14 Nov 2015, 9:53am
personal finance:
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  • the penny and the steamroller at Monte Carlo

    Note: the lower part of this post has rapidly moving/flashing graphics

    I am slowly inching my way to being able to run my DC pension flat in front of my DB pension, effectively burning up the DC fund over five years, drawing my DB pension at normal retirement age. The latter will give me enough to live on, and I can keep my ISA tax-free income reinvested against the day when wages in Britain begin to increase in real terms, whereupon I will start to fall behind without being on the side of Capital. Or I can use it to hedge against the demise of the NHS, when healthcare will become at best insurance-based like in most other European countries, or at worst like the evil that is the US system. I am fortunate enough to avoid doctors and hospitals at the moment, but nobody gets healthier as they get older.

    Running a DC pension flat over five years is an odd time-frame

    There’s an age-old rule of thumb, never have money you will need in five years anywhere near the stock market. Ever ask yourself why this is so? The basic reason is that the equity premium is tiny – about 1/20th of the capital sum per annum, and this is the fella who is fighting on your side. He is such a puny bastard you either need a lot of time or a lot of money on your side. They ain’t making any more time, which is why compound interest won’t save your ass unless you work till you have one foot in the grave…

    On the other side of the ring is the Bad Guy – volatility. He’s a moody bastard – sometimes euphoric, and sometimes down in the dumps. He will drag the aggregate value of your share portfolio up and down as he pleases, and that volatility is massive, because Mr Market is the 600lb gorilla, and if he’s in a grump everybody gets to know.

    So I asked myself what would happen if I started out with a lump of about 80k – if I want to run it flat in five years I can’t really use much more than that, and there is no point in running my DC SIPP into the revenue from my main pension as that is already over the personal allowance, so I’d be taxed on the SIPP in its entirety.

    Right off the bat I can take ~£20,000 as a tax-free lump sum, and this is the obvious thing to do. 1.

    After taking the PCLS I can take ~£11,000 per annum income tax-free from the personal allowance, and simple arithmetic shows that after I have iced £20k from my stake I have £60k to run out, and 5×£11,000 2 is 5k short of the £60k balance. If I am lucky they will lift the personal allowance towards the end of this Parliament 3 and an Ermine will squeak under the finish line with the goose feathers unplucked.

    What about that steamroller then?

    about that steamroller

    about that steamroller

    I have paid a lot of tax in my time, and I considered contributing £3600 a year to the SIPP over those five years at a cost of £2800 p.a.. Somehow I want a way for the taxman to share in the risk, so I asked myself the question of what I think about tackling the steamroller of the stock market

    What would happen in my SIPP if rather than cash I held it in some index fund of a market that isn’t on a high CAPE, so FTSE 100 or 250 rather than S&P500…

    I tried a Monte Carlo simulation. As an engineer I am deeply opposed to using statistical analyses without knowing their limitations. Stock markets are a bastard because they do not obey the central limit theorem, there is serious correlation between the supposedly independent actors and as such market distributions are fat tailed – shit happens (and euphorias happen) more often than simplistic risk calculations assuming normality tell us. Taleb wrote a book called Fooled by Randomness riffing on just that topic. So bear in mind that what you are about to see is an optimistic simplification on the volatility. And nobody knows exactly how optimistic! That steamroller is big, and it is virtually guaranteed that there will be a stock market crash in the next five years IMO.

    I ran 50 Monte Carlo trials each containing five independent scenarios, 250 trials in all, a fifth shown spatially (like FireCalc) and 80% temporally (like nothing else I am aware of) assuming that each year I take out a personal allowance-worth from my portfolio, from that money I add £2880 to which the taxman adds £720.

    The cash scenario assumes I get -1% interest on cash in real terms due to inflation. I have assumed an equity premium of 4.3% real, fees of 0.45% (HL SIPP, funds, no transaction charges) and a FTSE100 annual standard deviation  of 30% (about 2% rattle a day × √256 trading days p.a.). This is probably very harsh on the FTSE100, it doesn’t normally vary by 2% a day, so I will simulate more dramatic spreads than is probably the general case. I derived that from looking at the values now when there seems to be some upset in the air. As a prospective purchaser, this pleases me, but I should do more work to get a figure more characteristic of a five-year period.

    250 possible trajectories with 20% equities, and the comforting security of cash, 20% tax paid at the end

    250 possible trajectories with 20% equities, and the comforting security of cash, 20% tax paid at the end. The decline is because of the 20% drawdown rate. This chart is meant to move, BTW, I am using the time axis to show far more traces without them blending into a Firecalc-style mush

    Immediately this tells me that five years of contributing £3600 will leave me with a rump of £20000 on a cash only basis that I’d have to pay tax on 4. This is not earth-shattering, but I wondered if I could use the taxman to underwrite some of my stock-market risk – I have the choice of whether to put in that £3600 p.a, which makes the taxman contribute up to £3600 across the five years.

    As you can easily see from the variable parts, taking stock-market risk is distinctly favourable on average – I am happy to pay tax on money if it’s more than the cash position – easy come, easy go.The taxman’s bite gets less if I get hurt by the stock market, and to some extent that makes me wonder if I should take a bit more risk on his dime. Maybe I should only put in the non-earner contribution if I am taking flack.

    250 possible trajectories with 60% equities

    250 possible trajectories with 60% equities. Don’t be sidetracked by the outrageous lifts – they are few and far between but draw the eye. Only about a tenth end up more than the start, and I went bust about 5% of the time, once two years from the finish line! The moral of the story is don’t even think of drawing down at 20% for a sustainable result

    If I pump up my equity exposure to 60%, a common value for young ‘uns saving for 30 years 5 there are a significant number of scenarios where I run out of money. Now that’s not unreasonable – remember that I am drawing down at a racy 20% p.a. rather than a steady as she goes 4%. I’m not actually going out and buying a Lamborghini, but my aim is to drive this into the ground ahead of my DB pension in five years. So of course I am taking the piss drawing down so fast.

    But look at the potential for upside gain (with the volatility possibly overstated, I will study how to do this less inaccurately). I could take the line that forestalling running out of money at 60% split is what half my PCLS is for. Alternatively I should only contribute the £3600 if I am being clobbered in the markets, because I can get the taxman to help me with 20% of the downside risk. If I am doing well I should keep the £2880 and invest it unwrapped or in my ISA if there’s space. To simulate that properly I have to run this as a Excel VB function, it’s too mind-numbing and untestable to do all that conditionality with cell formulae and IF statements. But it is possible to specify this as a mechanical strategy.

    Wealth warning:

    if you are in the accumulation phase, do not extrapolate from this that you will have such a rough ride. Remember I am drawing down at 20% – as a result if next year is a bad one on the markets and I don’t slow my drawdown rate I will impair my performance simply by selling 11k of units in a market rout. You won’t be doing that, so those units live to fight another day!

    I have represented the taxman’s bite at the end by multiplying the terminal amount by 0.8, because I have to pay tax on the entire amount I have left over after 5 years, because I will then draw my main pension, which is greater than the personal allowance. Obviously if I’ve flattened myself there’s no tax to pay 😉 I’m not terribly worried about getting steamrollered in this SIPP. I saved this money for a different purpose, but Osborne’s changes let me front-run my DB pension with it, effectively investing it in increasing my defined benefit pension, as opposed to my initial plan of drawing the pension early, taking an actuarial reduction and investing the AVC. I have enough defined contribution savings in the form of my ISA, although half the PCLS will probably end up in there at some stage, with the rest to follow if I don’t get slaughtered in the SIPP.

    I was surprised by:

    • the fact that the odds in favour of the stock market were clear for such a short timescale
    • the sheer variability of sequence of returns risk – the integration time of five years is not enough to start to bring these together (if that will ever happen – firecalc seems to indicate a bad start isn’t cancelled over 30 years, and it may be that the high drawdown inherently changes the statistics). The moving presentation kind of brings that sequence of returns risk home in a more visceral way to me than the straight firecalc trace 😉
    • the worst outcomes all seem to start off getting hammered by the market in the next year. As indicated in the wealth warning, that’s not terribly surprising, given my high drawdown rate. I would be wise to use the cash from the 40% cash part to avoid being a forced bear market seller, bear markets often come back materially within a year. The simulation assumes I draw down from cash and equities in proportion to the holdings. I am not sure I would do that in practice – I’d first draw the cash flat.
    • The opportunity to only put in the £3600 p.a. if I get hammered in the early years gives me a way to get the taxman to sponsor some downside risk

    The cash conundrum on the PCLS

    The biggest hazards in the five year term that I can see is serious inflation, and also a serious financial crisis.  Both of which resulting from a fallout of the tricks used to kick the last one into the long grass. Cash troubles me generally – I really can’t be arsed to yomp a few grand from pillar to post to try and win a bit more interest. I am not constitutionally careful enough to line all the ducks up in a row, and I didn’t give up work to stare at screens to try and rake 5% p.a. on about 20k that seems to be the practical limit. £1000 a year is nice, but I prefer to put my time into trying to understand markets, risks and my financial situation better rather than to slog minimum wage opening bank accounts and fretting if all the direct debits go out right. There’s n’owt wrong with that if it’s your bag, but it just isn’t how I want to spend my days. Hell, I’d even consider working if I needed £1000 that much rather than fart about that way 😉

    I am thinking of holding some (about 5k) with Zopa, but unlike most PF writers I view Zopa as stupendously high risk, higher inherent turkey distribution risk than a stock market index fund. The risk becomes obvious when you take a look at what Zopa borrowers are borrowing for. I look at these dudes and I see far too many people borrowing for cars

    Total Amount Borrowed: £10,000
    Age: 32
    Purpose: Car
    Location:Teeside

    £10,000 borrowed for a car, FFS! I have never spent £10,000 on a  car in my life, and if you are spending that much a car then you should be rich enough to pay upfront… Here we have another paragon of fiscal probity, borrowing to repay loans

    Total Amount Borrowed: £15,000
    Age:40
    Purpose: Consolidate existing debts
    Location: Manchester

    This is a car crash in the making, those debts ain’t ever gonna get repaid…

    All these iffy borrowers will be able to service their loans, right up until we have the next financial crisis which will happen some time in the five years I am thinking of, and above all else when interest rates go up, because most everybody in Britain is overexposed to that financial weapon of mass destruction, the housing market, a mistress that whispers sweet nothings and dreams of endless riches in the good times, and then throws her lovers out on the street naked in the middle of the night when she has a hissy fit. I know, I saw it happen to my neighbours in the 1990s, and it’ll happen again. When your kids are wailing because you haven’t got a roof over your head, Zopa lenders can whistle in the wind for the money they lent you. I think there’s a significant risk of this happening in the next 5 years.

    Against this the stock market is at least down a decent amount on those stupid levels of 7000 plus it was earlier this year, and while the index may tank it won’t be wiped out. But that variability is counter-intuitively huge, so I will study the results of profiling it, varying the cash/market balance.  I have the privilege that I can take a reasonable level of risk with this, if I am wiped out in three years then I will have still done okay on the 40% tax I didn’t pay earning the money and the market gains from 2009-2012. Nevertheless taking a flyer on a 10% risk of losing half the value (I will still pay out 30k of the drawdown as income in the worst case scenario of the simulation, though  the risk is a bit higher due to those fat tails) is kind of straight between the eyes and not for the nervous of disposition.

    Notes:

    1. the PCLS is a special case, the actual income from the SIPP is the tax-free personal allowance each year
    2. the personal allowance is £10,600 at the moment
    3. the aspiration that nobody on the full-time national minimum wage should pay tax ought to help with that
    4. this is offset by the fact that I will have claimed 20% tax on it on the way in, tax I will never have paid, but is perfectly legit to reclaim in a SIPP as a non-taxpayer. The SIPP provider does it for you, you don’t have to do anything
    5. If I were such a young ‘un 30 years off retirement I’d be 100% equities – let’s face it I am considering that young whippersnapper’s split as an old git five years off running the lot into the ground!

    I’ve read the post a few times, and I’m still not sure exactly what you’re trying to achieve here and why you’d even consider ‘risking’ what you already have, and need, in chasing what it appears you don’t…

    Maybe a summary table of probablistic returns from the MC runs would help, because it’s not clear to me from the fast-moving graphics that 20% equities are either more or less likely to beat 100% cash over a four-year timescale.

    And perhaps I’m being dense here, but why is 55k your starting point for the exercise when 80k minus 20k lump sum = 60k ?

    In the circumstances, I’d probably initially put the 20k lump sum in Premium Bonds, and keep a watching brief on (1) the returns you’re receiving, (2) the markets and (3) inflation.

    Inflation seems likely to increase over the next few years, sure, but at least its trend will be highly visible on a monthly basis and so it gives you time further down the line to make strategic changes if required.

    And if there is another crash, and the FTSE should drop to ~4,000, then you’ve the ammo available instantly to fill your boots….

    I’m hoping the 5k difference (were I not to contribute anything in the next five years) would be taken up by the raising of the personal allowance which is a stated aim of the Government. I saved this money before being aware of this option, so I screwed up and saved a little bit too much.

    I have work to do on the MC analysis – the default position is to run this flat into the ground over 5 years. However, I am prepared to sport up to £2880 a year to get a bite at the stock market, with the taxman covering 20% of my backside. I can’t ever get at his £3600 using cash, but I might be able to use it to underwrite losses. The mean estimated gain from the stock market over 5 years is 20%, though it only holds for cash not drawn down.

    I have a couple of years basic expenses as cash elsewhere – I could live with this panning out short. I am trying to work out what the risk/reward is, particularly if I can shift the balance a little by bailing the taxman in…

    I will be doing something similar. When I hit 56 I will draw down 25% of currently 65k tax free and take annual personal allowance each year to age 60. Will also have some cash saving in case of stock market volatility and to supplement sipping drawdown(approx 50k). Will take teachers pension at age 60. Approx 20k pa plus 60k lump sum. Wife 6 years younger so she also has 65k in a sipping which we will use from when she hits 55. When she hits 60 we will take her teachers pension – approx 15k pa plus 45k lump. We both have equity is as of about 75k mostly equity income funds. Hope this makes some sense. Your blog is great.b

    I’ve been in Zopa for a while now. I only put about £1,000 in on some vague notion about trying to support any alternative to the Big Four banks. I never look at the detail and had to chuckle when I saw what you’d uncovered. Am I actually encouraging and abetting the thing I personally disdain, debt and consumerism?! Clearly. Oh well, time for a cup of tea and a biscuit. It’ll sort itself out…..

    I took a look at that earlier and there’s a histogram of what people use it for in this post. It’s really not a pretty sight at all.

    I’ve made a similar amount to you on a 2k stake since 2013, about par for the course. But success is still all about return of capital as well as return on capital, as DM highlighted earlier 🙂

    I’ve just checked, and my £1,000 in Zopa is now worth £1,264.13. I joined in May 2011. Just for info…

    15 Nov 2015, 11:50am
    by Underscored

    reply

    that’s an interesting article – and indeed my original favouring for dividends was

    This brings us to the most significant appeal of dividend payers. Dividends increase investors’ ability to accurately estimate at least some portion of future returns

    although I confess some of the other positive attributes mentioned in the paper didn’t feature in the decision tree because I was unaware of them, I tip my hat to fortune there!

    People do have to fully undertstand that P2P is investment, so has risk vs savings, but in a no-interest world when they’re willing to go for a % of their investment piechart in equities to get income to live on from something, then why not P2P. Even in a no-interest world, you cannot live off 0.02% from Any Venal Anon, High Street Bank.

    Given this I experimented with Funding Circle, having reasoned that whilst businesses also do fail, they’re often started by people who want to succeed, work hard & know their stuff in that field of expertise. In these interesting financial times, they’re often just a front to self-employment – A govt. – encouraged scheme for people to make themselves jobs. Either way, these people are then heavily incentivised to make it work, vs walking away from a common or garden, self-created cluster-fk in your life via personal bankruptcy. [from buying consumer bling to get status/an ego massage]

    After a year with a token amount tested in P2P, I worked out I’d made ~7.5% net of defaults & commissions & was really dissappointed as I’d started off with 12% & was making 10% net before a wave of defaults. To be fair that just brought it down to the admitted statistical rate in their literature, so there was no subterfuge on their part …..I’d just been guilty of counting chickens that hadn’t hatched.

    Since then, I put in more effort by not using the autobid function that invests in all loans indiscriminately & effectively ‘stockpicked’ loan by loan to try & weed out the more unpromising looking ones. This has cut down on the defaults & I am genuinely clearing 10% at the moment – whether this is sustainable as the loanbook matures – depending on the strength of the economy in the next few years – remains to be seen. A lot of people may not have the time for this though as you need to keep a frequent eye on the repayments for signs of trouble to be able to offload any sickly looking loans in time, before that company surprises with a bankrupcy announcement….

    At even 7 – 8 % though, for a risk-based investment & comparing to equities, the experience has convinced me to move 10% of my portfolio into this aspect of P2P to get some yield & also for the healthy aspect of diversification alone. If this % is the long-term annual average for equities, then it’s surely not so bad & the latest news seems to be that the mainstream banks are still cutting back on lending to SMEs, so the pipeline of new loans is safe for now.

    Funding Circle certainly looks like a way to diversify P2P company and arguably underlying asset class and I’ll probably do some of that from a diversification POV alone, but small biz also dies like flies in a financial crisis, so although the underlying asset class is a bit different it has the same sort of wipeout risk IMO, Interesting that FC are launching an investment trust on their loan book, which would be one way of getting this into an ISA.

    “at worst like the evil that is the US system”: oh do give over. There’s not the slightest chance that anybody else anywhere else in the world will copy that heap of steaming ordure.

    Obamacare is in fact a copy of the Swiss health insurance system, introduced in mid 90’s.
    We here in CH do not have the involvement of the employer, other than that the systems are identical. Insurance costs have since risen at approx 2 -3 times the inflation rate. My premium for 2016 has risen by 18%. In a zero interest, zero wage raise environment…
    It will be my biggest expense, even eclipsing housing, and my biggest scare, in ER.

    > It will be my biggest expense, even eclipsing housing

    Yikes. It’s not like housing is cheap in CH!

    I just got a quote for an imaginary Californian Ermine earning about minimum UK wage on https://healthquote.healthmarkets.com/Quotes.shtml and it appears I’d be 100% subsidised, which isn’t the story you usually hear about the US healthcare system. There’s a $6500 deductible – getting rid of that would cost me $123 but a $35 copay, whatever that means (per visit, per prescription?)

    Low income families in CH also do get health insurance subsidy, but it is means tested. Anybody contemplating ER in CH will be clearly above that threshold.

    Interestingly I didn’t pick up any wealth means test in the Obamacare quotation, it was all about income. So they’ve perhaps ‘improved’ on the Swiss scheme at least in that respect.

    The US $6500 deductible would challenge the minimum wage earner though – I figured they’re on about $18,000, so that’s a hit of about a third of their gross pay if they break a leg or something!

    And on the subject of health: I urge you to consider the possibility of adding a warning to the early part of this post, warning people with a tendency to epileptic fits not to scroll down. It would be a shame if your jiggling snakes did some poor bugger in.

    Ta.

    15 Nov 2015, 8:28pm
    by The Rhino

    reply

    On a total tangent, I’ve just finished a bit of M. Scott Peck on your recommendation. I smashed through ‘a road less travelled’ which i think is the famous one, and also ‘denial of the soul’ which is maybe a bit more niche.

    I enjoyed them, I think the many personal case-studies deliver a lot of authentic insight. He seemed a wise fella. One thing he does do is veer off into religious ramblings in the last quarter (of both books), which is a little sneaky but its his ball so I guess he can take it home if he wants.

    Theres also some really weak stuff when he attempts to comment on the physical sciences.

    But I’m being picky – good recommendation – many thanks..

    Glad you enjoyed them – Peck was a fellow who made me think, and an author who can do that is worth rading IMO. His thesis that growing and deepening also involved coming to terms with loss has some parallels with Jung’s concept of the psychology of the second half of life. I’ve never read denial of the soul.

    I also enjoyed his ‘in search of Stones’ partly because I have a fascination for prehistoric stones which was the backgorund but he used the travel as a framework for some quite deep reflection.

    Those p2p examples you’ve given are pretty horrific. Most of my p2p cash is with Funding Circle – in my mind, I like to think that I’m helping little British companies but hear what you’re saying regarding the risk when the economy goes belly up again.

    Hence, I do consider p2p a fairly high risk so unlikely to pump much more money into this kind of investment. It’ll be nice however when it’s inside an ISA wrapping though.

    Good luck with flattening your DC pension in 5 years – how will it feel to be spending instead of saving/investing!? 🙂

    > how will it feel to be spending instead of saving/investing!?

    Strange – it’s a big change to start on the final approach to becoming a normal member of society with a steady income again. In some ways I look on this as investing the DC pension in eliminating the ~27% actuarial reduction I’d have to eat if I drew my main pension now. Granted that’s smaller net reduction because I have to pay tax on it in payment, but the return I could get on investing this is, say, 5% real, so say £3k p.a.

    I don’t have enough confidence in my skills as an investor to turn this into a better income than an inflation-linked defined extra amount of DC pension. If I were George Soros or Neil Woodford, I’d feel different, but beating the index starting in 2009 to date isn’t a long enough track record to bet the next 30 years on it. I’m ok with being a wuss 😉

    Those US copays look seriously dear to me. F’rinstance when I look at prices at the Nuffield Hospital and take, say a large operation like hip or knee replacement you’re looking at £13k. Which is a fair old hit, but tractable – and some of these US guys are paying half that cost in copay alone, which makes you wonder what’s actually being insured. The Fannings, f’rinstance, are paying $6,000 p.a. in premiums and $10k in excess/copay. They could take their pick at the Nuffield, which is a private hospital I believe.

     

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