personal finance: budget complainypants spendthrift welfare reform
by ermine
16 comments
A Feckless Family Fruitlessly Frittering Financial Future Away
It was news to me that there were people getting more that the £26,000 average household income from benefits, but it appears this is a problem, to be addressed by the Welfare Reform Bill. Which seems to have taken a kicking from some bleeding hearts in the House of Lords. The kicking is taking a kicking in the Commons as I write.
Let’s take a butcher’s hook at one of these offending families, kindly drawn to my attention by Lemondy, who was in the market for a good rant, pleased to oblige 
What’s been going on here? It doesn’t start well, we have a blended family of two of Ray’s daughters from a previous relationship and three of his wife Katherine’s kids from her previous relationship. Fair enough, these things happen, looks like there is no contribution from the other people who helped bring these children into the world.
Raymond, a former educational software writer, has been jobless since 2001. His wife Katherine suffers from bipolar disorder with an anxiety disorder and is also unable to work.
Says Ray: “The market for my skills dried up 10 years ago – there’s a total lack of work in my area of expertise.”
There are two problems here. One is that Ray, despite being unemployed for the last ten years, decided to sire a son five years ago. At least it was with his wife. Ray, me old mucker, precisely why did you decide to produce this child when you knew you were unable to support it? Perhaps you ought to take a look at what the NHS has to say about stopping this happening in future…
Don’t get me wrong, I am open to taxpayers supporting families up to three children in some cases. After that I believe family support should be supplied in kind – food stamps, clothing vouchers for named individuals with a photo, and free school meals. Why is that? Because having children when you can’t afford them should seriously screw up your standard of living!
I am happy with supporting normal sized families (that’s up to 3) through the tax and benefits system, though they’ll have to move to cheaper areas. However, larger familes should be actively discouraged if you’re going to do it on the public purse. In the past, when I asked myself whether I could have children, the answer was no, I couldn’t afford it. So I didn’t do it, FFS! What makes Ray and Katherine so damn special that not only do I not get to have the experience. I have to pay for them to do it?
When I was growing up, when parents couldn’t support their children longterm the children were taken into care. There was a lot wrong with that, but there’s a lot wrong with people like me paying for the likes of Ray and Katherine to have that special experience of having a child of their own blood too. Supporting these children and only the children via food and clothing vouchers would at least screw up the parents’ living standard a bit while protecting the child’s essential needs.
The second thing wrong here is Ray’s assertion
“The market for my skills dried up 10 years ago – there’s a total lack of work in my area of expertise.”
Don’tcha think it might be time to learn something new, then, rather than sitting on your big hairy butt firing out children on the taxpayers’ dime then, Ray? You have sat on your lazy ass for longer than I aim to retire early. For a quarter of your potential working life you have done diddly squat, while Gordon Brown, in addition to saving the world solved child poverty by dropping money from helicopters to people like you. Solving child poverty was a laudable aim, but not if you start creating more of it by making it easier for people like Ray to sit on their Lay-Z-Boy recliners watching Sky TV….
Talking of which, let’s move on to the spending of this feckless bunch of time-wasters
‘There are four children to supply school uniforms – including gym kits – each year. The school trips aren’t days out to Alton Towers – they’re educational trips for several of the courses, like history, geography and media studies, that the school tells us will form an important part of their course. Then there are seven birthdays a year, and seven children to make Christmas happen for each year.’
Whenever anything that looks like frippery is given the adjective ‘educational’ we know we are being rooked. In the 1960s and 70s families sometimes just had to say ‘we can’t afford it’ to school trips. If enough families didn’t sign up, the trip was cancelled. It wasn’t the end of the world. And I’m sorry, but media studies isn’t even worth the time it takes in the school day, and it definitely isn’t worth some of my money to send Ray’s children on school trips for.
As for the seven birthdays and Christmases, well, used to be if you couldn’t afford Christmas you’d make the presents yourself. Ray and Katherine need a spine transplant, so they can say to their kids “we can’t be bothered to go to work to give you that iPod you wanted, so you’ll have to do with this tube of Smarties instead”. Instead they tell their children the lie that the fairness fairy will given them their heart’s desires, propagating the entitlement gene across the generations. Oh and you, dear reader, and I get to pay for it, too…
‘We get the Sky Movies package because we’re stuck in the house all week – otherwise we wouldn’t have any entertainment.’
Bit of a battle for the old remote control, eh? And why are we paying the Digger £780 a year, Ray? Tell you what, since you’re so keen on things ‘educational’ howsabout you haul your lazy ass down to the library and borrow some of those flat things called books, and get your lot to read?
Anybody who has Sky TV should have benefits docked to the same amount. It’s a want, not a need. My TV delivers enough entertainment without Sky, I reused the dish for FreeSat. Want Sky to watch the footy? Get a flippin’ job, Ray!
‘Most of this goes on our eldest son’s bus fares to college and back. For me, if it’s less than five miles, I’ll walk.’
For the first time, I tip my hat to you, sir. That’s the right attitude. Heck, I’d be okay with putting some of the saving from the Sky TV package I’d cancel to get you a reasonable pushbike.
‘My wife and I have mobile phones, and so do all of the teenage children. You try telling teenagers they’re going to have to do without their mobiles and there’ll be hell to pay.’
How about telling them where to get a paper round if they want a mobile? It’s back to spine transplant time for you, Ray, my boy. And why the bloomin’ heck is this costing you over £1500 a year? What part of PAYG and ‘shut yer gob’ do you and yours not understand? I have never paid £1500 a year for mobile phone service. Nor even £200, which is the per head rate, and I don’t plan to start. Ever heard of Skype, since your lot seems to spend most of the time at home?
‘Gas and electricity bills have gone up massively over the last couple of years – two years ago we were paying £20 a week. If they do cut our benefit we are going to have to choose between eating and heating the house properly.’
Even when I was running a video conversion firm with loads of electrical gear I never paid that much for heat and power. Presumably the jumper is not an item of clothing your family is familiar with? Or the clothesline, though I accept that may have limited use in Wales.
‘ Rent £76: This is social housing in Wales, so the rent is hardly massive. If we rented privately in this area, then the cost would be four or five times as much.’
Nicely played, sir. At least it is a different bunch of taxpayers keeping a roof over your head… There’s a lot to be said for diverisfying your income.
Weekly shopping £240, Includes food and household goods, 24 cans of lager, 200 cigarettes and a large
pouch of tobacco:‘Our biggest expense. We do all our shopping at Tesco or Morrisons in one big go. Mostly we buy the “value” range – tinned meatballs, baked beans etc. On the cigarettes, my wife tried to give up, but she missed one appointment on the course and they threw her off it.’
Looks like tobacco is £65 then. So I can sort your £82.40 weekly saving at one fell swoop. Cut the ciggies right out, drop the Sky TV and the remaining couple of quid can either come off the children’s Christmas and Birthday presents or you can drop a tinnie or two of the lager. They do have Aldi or Lidl in Wales?
There you go, Ray. Fixed that for you, and you’ll have your no doubt lovely wife with you for that much longer because she doesn’t smoke now 
For far too long the goal of reducing child poverty has led us astray.We did not raise our eyes to the monster that we were creating as a byproduct, of increasing the ranks of the undeserving poor.
It’s all very Victorian, but we need to start discriminating again between the deserving and the undeserving poor, because at the current rate of progress we are all going to be poor.
We could start by making access to a higher level of welfare payments contingent on having paid into the system in the last few years, like many European countries. I wouldn’t mind paying toward’s Ray’s brood if he’d been working for the last 10 years and then lost his job in the current downturn. What incenses me is that he had another child while on benefits! We could make child benefit payable in kind, particulary if the child appears more than 9 months after you’ve been claiming!
Something that always puzzles me is how many poor people smoke, or is it that smoking makes you poor. In the end if you can afford it I don’t give a toss if you smoke or not, as long as you don’t do it near me. If you’re on benefits then I do mind. If I were on benefits I would expect to have to drink less!!!
A first step of capping benefits at £26,000 (the average wage) seems like a pretty good start. Bring on the Welfare Reform Bill. £26,000 is a high proportion of my annual wage. Hearing slackers like Ray and his bunch get it for free make me feel like a right mug for working for a living and going without to try and buy myself a few years out of work.
Hearing him whingeing about having to choose between heating and eating when outing the tobacco and the Sky TV would more than bridge the gap makes me want to slap him round the face with a wet fish and insert a bit of steel into his spine, and tell him to man up and sort out his responsibilities rather than moaning about his rights.
Oh and I’ve borrowed the concept of a complainypants from Mr Money Mustache. And tagged the posts about moaning benefit recipients as such. In the end if you get benefits, then that’s nice. Just don’t build a lifestyle on it, OK?
Why do I say that? Look at the words of Bill Gross from PIMCO where he asks where credit goes to die.
Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound.
We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.
Your frickin’ benefits are being paid from that abundance. Austerity won’t be paying them in future. Child poverty will reappear. All benefits will fade away. I’d be surprised if I get to draw a State Pension in 16 years’ time, it will probably be means tested and hopefully I will have too much capital, though Bill’s prognosis isn’t so good for that either. That is the trouble with relying on benefits – governments can take them away, just like they did for people that paid into SERPS who took the shaft recently.
So don’t have kids on benefits so that you get more CTC. You’re likely to see that kid go short over the next 18 years unless you get a job. The writing is on the wall, pal, and it’s going to stay up there for a long time.
We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.
How to use Sharesave Redux
In my original how to use sharesave SAYE schemes post I assumed that the changes made by my company to stop employees dropping share options that were underwater were universal.
They aren’t – some firms continue to allow employees to drop previous SAYE schemes and reallocate the dropped scheme’s allowance to the current year’s scheme, up to the HMRC £250 a month limit.
This was how my company used to do it, and I always took the line to drop the previous scheme and reallocate to the current one if the current offering’s option price was lower than the previous scheme.
I backtested the efficacy of this approach, compared to the rolling equal allocation I’d have to use now. Turns out the orginal gut feeling to drop was right. Tragically I always spread myself across the 3 and 5 years schemes, failing to appreciate how much better the 5 year schemes were, because of the longer time in the market. So going with my gut was overall only half right, a reminder that for those things that are amenable to analysis, there’s no substitute for doing the analysis, which is what I should have done in those dark days of DOS and Lotus 123, way back in the early 1990s…
cumulative returns of differing approaches to sharesave, using FTSE100 index prices
No-brainer. Go for the 5 year scheme and drop underwater schemes. Note you should still test this with back-values from your employer’s specific share prices, sampled at the time of year your specific sharesave options are granted. This is using the FTSE100 as a proxy for the share price, and your industry may have peculiar cyclical patterns that just might make a difference.
It stacks up with my recollection. Feast in the barnstorming years of the late 1990s, mostly famine since then…
For this to be any use to you you need to be a worker drone in a company that is listed on the London Stock Exchange, and has a save as you earn scheme. In practice I think that means it’s probably a FTSE100 firm. If your firm doesn’t allow you to reallocate previous sharesave allocations before the term is due, the original How to Use Sharesave SAYE post is more relevant to you.
2011 ISA investment review – rough waters but maintained speed and heading OK
Most people do their new year review in January, and it’s still January, even if I’m nearly a month late. Last year I was looking for income, and this year I can look back, and conclude that I got it, to the tune of about 4% on the cost of what I put in. That’s possibly a minor fail as I target 5%, but I only have two-and-a-half year’s worth in my ISA and I buy throughout the year. So it’s possible that the ramp up across the year has something to do with that.
An Interesting Taxonomy of Personal Finance approaches from Moneysaving Challenge
I’d never really taken the time out to analyse the different approaches to improving your financial situation, but MoneySaving Challenge did some of the the legwork came up with this intriguing summary
UK Personal Finance Blogosphere, Source: www.moneysavingchallenge.com
It’s reasonably obvious that frugality is at the opposite pole to consumerism, and indeed money management is also an antidote to consumerism. It did make me wonder, however, wherther frugality is a hazard to growing wealth. Although it’s a small sample, it indicates that British personal finance is sparser on the growing wealth axis than the American PF scene. Although the American Dream has taken a serious hit over the last few years, perhaps the myth of continuous progress is helping people in the States feel more chipper about their plight.
Some of the same optimism, though in a more understated British way, is displayed by Monevator who is still upbeat by the end of Gruel Britannia, leading one commenter to observe he may “see sunrise as a bullish indicator“.
Perhaps that’s where I’m going wrong… There is also the implication that frugality is not necessarily the best way to growing wealth, and this is another notable difference with US perspectives, there tends to be a stronger bias to increasing your income rather than cutting spending. This wasn’t my experience; I only started to build significant financial assets after taking an axe to spending. For most of my working life I was building non-financial assets, in particular buying out my mortgage. Cost control worked for me.
I also observed an interesting gender distribution on the plot, let’s just say that the distribution does not appear to be gender-neutral to me. And that’s all I’m going to say on that front, but it is interesting what areas are focused on by the ladies and the guys For the sake of clarity, I don’t think this is because MSC imposed this distribution, I’ve observed it in the PF blogosphere as a whole.
How to Use Sharesave Save As You Earn schemes
For this to be any use to you you need to be a worker drone in a company that is listed on the London Stock Exchange, and has a save as you earn scheme. In practice I think that means it’s probably a FTSE100 firm.
The idea of sharesave is to encourage employees to take a share in the company, all considered A Good Thing. They’ve been running for years, I recall my Dad doing these. If your company offers one, they are a no brainer, do it, do it now, and do it to the max (£250 per month), as long as you don’t go into debt and have cleared your consumer debts other than mortgage. Once you have five year’s worth of contributions, you get that one way bet at no extra cost. It’s rude not to take part in an offer like that
Caveat employer… don’t hold shares in your employer longer than you need to
You should generally avoid holding shares in your employer other than as part of sharesave or share incentive plan (another wheeze like SAYE, without the one way bet but with big tax advantages). That is because if your employer falls on hard times not only do your savings take a hit due to the share price bombing, but you are more likely to lose your job. The only exception I can think of is if you believe your employer is likely to be bought by another company, which is usually terrible news for employees but can be associated with a share price hike. It’s still a long shot and there are better ways of preparing for redundancy…
For a similar angle but from a bunch with more financial clout than me, see the FT on will you buy into the John Lewis economy on the hazards of over-exposure to your employer. Think Northern Rock when you fancy holding onto shares in your employer longer than you have to…
What’s so good about sharesave?
The reason sharesave is a no brainer is that it makes you the kind of offer you will never get anywhere else, a one-way bet on shares. The worst you can do is simply end up saving cash for three or five years.
What happens is in any year you are offered the option to buy shares in three or five years time at a price fixed at near what it is now. You start a monthly savings plan for up to £250 p.c.m. post-tax allocated in any proportion to the three and five year schemes. In five years time if the share price is higher than the option you exercise the option and then sell the shares immediately, pocketing the difference. Obviously if it’s lower you don’t exercise the option, and say I’ll have my cash back thank you very much, with some interest added usually. In a slightly depressing observation on the financial acumen of some of my workmates, I’ve known some people exercise the option when it isn’t in the money, and that’s even after the firm has added a letter to the maturity note saying you should note you can buy the shares cheaper on the open market. There’s no helping some people
In the past it was easier because you were able to drop schemes where the option price was higher than the latest offering, but HMRC has stopped that wheeze, (No, they didn’t, just some accounting changes made it so letting employees do that cost the company. See this comment for details. If your company still allows you to drop a scheme and reallaocate the savings allocation to fresh schemes, then you want to read How to Use Sharesave Redux) so though you can drop a scheme you aren’t allowed to allocate that monthly allowance to later schemes until the original term is up. This means you need to think first before acting, to avoid stiffing yourself further down the line.
How to play sharesave to best advantage
First you need to ask yourself realistically how long you expect to be working for this firm. If it’s only for five years then buy the three year scheme for two successive years, £125 a month in year 1 and the same amount in year two (i.e. £250 in total in year two and three, then £125 in year four). However if you are looking at working there longer, then you need a plan.
Diversification is still your friend with sharesave, even though you are only dealing with one share. What everybody seems to miss, is that you have two temporal periods (3 and 5 years) and the chance to sample the share price every year.
What you don’t want to do is look at the option price for the two schemes in the first year, decide the 5 year scheme is cheapest, and lob your whole £250 savings into that. You want to maximise the diversity of your time-slots.
Diversify your temporal risk
You also want to maximise the amount of time you’re in the market, so if you are going to be a lifer in this firm (or even aim to work there for a decade) then buy £50 of the first year’s 5yr scheme, £50 of the next years 5yr scheme, and so on. After five years, your allowance for the first year’s scheme will come free as it matures, and you can allocate that to the sixth year’s SAYE scheme. If you sell as soon as your options mature, assuming they are in the money, then you will have the cash to allocate to your next allowance, so this one-way bet is now free.
You can do that instead with the three year scheme, but your options will only be in the market for three years rather than five, which reduces the amount of time your cash is in the market exposed to that one-way bet.
I simulated this using the FTSE 100 index as a proxy for a typical blue-chip firm offering a sharesave scheme.
yearly Sharesave returns if the company followed the FTSE100 index
and the cumulative profits over a 20 year period:
Cumulative sharesave profits over 20 years
The cumulative profits understate things because of inflation, and it also shows the heady profits that were to be had from the stock market in years gone by, the fat years after the early 90s recession up to the dot-com boom, then the 10 lean years from the dotcom bust to now…
The pattern is familiar, I made most of the money from sharesave in the years leading to the dot com boom, and very little in the decade after. Unfortunately there was corporate action for my employer in 2001 which means I can’t get a historical time series back to 1990. The ride was a bit more choppy than this graph shows, and sadly I didn’t realise that the 5 year schemes are so much more valuable than the three, so I did a mix of 3 and 5 years.
Watch out for specifics
The industry your employer is in doesn’t necessarily have the same statistics as the FTSE100. It’s likely to be a damn sight more choppy – I know my company is. So it may be worth simulating the last decade or so of price data for your firm. Here is the spreadsheet I used, exported to Google docs. There may be cyclical patterns in your company’s share price that make some of the assumptions break down. Having said that I’d have done fine running rolling five years sharesaves with my employer’s shares.
Don’t go with your gut
I learned something from writing this post. From a gut feeling, I had gone for diversifying the period, buying a mix of 3 and five year schemes. I had not realised until now the fact that the 5 year schemes give me more time in the market and how valuable that was.
This may have been offset by the fact that for my entire sharesave career I was able to drop previous schemes where the option price was higher, and reallocate the allowance to the more advantageous sharesave scheme. HMRC disallowed that in 2009, so you won’t be able to do that. Now if you take out a 5 year sharesave scheme even if you stop saving you can’t reallocate that allowance until the original 5 year term is up.
Responding to exceptional share price events
My employer had a near death experience which resulted in some pretty nasty management practices. Previously I had assumed I was going to carry on working to 60 at that time, but one particular incident showed me I was unlikely to make the course, so I switched all effort into saving up to be able to retire early. This near death experience slammed the share price in 2009, so the option price on that sharesave was very low. Though I didn’t know if I would still be working there in 2012, I dropped every single previous sharesave and threw everything into that year’s sharesave, with half the money allocated to the 3-year and half to the 5-year scheme. Obviously I have to put a lot more per month into the 3-year scheme as you only have 36 months to buy your shares, as opposed to 60 months. The aim is to have an equal monetary stake at the end. This works out to £94 in the 5-year and £156 in the three.
The principle is that you don’t know what will happen in 3 or 5 years time, so I want to bet on both horses. Say the Euro blows this year, then the 3 year options might lapse but the price on the option maturing may be lower. In that case don’t execute the option. There’s still chance for some of the storm to blow out and the 5-year option to come good. Although I don’t expect to be working there when the 5 matures, once the scheme has been running for three years then under some of the circumstances I may leave I could make it paid up.
If the 3 year option matured tomorrow, I would do very well out of this sharesave, indeed I couldn’t liquidate the shares without becoming liable for capital gains tax, which would be a first for me. I believe that the Euro is doomed beyond redemption, and that the denouement could very well happen this year.
So I have gone to IG Index and shorted half the number of shares I have options in. Barmy, you might say, why the hell short something I own, but that has the effect of locking in half the options at the current price. If they go down I make a profit at IG to compensate, if they go up I have to pay IG but I get more selling the options. I’m prepared to pay that as insurance. In three month’s time I will short half the remaining half, assuming it makes sense, to lock in the price for three quarters of the shares.
Spread betting comes with an extreme wealth warning, but it’s the right tool for the job here. Another case where you may want to short a stock you hold is to avoid eating a capital gains hit. Just carry on holding the shares and short them, buying the short and the number of shares you own / 100 (because IG prices move £1 for every penny the share price moves, with you rescale back but selling 1/100th of the amount). If nothing untoward happens I may have to do that in August; sell half the shares to avoid the CGT liability and roll over the IG short on half the total which I will still hold, eliminating my exposure to my employer without selling the entire stake.
Spread betting works for the tax-free employee share incentive plans too. With these, you buy up to £125 of shares from pre-tax and NI income, which you have to hold for five years before you can sell.
Sadly, this is another trick I missed, so some of the shares I hold went through the near-death experience, though they’ve come back up. I could have shorted thse guys as I bought them every month, taking the tax-free bump up and protecting my purchase against the vagaries of the stock market. However, it just goes to show one of the dirty little tricks of capitalism. By the time I got experienced enough to spot this insurance scheme, I’m about done with the opportunity to use it. As a colleague once wryly observed, money is drawn to money…
personal finance: compound interest financial planning pensions
by ermine
13 comments
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)
It’s time to buy
There are few decent signals to be had in the stock market. If this report from the Investment Management Association is correct, then we’ve just had a good one.
Equity funds saw their largest outflow on record, with net outflows of £864 million in November, compared to a monthly average inflow of £506 million for the previous twelve months. Equity funds have seen net outflows in four of the last five months, following over two years of net inflows.
For the third month running, the highest selling asset class was Bonds, with net retail sales of £443 million, above the monthly average of £332 million for the previous twelve months.
Balanced funds were the second highest selling asset class when excluding the ‘Other’ category. Net retail sales of Balanced funds totalled £262 million in November, the lowest since April 2009 and well below the monthly average of £493 million for the previous twelve months.
The message is clear. Buy equities this year I was so chuffed on reading this I caught up with my regular purchase of a FTAS and a global EM tracker funds which had gone astray over the Christmas break. As Warren Buffett said:
Be fearful when others are greedy, and be greedy when others are fearful.
Looks like people are fearful…
How I Got Away With Not Saving For a Pension in my 20s
The standard advice for anyone in connection with pensions is start early, young man, start early. Do it, and do it now – your early savings are what makes all the difference.
I didn’t. I effectively started at 28, and even worse because I want to retire early I effectively started later in my working life. For a normal worker in my industry retiring at 60 I would have been saving for 32 years whereas I’ll be lucky to reach 25 years. I’m therefore like a normal worker starting at 35. Because my company pension is a final-salary one, the difference is less than it would be with a DC scheme. However, I’ve had to make changes in the last three years to try and make up for the difference.
Because I own my house outright this has been easier for me, and it make me wonder if the standard advice is simplistic, and people should take a systems approach to their lifetime finances. In a later post, I will try and work out what proportion of income I did spend on the various key aspects of life (housing, hedonism, tax and pensions). The information isn’t precise for some of the early years, and yet I believe it shows that as long as you do save for some key asset classes in your 20s, it doesn’t have to be a pension in those earlier years.
I’ve analysed my working life, and mortgage, rescaling values to eliminate the scourge of inflation which makes it so hard to compare values over a thirty-year working life. Here, I have looked at various pension saving scenarios and how they would work out, as if I were saving into a defined contribution pension at 15%, about twice the rate of NEST’s 8%. Defined Benefit (final salary) pensions are better than NEST largely because more money goes into them, usually from the employer so it is not always visible to employees. However, a pension is deferred pay, so two employers both offering the same salary but one offering more contribution to a pension are actually offering different salaries.
First off, an extreme wealth warning. If you are in your 20s and looking for an excuse to live it up at the expense of saving this is not your ticket to ride. You have far more unknowns ahead of you that I have in describing this story, because I am in my early 50s and my career trajectory is known. If you’re young and you use this to justify not saving your 8% of income into a pension then you need to save 8% of your income into some other asset, and assets do not include most of the things you might want to buy
I got into deserved hot water over here for the assertion that you can make up for a lack of saving in your 20s, and that compound interest will not necessarily ride to the rescue. Not because I didn’t get away with it, but because
@ermine — Thanks for the follow-up. I’m going to argue strongly against what you’re saying, for the sake especially of young readers reading, as I think it’s dangerously misleading.
[...] I don’t want Monevator to help put people on the exactly the opposite path that I set out to postulate, and that we post on every day – i.e. at a minimum, realistically aiming to achieve financial security within their lifetime, or better yet some financial freedom.
Consider yourself warned young person, Monevator is right in that you can’t know until you are 50 that you won’t take some important hits I didn’t. I am looking back over my working life and I know what happened. Young reader, you are looking forward over an unknown career arc. You may have less luck that me. In particular, if you are a woman in your 20s do not follow my path. I will explain why later, but you are exposed to more serious risks statistically that men at the same age. It’s not feminist, it’s not fair, but it seems to be what happens, and you should protect yourself against the world as it is, not as it should be.
Having said all that, I consider this pretty clear proof that the magic of compound interest is not all that it is cracked up to be, and that is is perfectly possible for someone who has a career path similar to mine to catch up for the lack of early pension savings in ther 20s. Observe that I did not accumulate any debts in my 20s, and my savings went towards putting down part of a 20% deposit on a house I stupidly bought at the height of the Lawson boom. For all the good those savings did me I could have drunk it all in the Television Centre bar and had twice yearly holidays in the sun, but I stuck with just reasonably excessive drinking and one holiday most years.
The community that can take inspiration from this analysis is the one of the greybeards who didn’t follow the recommended route, and delayed saving till their thirties or even forties. As long as they didn’t screw up with debt, and as long as they paid their mortgage down at the recommended rate, they can recover without working till they drop, through the application of ERE’s methods, but perhaps calling it Earlyish Retirement Extreme
Setting the scene – how I simulated different saving approaches
To try and make sense of the last three decades, I have taken my salary and normalised it to 1 for my first proper job with the BBC in 1984. I am British, and unlike our American friends I just don’t like talking about how much I earn. Regular readers have probably roughed it out by now, but you ought to have to work for it.
I’ve then rebased everything by scaling for inflation using the RPI index, setting that first BBC job to a nominal value of 10000 pounds. In the RPI adjusted world I have created, that 10000 pounds holds its value across the three succeeding decades, because I deflate prices and my salary by RPI inflation.
an ermine's inflation-adjusted income and mortgage stupidity
You can see that over the years I improved my income in real terms by over two times. The dip in 1987 was when I took an MSc with a Manpower Services Commission grant. You can also see that the ermine is taking a hit from the stinginess of my employer and the rampant inflation of late towards the end. The actual high-water-mark of my real income was in 2008.
I’ve also represented my mortgage on that. Look at that awesome income multiple of what, 5 times? Millennials and the Priced Out generation take note, I had to stump up a deposit of about 10% to bring that multiple down to within spec so my debt was lower. I then had to borrow another 10% interest-free on a credit card advance to avoid taking the shaft from high loan to value insurance, which I paid down in the first year. Whenever it looks like a good idea to pay more than 4*salary for a starter house, STOP. You are either earning too little or paying too much, just like me What isn’t shown here was I had an endowment mortgage which I only managed to conclude a mis-selling case on in 2004. Friends Provident sold a single ermine with no dependents a life insurance product, FFS. Fundamentally I shouldn’t have been so stupid, but at least I did get the situation restored to what a repayment mortage would have been (the endowment had fallen behind by 1/3). That payment from the endowment is why it looks like I robbed a bank in 2003/4…
Although I was a feckless young ermine, taking my BBC final salary pension as a cash lump sum on moving to my current company, I am lucky enough to have been in a final salary pension scheme since then for the rest of my working life. Taking a leaf from SG, I have simulated that pension with a steady pension saving rate of 15% from my rebased and inflation-free income, compounding at 5% which seems a reasonable estimate for the long run stock market total investment return after inflation. Mind you, someone who has been saving using an index tracker over the last decade may take a dim view of that 5% assertion! I’ve then modelled how various different variants of me would have done with different pension savings strategies.
Meet the Cast of Characters
Steady Eddie
First we have Steady Eddie. He starts work, saves his 15% gross into a pension scheme from 1983 until he retires at the end of 2010, 27 years later. He is the benchmark for how you should save into a pension. In all these graphs, the magenta bars are the parts contributed by the magic of compound interest. Note that most of this is Eddie’s own saving, though I do agree it would be churlish to deny the value of compound interest, as it makes up 48% of his pension capital.
Steady Eddie. Take it slow, Eddie, this is how pension saving should be done
He has experienced the same career progression in real terms as I did, so he earns just over twice as much as a greybeard as when he got his first real job. I normalised his wages to £10000 in 1984. I don’t count my very first job as that was a poorly paid technician post; I started looking for work in 1982, into the teeth of Margaret Thatcher’s first serious recession, so I took the first vaguely relevant job I could get. Eddie is sitting pretty with a pension of 6554 pounds in my normalised universe with a pension capital of £131000. That’s slightly under 40% of his average salary and 28% of his final salary. I am lucky; if I left and drew my pension now I would get a higher percentage of my final salary, and I am duly grateful for my good fortune in that I have had a stable job that has been interesting and rewarding for the vast majority of my time there, regardless of things that may have gone wrong in the recent past.
Sensible Susan
The only lady in the bunch, Sensible Susan follows the same path as Steady Eddie for 11 years. Ball-breaking feminists are going to hate this, but she then quits work to have children.
What can I say? I’ve observed it happen that way often enough, and even if Susan returns to the workplace the missing years are critical to one’s career deveopment. Though my pay didn’t go anywhere in real terms in my 30s the projects I worked on built the platform on which I got the next decade’s rises. However, since she was sensible, Susan has built the classic early starter ‘magic of compound interest’ example of saving for ten years and stopping. Except I’ve had her save for eleven years, because I took time out to to an MSc in 1987 and it seems a bit tough on the Sensible Susan version of me to KO 10% of her earnings as well as well as have her stop work early. Articles like this, this and this lead us to believe that the magic of compound interest will save her pension, but a casual inspection of her savings graphs relative to some of the later more feckless versions of me will show that just isn’t true. I have kept the vertical axes the same scale.
Sensible Susan - the magic of compound interest (magenta bars) works for her but it doesn't make up for the serious lack of contributions
Sensible Susan is on less than half of Steady Eddie. Compound interest makes up more than half her pension capital (66% of a total of £53000). She’s going to feel the pinch with less than half the pension of Eddie. On the other hand, she’s contributed less than a third of Eddie’s contributions. That she is closer to half than a third of his pension speaks something for the magic of compound interest but no way as much as you’re led to believe.
Feckless Freddie
He’s a lazy B’stard, our Freddie. He spends far too much time in the BBC Television Centre bar eyeing up the beautiful people of the luvvie set, who are far prettier, and, er, of the right sex, than the hairy-arsed engineers in the bowels of TVC where he works. As a result, he doesn’t realise till too late that London prices appear to be getting away from him. One day he ends up in the Broadcasting House bar (a classier lot in those days, the Radio types than Freddie’s Television Centre chums) and listens to yet another gorgeous sylph-like Rebecca and her pretty-boy BF talking about how much the price of their house has gone up and “oh gawd, Tarquin, ahhhrn’t we rich, dahlink”. On the radio Freddie hears Elvis Presley singing “We can’t go on like this”.
and thinks to himself that yes, London, we can’t go on living like this, I am caught in a trap. As Freddie pulls his head from yet another pint of E.S.B. he looks up and gets his coat. Freddie figures he needs to go up the value chain a bit from being a studio engineer, and get away from the city that won’t let him live in it without paying exorbitant rent. After a Tube journey he gets on his bike to cycle up the Western Avenue from TVC to Hanger Lane, and thinks about a research job with more pay and a chance to buy a house. But first he needs to fix his ropey Batchelor’s degree. When he gets home he notes the beginnings of a gleaming white pelt starting to show.
Yup, Feckless Freddie was me. I did the MSc, returned to London for a year then moved up to Suffolk. House prices were still sky rocketing, and I had to get on the ladder before it became out of reach. Oh dear…
I did investigate whether my BBC pension could be transferred to my current employer, but it didn’t work out. If I had those three/four years they’d be useful but I’ve been here long enough it isn’t a huge amount. As a deferred pension it would be diddly squat, as it is referred to my final salary on leaving the BBC, so even if it didn’t lose over the years to inflation it would be referred to as final salary less than half of the one I retire on. So I used the £700 surrender value to a good purpose towards the deposit on the house. Oops…
So how does my alter ego Feckless Freddie get on?
Feckless Freddie and his Frantic Antics at the end
The three yellow bars are the savings I have managed over the last two and a bit years, effectively twice my gross annual salary. If we ignore these, we still see that Feckless Freddie has an accumulated pension capital of £78000, less than Steady Eddie but still a lot more than Sensible Susan. Why is this? It is because twenty years of compound interest doesn’t make up for Susan’s shortage of contributions, and this is made a lot worse by her lack of the boost provided by career progression.
It is the weakness of compound interest at realistic rates of real return, combined with the fact early pension contributors are contributing from a low earnings base that means all those stories about early starters staying ahead are just wrong. Feckless is obviously feckless, because he is about half short of Steady Eddie. However, he’s paid off his mortgage by the end, so he can now hit the tax-advantaged pension savings hard. His risk of the government shafting his plans is reduced as he is within a few years of drawing his funds, and the tax-free-pension-commencement lump sum could be just the ticket to make up for his fecklessness earlier. Feckless Freddie ends up with £129k, compared with Steady Eddie’s £131k. After three years of austerity, Freddie can sign up for his pipe, slippers and cruise brochures too.
The fact that Freddie ends up with the same as Eddie isn’t totally coincidental. I targeted making up for the lack of pension contributiuons due to my missing years as well as compensating for retiring early. I can’t compensate for both unless I work another two or three years, but I can eliminate one. The bar was set by what my own pension would be if I stayed to 60. My assumed real rate of return was 5%, and though I can realise that as dividends I don’t believe I will get a total return of that much even though I have bought mostly since the crash, and a lot at the early 2008 low. I think my share capital value will fall behind inflation in the years to come, but this will hopefully happen slowly so if won’t kill me off in the period between leaving work and actually drawing my pension. If my share capital and dividend income starts to get nuked, well, that’s why I have about the same amount as my shares ISA in cash savings, because there is the mother of all economic shitstorms coming our way. I won’t be a forced seller in that intervening period unless the value of that cash is destroyed because this sort of thing happens.
Looking at Sensible Susan’s holdings, note that what early saving and compound interest have bought her is insurance. She is unlikely to be totally unable to work again, and if she returns to the workforce then some of the same techniques used by Freddie are open to her. She is likely to reach a lower maximum salary in real terms than if she hadn’t taken time out of the workplace because other workers will have been honing their skills and schmoozing their way up the greasy pole in the gap, but there’s nothing stopping her making up some of the difference. Had he not done something drastic, Feckless Freddie would be closer to her pension than to Steady Eddie’s.
Finally, let’s meet
Stupid Steve
Steve couldn’t see the point of all this saving for retirement malarkey, life was for the living here and now. He’s been a bit stupid, really, our Steve, and only started saving for retirement for the last ten years of his working life. He’s almost like Sensible Susan in the number of contributions, but what makes him stupid and her sensible is he did it the wrong way round. Everybody tells you you have to save early on, right? So what happens to Steve, he’s going to get slaughtered, right?
Stupid Steve loses out, but not as much as people would think, since his contributions are twice as high as Susan's
He’s had the same career progression as I did, so his pension contributions are made at the peak of his earning power. He’s on a pension capital of 43,000 compared to Susan’s 53,000. But he’s still got one ace to play that she doesn’t necessarily have. He’s still working, so if he manages to sock away twice his gross salary towards the end, getting himself up to 94,000.
Now there are some things about Stupid Steve that make you think perhaps he may not be the most financially savvy cookie. But there may be mitigating factors. Say Steve is self employed, and he’s been building up his business all his life. When you or I leave work, we have nothing to show for it expect a few beers down the pub, a gold watch and of course the pension. When Steve leaves work and retires, maybe he has a viable business he can either get someone to run and it pays a dividend, or he can sell the company as a going concern and recover the capital he built up over his working life. Suddenly Stupid Steve isn’t so Stupid at all, perhaps he is Smart Steve. He’s only doing the pension saving at the end because it’s rude to say no to a 40% tax break with five years or less to run.
Conclusion
The advantages of compound interest are vastly overrated as they apply to real-world pension saving. Real people
- don’t have enough time
- can’t get enough real investment return
- haven’t advanced enough in their careers
for the much vaunted example of Sensible Susan ending up with more pension capital than Feckless Freddie, even if he starts 10 years later. They’d have to achieve an investment return of > 8.5% in real terms for that to be true, and it just ain’t going to happen.
The main thing you buy by saving into a pension early is insurance – against long spells of job loss, unpaid sabbaticals or incapacity.
Earlyish Retirement Extreme
The message to greybeards who have spent too little time saving in their youth – there is hope! You can do it. Austerity is a lot less painful for a 50-year old with their house owned mortgage-free than it would be for a 25-year old. Most of the things that are wrong in my life are to do with the fact I am working, the environment is enervating and it consumes a lot of my time. Very few of the things wrong in my life can I solve by spending more money!
The Archdruid identified the key issue in this post.
What most Americans do not know, and have no interest in learning, is that it’s possible to be poor in relative comfort.
I found the transition, from a normal average consuming lifestyle to one of consuming less, very hard. I was far more motivated to go through it because I was under the impression I would become unable to work or ejected from work in months. I wouldn’t have been able to complete the transition otherwise, but after six months of consumerism detox I was off it.
Above all else, if you’re doing Late Retirement Extreme saving as opposed to Early Retirement Extreme saving, you are probably saving at the peak of your earning power. To save in real terms what I saved in the last nearly three years would have taken me nearly seven years of saving at the BBC – I didn’t work there that long! Plus my outgoings were a higher proportion of my pay than they are now; what would I have done about paying the rent? Not only that, the money I saved would be locked away for three decades for governments to try and get their sweaty mitts on it, and I would have saved less tax.
As for seven years staying in my sleazy bedsit as opposed to three years reduced outgoings at home with the lovely company of DW, well, I dunno. Getting on isn’t all bad
the young person’s dilemma
Even for young people, and subject to this dire warning I’m just not so sure that locking your savings in a pension for 40 years (by the time you are 30 the retirement age is probably going to be 70+) is the best thing to do with any cash you may be able to save between 20 and 30. There’s lots of contrary opinion, like this and this to the effect that I am wrong here, so you have to make this call yourself. The primary risks that mitigate against later saving are if you expect to take significant time out of the workplace to pursue lifestyle choices or you expect career progression to be lower than mine. Taking time out tends to lower career progression, switching jobs between and within organisations more than me tends to increase it.
Look at those charts, and they are for a relatively short working life of thirty years, compared to 40 or 50 years that are implied by State retirement ages of nearly 70. As long as you start by the time you are 30, giving you 40 years to save before retirement, I’d say there may be other more pressing calls on your saveable cash. After all, though I was a dipstick for using my BBC pension funds towards a house, the financial strategy was right – put this into a capital asset. You recognise an asset because it either saves you more money in its lifetime than it costs you, or it pays you an income.
A house is a capital asset if it saves you rent, and the many reasons for not buying a house don’t outweigh the many reasons for buying a house. Machinery, services and supplies for a business are an asset if the business can turn a better profit than the cost of those assets properly depreciated would return on the stock market on in a bank. Your van is an asset if it lets you get more work than it costs, your Ferrari, designer suits and your Sky subs are not assets.
So as long as you understand assets, and as long as you save into assets or RPI index-linked cash the amount you would save into a pension (at least the equivalent of 8% pre-tax), I would say a young person might do well to take a strategic view that saving to a house or saving to buy assets for a business or saving cash is more relevant to their financial lifestream. Pensions advice is so one-dimensional. Do it. Do it now. How about no, let’s work out that this makes sense?
Assets can help you save in a pension later on. My house contributes £9800 p.a. to my pension saving – it would cost me £7k to rent it but I don’t pay myself rent or a mortgage and I’d have to pay 41% tax and NI on that, which I save going into a pension. That’s not a bad ROI, it’s actually over 10% p.a. on the RPI adjusted price I paid for it.
There’s a time and a place for pension savings. As long as you heed the dire warning and understand it, I’m not so sure between your 20s and 30s are that time. Just save that 8% of income somewhere accessible and tax-sheltered if in financial assets. Yes, you’ll lose the tax break now, but heck, you’ll probably pay basic rate tax on it on the way out so don’t sweat it. Who knows what tax will be in 40 years’ time! It is possible to make up for lost time. The amount I have in pension AVCs alone is enough, at a real return of 5%, to compensate for the six years of contributions I am short.
The Magic of Compound Interest is Vastly Overrated
Albert Einstein is reckoned to have thought it the most powerful force in the universe. It’s often used to exhort young pups to stop blowing their first paycheques on sex, drugs and rock’n'roll. A Google search for “the magic of compound interest” throws up no end of sites telling you that compound interest will make the job of saving for retirement easy, if only you have the intestinal fortitude to do without when you are young. The regular meme trotted out is that Sensible Susan who saves in her pension for 10 years from 25-35 retires on more than Feckless Freddy who lives it up for 10 years before starting to save at the same percentage of salary as Susan, but from 35 to 65. The magic of compound interest is supposed to mean that Feckless Freddy will never catch up.
Wealth Warning – if you’re younger than 40 and looking to use my POV as a reason to redirect your pension contributions into beer and high living you ought to first read this eloquent description of the contrary view
The magic of compound interest is bull, in my opinion, and in my experience. The reason it is bull isn’t that compound interest doesn’t work. The reason is that the examples used to show the young pup that he should forego his hedonistic lifestyle and save into a pension as soon as he gets his first paycheque all assume high compounding rates.
That’s not to say you shouldn’t start early, but realistically, your early savings will pale in comparison with your later ones, and compound interest isn’t some magic fairy dust that will make up the difference. If you don’t start by the time you’re 30 it’s probably no big deal. If you don’t start by the time you’re 40 it probably is a big deal, because you’ve reduced your savings window to half your working life.
Let’s take three guys, all leaving university at 25. Let us also take the view that these guys don’t have any career progression, something that favours the compound interest advocates. They all get the average wage of £25k. Let us assume an approximate inflation adjusted return of 5% p.a. which is better than the 3% of the FTSE100 on a total return basis for the last 10 years. The FTAS isn’t much better over the same time frame. Let’s assume annuity rates are about the same at 5%, or these guys target a safe withdrawal rate of 5%.
Lucky Luke is a born idler whose Dad put £2k into a junior ISA when he was born and left it to accumulate. Presumably his family is old money that knows you never spend capital, so he resisted blowing it on a car when he was 21. Because he lives a life of luxury and never had to work so he never added to it.
Steady Eddie starts work and works for 40 years straight through, paying into his NEST pension at the recommended rate of 8%. He retires on a pension of about half his salary at £12,600, which is fine as he’s paid his house off. Along with his pipe and slippers he gets a bunch of cruise line brochures.
Burnout Brian starts as a runner at Goldman Sachs, but can’t hack it after 10 years and drifts off to a life on the dole, so he only pays into his pension for 10 years and stops. Articles like this, this and this lead us to believe that Burnout Brian will retire on more than -
Feckless Freddy who also starts at GS but spends his first ten years there binging on booze, birds and cars. When he’s 35, however, he meets his true love and settles down. They have The Money Talk and Lovely Lucinda gets Feckless Freddy to start paying into his NEST pension at 8% of salary.
The articles are wrong. Brian retires on 5,700 and Feckless is on 7,400, nearly 30% more! What went wrong? A spreadsheet showing how our three fellows do over 40 years can be seen here.
For Burnout Brian to get the same pension as Feckless, everybody has to achieve a real investment return of 6.8% in real terms, year on year throughout their investment careers. Now Warren Buffett can hit that. Over 40 years to 2006 he delivered a 22% year on year return. Over the same 40 years, US inflation has increased prices by 520% so you have to scale his performance down to a still very creditable 13% p.a. in real terms.
You aren’t going to do as well as Buffett. You have to be very optimistic indeed to anticipate an investment return of nearly 7% in real terms year on year for 40 years.
We all want to believe in magic, but the magic of compound interest is just not that strong in the real world, over a normal human lifetime. Where it comes into its own is for multigenerational wealth accumulation. If you’re an Ivy League endowment fund, sure, compound interest working over hundreds of years can work for you. If you have multiple lifetimes for your money to work over, particularly if you can hibernate for one of those, you’ve got it made. Vampires may have the edge here – long lived, long periods in the coffin keeping spending down, what’s not to like apart from the bad press and difficulty finding a dentist?
become a long-lived vampire to get compound interest really working for you
Compound interest is very dangerous to the economy in the hands of dead people with ambitions beyond a single human lifespan, it is so dangerous that laws like the Perpetuities Act have been enacted to prohibit testators projecting huge economic force centuries into the future.
If you’re Lucky Luke or Burnout Brian, then a large majority of your pension fund comes from the magic of compound interest. The downside of that is your fund just ain’t that big. Burnout Brian is on a quarter of the average wage, and he probably didn’t have enough time to pay off his mortgage before his burnout, so his costs include rent and are higher than Feckless Freddy, who owns his house outright.
Something else that this simplistic treatment doesn’t allow for is that Feckless Freddy may have been feckless but he may have got some career progression. As a result the 8% he is putting into NEST may be 8% of a higher salary. Look at my career progression. A lot happens after those first ten years. It would only take a thirty-percent bump up in Feckless’s starting point or a sudden heft like the 20-25 year mark of my career to have Feckless Freddy on twice as much pension as Burnout Brian. Say Feckless Freddy pays his mortgage off a little bit early. All of a sudden he doesn’t need to pay the mortgage. He can save that into a pension, tax free. He might even be able to get the money out without paying tax by using the 1/4 pension commencement lump sum tax free allowance.
I’ve got it in for boosters of the magic of compound interest, because I was Feckless Freddy. When I stopped working for the BBC in London I took the accumulated money from the three or four years’ worth of BBC final salary pension I had accrued as a taxed lump sum of £700 (worth about twice that now, according to the Bank of England’s inflation calculator). I did investigate at the time whether it could be transferred into my current employer’s final salary scheme, but for some reason it didn’t work out. So my pension fund is about £2k less. Big deal. I started pension saving effectively in my very late 20s. In the last three years I’ve made up the difference and then some.
Look at Feckless Freddie and Burnout Brian. The reason Feckless’s pension pot is bigger even though he started ten years after Burnout is because Feckless stayed at work and continued saving for twice as long as Burnout. He’s put in 100% more than Burnout, and compound interest just can’t compensate for that with realistic rates of investment performance.
Therein lies the message. It isn’t fairy tales like the magic of compound interest that does the heavy lifting. It is steady saving of 8% of your gross salary for more than 20 years that does the grunt work, and then compound interest helps you out by up to 60% if and only if you can achieve a 5% return in real terms. If you’re into FTAS index tracking your returns over the last 5 or 10 years have been about 5%p.a. or about 3% post inflation so your compound interest is definitely lacking in magic compared to the 5% I assumed. Some of you have just had ten years of this, and the bad news is that there is the mother of all incoming financial shitstorms looming on the horizon…
In the case of a defined contribution pension scheme it becomes more and more attractive to hit pension savings as hard as you can late on in your career. You’re more likely to be paying 40% tax which you can save. You’re more likely to have paid off your mortgage, so able to save more of your income. You’re less exposed to government skullduggery in changing the taxation of your pension when you’re within five years of drawing them compared to if you are thirty-five years away. My pension isn’t DC, however there is a DC component in the additional voluntary contributions section of mine. So I hit that hard. You just can’t say no to a 40% saving going into a fund you can use tax-free in five years’ time; that’s an investment return on the tax saving alone of 8% p.a. and rising to 40% in the last year (less inflation, of course). That’s a very different proposition from saving 40% going into a fund you have to wait more than 10 years to get hold of, even if it does grow at 5% p.a.
The job of achieving financial independence isn’t easy. Saving small amounts early in your career and expecting the magic of compound interest to let you kick back after ten years just won’t work, and the reason it won’t work is that you must look at investment returns in real terms, which just aren’t big enough. Look at the investment return values used by Morningstar - a return of 12% is only 1% shy of the returns of the greatest investor that has ever lived. Del Boy and Rodney just ain’t going to manage it. If anything there’s been a marked long term decline in stock market total returns over the years. Returns are broadly correlated to GDP growth and where are we going to get more of that from in future?
Compound interest may perhaps add about 60-70% to typical pension returns over a working lifetime. Not to be sneezed at, but the biggest determinant of how well you live after stopping work is how much of your income you saved. Upping this ratio does you two favours. One is it by definition increases the amount you save. The other is it stops you inflating your lifestyle with all those consumer fads they try and sell you on the telly, and stops you buying too much house for your needs. Much of the key to financial independence is cost control. Spend less rather than earn more, particularly if you want to retire early.
I feel strongly about taming the meme of the magic of compound interest and the futility of saving in the second half of your working life because when it became apparent to me two and a bit years ago that I would probably not manage to carry on working to 60 I heard the compound interest message and figured there was nothing I could do to shorten my working life. I was Feckless Freddie, I was missing those vital early years that I could never get back again.
It wasn’t true, but at the time my world-view was distorted (okay, more distorted than it is now ) and I did not have the energy to analyse this myself, until I came across this post by ERE which showed that there was a way to beat the tyrant of compound interest that is supposed to save everybody else’s bacon. And that way could work, even if applied at the eleventh hour.
Extreme saving is not an easy way. I find it hard to fill my ISA each year because I am saving more than that into my pension, and about the same amount into cash savings to carry me across a few years of finishing work so that I can defer drawing my pension. In three years I have saved twice my gross salary, spread across pre-tax pension savings as post-tax ISA and cash savings. That’s the equivalent of four or five years of my inflation-adjusted gross salary in the first decade of my working life, the Sensible Susan years. I don’t care how sensible Susan is, she’s just not going to save half her gross salary in her sensible start-young saving decade. Even if compound interest magically doubles her savings over the ensuing thirty years, she’s not saving 25% of her salary which would match in real terms what I’ve done in the last almost three years .
Now you don’t save that much by skipping lattes and using quidco. You do that by going into across the board lockdown mode, you do it by investing for income, and you do it by having the brass nuts to throw more than half your salary into the stock market from April 2008 onwards. I was doomed anyway, but I still had enough intellectual capacity to understand the logic of this sort of thing.
In those three years I will have enough capital to make up half the value of my pension if I drew it early. Compound interest be damned. There are other ways, if you are desperate enough or want it enough. To achieve extraordinary goals you have to do extraordinary things.
I may not draw my pension early – I may choose to live from my cash savings and investment income, or convert more of my cash savings to investments to get more investment income. As the ad said, a man with savings can choose his way in life. I didn’t get that freedom of choice from compound interest. I got it from extreme saving and the peak of my earning power. At current rates of investment returns, Feckless Freddies can beat the legendary Sensible Susans/Burnout Brians. They just have to apply themselves to the task in hand with extreme prejudice. If he pays down his debts, Freddie can save a lot more than Brian’s 8%, and from a higher income base too. Don’t underestimate the capacity of an doomed and angry greybeard on the final approach at the height of his financial power, compared to the puny financial capacity of the young pup in his first decade of working life
Oh yes, and if you are the young pup looking to get out of paying into your pension, well, you have been warned. You have to get the career progression to be that greybeard before you can wield that power. This is not a foregone conclusion in a world where the power is shifting from labour to capital.
Early Retirement is all about Spending Less, Not Earning More
That’s an odd assertion to make, and illogical to boot, no? If you need to save £10000 a year, and you’re breaking even at the moment, then you could either spent £10,000 less, or carry on spending at the same rate, and earn £10000 more?
Not so fast. For a start if you earn £10000 more you’ll get to lose £3000 to £4000 to the taxman, so you do in fact have to earn even more. However, there are added ‘soft’ issues. You may have to spend more time at the office or commute further, so your domestic ocsts may rise as you favour convenience over DIY. More subtly, there may be lifestyle inflation pressures.
For instance, when I go to Canary Wharf I stick out as a slob – I’m the guy in the T shirt and no-label trousers where all around me are designer shirts and well-cut suits. I’ve just looked at what engineering jobs pay there it appears that I earn similar to some of these folks or even a little more, however I don’t need to spend the money on the designer gear That’s average engineering jobs – obviously if you’re network admin for a big bank I’m going to be way down in the salary stakes!
Mr Money Mustache’s courageous outline of the history of his increasing net worth (‘Stash) reminded me of this. When I first looked at it I thought blimey, I haven’t got anywhere near that figure (USD800,000 ≈ £500,000) so either I am outrageously necky even thinking about early retirement or life in the UK is a lot cheaper. Monevator has a pretty similar value for his baseline reference, though unlike MMM his example income replacement portfolio is pure financial assets. However, digging deeper MMM considers his house part of his net worth, and this is a total 360 degree net worth calculation. I’ve never calculated that because of my income focus, and I have a greater diversity of ‘Stash than MMM, accumulated over three times the amount of time, so I’ve never seen a large amount of it in one place. He did me a favour in getting me to tot this diverse mess up. It’s probably at least in the same ballpark, despite the fact that I personally have never seen a single financial transaction or single asset purchase for more than £60,000 in my life. Ever.
It’s the Spending, not the Earning
More interesting, however, is how he got there. I built my net worth largely on my own (I was single for longer than most people) so he had the edge with having two people bringing in money to the household, and MMM earned significantly more than I have ever done, so he got there in 10 years whereas I have been working for nearly 30.
However, it wasn’t that MMM’s household income was higher than mine. It was that they saved a far higher proportion of their income than I did prior to 2009, and invested it. The so called magic of compound interest hasn’t made a large difference to his wealth, this is pure saving. Apart from the value of my pension, which presumably the Trustees invest and use compounding, I don’t think much of mine is due to compounding either, indeed unlike many I don’t rate compounding as a way to make things easier over a working life, Yes, pension contributions you make in your twenties do appreciate numerically, however they better had do, because inflation means the value of £1 then will be a lot more than the value of £1 when you retire. The differential once inflation is taken out is not huge.
Compound interest ain’t as magical as they say
I experimented with the Motley Fool’s compound interest calculator. Say I invest £1 a month for my working life of 30 years. Without inflation I would have 30*12=£360 at the end of it.
Now if I was in an inflationary environment and scaled my annual savings and got interest to match inflation in real terms I’d still have the equivalent of £360. So if I’d started in 1980 and opened my pot in 2010 I would have £1200 in there, but it would have been worth the same as the £360 in 1980.
Let’s say I’m a savvy investor and get a return of 3% above inflation, I’d be sitting on a pot worth £580 in 1980 pounds. It’s a 61% increase, so worthwhile, but not a total game changer.
money is drawn to money so if you have money it’s easier to save
I started my savings from a standing start in 2009, after three years I have savings of twice my gross salary. The heavy lifting here is done the same way as MMM – spending less than I earn, aided by some investment appreciation, some dividend income and a lot of stopping the Government thieving half of it in tax. It really is remarkable how much you can reduce taxation if you don’t need to spend most of your income…
Unlike MMM, my investment income is pretty poor at the moment, as my ISA is small, and tax-free pension savings are in accumulation mode. Young early retirees need to make their investments pay a decent income quickly, there is the same pattern in MMM and ERE. Mine are operating in the traditional form of being in accumulation mode right up until they are drawn.
I have the challenge of trying to bring the post-tax investment income up to service my basic living costs between retiring and drawing my pension, a gap of about three years. Because it’s a near-term requirement unsuited to the ravages of the stock market, I have three years running costs as cash, which is galling because this is about half of my post-tax savings. Cash earns no real income, whereas at least my ISA is achieving its nominal 5% dividend return. I could double that dividend return by committing the cash to it, but the maths doesn’t work out. A 5% dividend return means you need a stake of 20 times the desired income, and I haven’t got that yet.
One way to improve my situation would be to reduce my outgoings. The poster child for how to do this in the UK would have to be Macs, who has managed to get his running costs down to £5k p.a. which is a damn sight less than mine. Interestingly enough, much of the difference would be reduced if I didn’t run a car. On the downside neither estimation accounts for the ~1% of house value you should allocate for maintenace and repairs. As owner occupiers we are probably way less hard on the fixtures and fittings, and yet over the last 5 years I have spent over 1% of the house value on repairs and improvements.
My career profile was much more conventional in that my earnings peak was much, much later in my working career, about 20 years in. However, the common takeaway with MMM and ERE is that you only build up enough capital to get a decent income if you spend much less than you earn – and that much less needs to be about 50% if you want to do something very different to the normal pattern of working.
For me the savings pattern isn’t anywhere near as different from the norm as those guys. It’s much closer to Salis Grano, who sums it up in this post titled Where Did It All Go Right. I am insanely jealous of course, as I haven’t got there yet. Unlike MMM who retired after 10 years, thus shaving 20-30 years off his working life, my aim is taking a more modest 10-12 years off my working life, I have already been working three times as long as he has.
It is one of those ironies of life that saving money is easier once you have money, when of course the people that really need to save money are those that are in debt. It’s how capitalism keeps most of us debt slaves, particularly those who acquire debt young and warm to the lifestyle.