – but that doesn’t greatly matter. I focused my investment as a young man in paying down my mortgage debt. That is still working for me – by dramatically lowering my costs so I can save and invest now.

Investing is a dangerous game, particularly for the young-ish and optimistic – I was slaughtered in the dot-com bust, largely from being too hot-headed and not knowing some of the ropes. You can get round some of that as a young investor by using passive investing, provided you start at a good time when equity market valuations are cheap. If you passively invested in the dot-com boom you’d still have been slaughtered in the last ten years, just not as quickly and perhaps not as comprehensively as I was. (edit – no you wouldn’t – see this comment for why)

Am I a better investor now? It’s impossible to know without looking 10 years ahead. I have better guidance, I have the learning from last time, and I am richer, so I won’t become a forced seller because I have more than half my non-pension savings as cash. I diversify by sector and to some extent by geography, though not financial asset-class, I’m either an equities guy or into non-financial assets. Well, apart from cash, I guess.

It surprises me that there’s so little said about life cycle financial planning. If you’re wealthy enough to be doing financial planning, you will probably experience a similar sort of life cycle. Yes, timing will be different for people who have children, but the arc of the life-cycle will still follow similar stages – you’ll probably be skint and capital-poor when young, you’ll be better off though probably with more dependents when middle-aged, then more capital rich but with a lower income when older. Saving 5% of my salary was a much bigger ask in my 20s than saving 70% of it in my 50s.

I was lucky in a lot of aspects, despite being hopelessly incompetent with the housing market.  Rolling with my financial life cycle was probably one of those pieces of luck. I didn’t sit down to do it at 30, though some of it was instinctive in following the financial life-cycle of my parents, who discharged their mortgage when my Dad was in his late 40s, earlier than me.

Someone in their early 20s who takes Merryn Somerset Webb’s article and uses the information with self-knowledge, determination and persistence could do well by maximising their life-cycle standard of living. Of course, the need for self-knowledge, determination and persistence at 20 may be the rub. I struggled with the self knowledge, else I would have listened up and not bought a house at a market peak because I wanted out of the endless having to move because of other flatsharers’ life decisions.

Anyway, in one sense I was wrong about compound interest being overrated. It’s great. It’s just not useful to most of us who start out their adult lives skint and with massive claims on our income for the necessities of life. Obviously if you start work at Morgan Stanley in your twenties, fill your boots and all the great stuff about compound interest will come good for you.

References

For the more analytical, the Pensions Institute papers referenced by the FT are

Age-Dependent Investing: Optimal Funding and Investment Strategies in Defined Contribution Pension Plans when Members are Rational Life Cycle Financial Planners by David Blake, Douglas Wright and Yumeng Zhang (Sept 2011)

and

Target-Driven Investing: Optimal Investment Strategies in Defined Contribution Pension Plans under Loss Aversion by David Blake, Douglas Wright and Yumeng Zhang (Sept 2011)

Hello –

I haven’t commented before, mostly because my usual response to your posts is basically just to agree completely, but wanted to let you know that I always really enjoy the writing. Keep it a’coming.

Martin

Another thoughtful article, and I think we’re reaching some middle ground here. :) I saved harder than the 5% or whatever touted in my 20s (try 4-5x that from my mid-20s onwards) so I guess my experience is coloured by that.

The bit I’m going to argue against this time is your comment that if you started investing in the dotcom peak you’d get slaughtered. This just isn’t true.

With a monthly regular investment strategy into an index fund, and reinvesting dividends, you’d only have been investing at around the market peak for a couple of years. And you’d have equally been buying in the troughs in 2003 and 2008/2009, too.

In fact, while I haven’t got the exact figure to hand, from memory a strategy like the above would have left you something like 30-40% up over the 10 years from Jan 1st 2000 to 31 December 2010.

Apply that over a 40 year timeframe, and individual years become even more irrelevant.

In contrast, a strategy of ‘save a lot for a few years later’ takes on a lot more risk, if any of that money goes into equities. If a high-earning 55-year old began loading up on equities in say 1998 for early retirement in 2003, well, he or she would have had to change his plans.

If you’re saying “if you haven’t got any money in your 20s and you can’t get any more and you can cut back then you can’t save”, then I agree. And if you’re saying “if you haven’t saved enough and it only dawns on you in your 50s then you’d better save hard because that’s better than nothing”, then again we agree. ;)

I disagree though that we should draw strategy from this.

Paying down your mortgage though, absolutely agree. For many people, the small risk of a housing market collapse probably outweighs the psychological trauma and complexity of saving through peaks and troughs as described above. Massively over-paying their mortgage ASAP isn’t a bad idea in that event.

Cheers for continuing the conversation! :)

(Oops, in the bid about being in your 20s, I mean of course “if you CAN’T save”…)

@Martin, glad you enjoy reading, and that’s one awesome set of 2012 goals you have!

@Monevator

> if you started investing in the dotcom peak you’d get slaughtered. This just isn’t true.

That is fair comment, and you are quite right ;) I inferred incorrectly from my own experience, where after getting nuked in the .com crash I lobbed what remained of my much denuded ISA into a Virgin FTAS tracker with a shocking TER of 1%, which was considered good at the time. And exited the stockmarket in disgust and focused on paying down my mortgage.

I took this FTSE 100 / FTAS TR graph and rescaled the start to 130 from the Bank of England inflation calculator for 2000-2010.

Which, although it represents my experience, doesn’t represent what our saver would experience, thanks for picking that up!

I was intrigued by that FT article and the Pensions Institute life-cycle analysis because it aligned with my experience of the life cycle. Unlike you, I found it extremely hard to save at all in my 20s, London was an expensive city to live in. Although I didn’t accumulate debt, I saved sod all.

Compared to people now of that age, I had no debt, and less stuff, particularly electronic gizmos despite having an expensive hi-fi and spending too much on records. Since rent/housing is dearer nowadays I can only assume I spent too much on convivial company and the fruit of the grain and the vine ;)

[...] Life cycle financial planning – Simple Living in Suffolk [...]

Great piece! A few notes:

1) For many worker drones in DC pension schemes, the most significant return on pension saving in your early career comes from the employer contributions, which are generally conditional on your own saving. That is “free money” which almost everybody should grasp with both hands; it is not unusual to get matching contributions up to a % of salary limit; so a 100% return.

2) overpaying a mortgage means you benefit from the effect of compounding! Every time you pay down extra principal, more of your monthly payments shift towards paying down principal vs paying interest. Hence, overpaying has the *acceleration of savings* effect just like compound growth.

3) Have you worked out what your financial situation would be now in the counterfactual where you rented rather than bought? Would you still have managed to be free of housing costs?

I worry when people compare homeownership against other types of investment and see it as a bad bet because you can lose so much equity. That is the wrong baseline: the baseline is always a cost/benefit analysis against renting.

The idea is fundamentally flawed. The pension concept is to SAVE money while working for fifty years, for draw-down when income ceases .

Instead people expect to get significantly more than they saved as a result of ‘earning’ investment gains over time.

Nobody seems to appreciate that investment is risky and results are speculative and shouldn’t arguably be the basis of a concrete retirement plan

This result of unappreciated gambling is under saving and poverty by pensioneers, and loadsa fees for the financesariat in control of the debate.

@Lemondy.Paying down debt is always good but one could argue that paying down a mortgage quickly might not be as effective as many think. If you have a long-term fixed mortgage rate, you might be better off just making the regular payment because the dollars or pounds you’re using to pay down the debt are worth less each year owing to inflation. having said that I still believe it’s better to get rid of all debt ASAP.

Paying down mortgage is relative to the interest rate compared to an investment.

Here in the USA, my latest mortgage is fixed at 2.75% for 7 years (and then becomes variable). I fully intend to invest those mortgage payments instead and my track record is good enough that I’m certain I can average over 6% during the 4-7 years before I retire and pay off that mortgage.

The important thing is to have the mortgage paid off before you retire. An unfinished mortgage is one risk you don’t particularly want when your ability to generate income is limited to investments.

@ Lemondy, yep, all things being equal taking employer match is good. I don’t know if I was a particularly bad money manager in my twenties, but I recall them being extremely hard, and I had very little surplus savings. I was saving to taking an MSc in the late 80s to pay fees and board myself, though I got a grant for it in the end, which may skew my perception compared to most. And I was rabidly scared of any for of debt over more than a credit card month. I would go as far as to say if you have to incur debt to contribute to the pension to get the employer match, then don’t do it, but otherwise it’s a good win.

2) maybe more you discharge negative compounding of the debt earlier, but yes, the maths is similar. That’s whay after I dramatically failed to make money in the dot-com bust I turned my fire on the mortgage as a slow but sure fire way to get ahead.

3) I’ve ‘owned’ a house for 23 years, and discharged most of the mortgage after 16 years. The first was a two-up two down, this is a semi. So it’s hard to equate like with like. If we assume I paid in total twice the capital value I borrowed due to the mortgage interest, that would equate to roughly 17 years of the rent I would pay to rent an equivalent house to the one I am living in, in the same part of town. Allowing for the fact the rent would have been cheaper for the two up two down, I think I can say I am evens about now, and in barnstorming profit from here on out.

> see it as a bad bet because you can lose so much equity

Yes, that’s curious. Any asset with a marketable value is susceptible to that, though housing is illiquid and always one of a kind which makes it harder to value when not selling. I had a talent for losing even more equity on te stockmarket, hello RGE and ION, where are you now ;)

@Trevor, I can see where you’re going with that but what asset would you use to save money that holds it value across five long decades? Cash on deposit usually quietly dies a little every year, and the Government is cheeky enough to tax any interest. They should tax just the interest over RPI IMO…

@g & George, I think both of you are comparing with the more rational US approach to mortgages, which tend to be fixed for significant periods for finacially savvy mortgagees. In Britain fixed rate mortgages are notable by their rarity, and relatively short duration (3-5 years)

Instead our mortage market is a bizarre range of short-ish term promotional deals, where he headline interest rate is deflated and the difference made up in ‘arrangement fees’, one-off upfront ‘mortgage indemnity guarantees’ or ‘high loan to value charges’

These charges greatly inflate the rate of interest British customers pay, because if you pay a 3% fixed lump on a 3-year mortgage product, then to my eyes the interest rate just went up by 1%. But the British mortgage buyer seems to not notice that, so he chases the headline interest rate and takes the sucker punch on the extras.

It happened to me once, before I thought about what had just happened to me. With US style longer loan periods, I would have had more time to amortise the cost of the extras.

On my last mortgage, that was still linked ot the bank base rate, not fixed.

“barnstorming profit from here on out”

A fantastic place to be, more power to you :)

On mortgages: when I remortgaged last year I was pleasantly surprised, lots of 5 and 10 year fixes around. I’m not sure I’d advocate a 10 year fix to many people, though, you risk getting stuck with a huge early repayment charge if you need to sell or move for whatever reason.

@Lemondy. I have a 5yr. short term fixed but can pay down a large amount each year, without penalty, on the balance, that would virtually eliminate the balance in about 6 yrs. So, if I pay down the Max. per year the balance will be small enough that even with a penalty it won’t hurt too much and, since it’s a rental property, I should be able to make back the penalty within three months. Of course, we’re talking sacrificing gains on the investment side, but in this case it’s worth it.

@G, a long-term fix makes perfect sense for a rental property, no argument from me there.

I was thinking of the average worker drone who does face the risk of being forced to relocate to stay in employment.

[...] have been very interested to read recently a number of posts on one of my favourite personal finance blogs on the apparent wisdom of not saving for retirement [...]

 

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