Middle Class Finances – Death by A Thousand Cuts
Another one in the complainypants section, but this one’s a more subtle object lesson in how not to lead a middle-class life. Perhaps the Ermine’s heart is softening as he gets older, or there’s a little bit of the there but for the grace of God since I screwed up with the toxic UK housing market too, though I don’t have 4 children 
Let’s hear it for the Daily Mail’s Shona Sibary, who sold her house and considers herself now in the rent trap.
Shona and family, before they got into the rent trap
Now I was able to see her fundamental problem, just from looking at the picture. In Britain today, a middle class family with both parents working will find it hard to raise four children. We normally associate big families with the undeserving poor because of the headlines, but thankfully they are not the only section of society that has large families, otherwise we would long ago have succumbed to the premise of the movie Idiocracy. The unsung other sector of society that often has larger than normal families seem to be those with a bob or two. Like David and Samantha Cameron, who ain’t short of a bean, or even IDS and Nick Clegg. Other wealthy families include Victoria & David Beckham (4) and Boris Johnson (4)
I first noticed this with older colleagues at work. The Firm was a prestigious operation in the 1970s and 1980s, and pay was probably upper middle class (in the eighth or ninth decile of the IFS income scales). There is a surprising prevalence of three-child families there, which I had found particularly surprising when I joined nearly a quarter of a century ago.
It’s not surprising that nowadays it is the poor and the wealthy that can go beyond the one and two-child norm. The former get us all to pay for it, and the latter are presumably rich enough to pay for it themselves. Anyway, ’nuff about families. How did Shona screw up?
Shona’s financial red cards
By failing to watch her back. Shona had a couple of big red cards, I suspect that family was living way beyond its means for a long time.
Red flag #1 – they were remortgaging, not building equity in their home.
Look at how an old-skool repayment mortgage builds up equity in the house, by repaying some of the capital.
how a traditional mortgage builds equity
I pinched this from the excellent Mortgages Exposed website, which unfortunately uses infernal frames so I can’t link to the source itself, it’s under Capital Repayment in part 1. Now there are other ways of doing it. My original endowment mortgage was interest only, so in parallel with the mortgage there was an investment that should have been slowly rising to match the original loan. Either way, you should be building up equity, even if it takes the form of a separate asset.
Now the modern way to look at a mortgage is to take out an interest only loan, sit on your butt and whistle a dancing tune while the value of your house goes up. Voila, free money, you get equity without having to lift a finger. The catch is, of course, that the value of the house has to go up 
Shona asserts that
After two decades of slogging to buy a house, maintain it and give our children security for the future
an ermine's inflation-adjusted income and mortgage stupidity
You see that by 1996 I had at least reduced the total, by about a fifth in real terms (this graph is inflation adjusted to a nominal salary of 10k in 1984). That underestimates my repayment as it doesn’t show the value of my endowment.
So what did you do Shona? You remortgaged. Taking that equity out, and spending it. Doing that once is a bad sign – nothing wrong with remortgaging per se, but spending the proceeds is bad. Doing it another two times is more than careless, it’s positively greedy.It’s a big red sign in your finances that says “Wrong Way, Do Not Enter, Turn Back NOW”.
Your house is a place to live, it is not an ATM. Over the 25 year span of a mortgage, you will probably see at least two housing booms and busts. I bought in a boom, ate a 10-year bust, and discharged my mortgage in the next boom, that has now turned to a bust (my mortgage would have finished in February 2014 had I not discharged it early)
It is the foreknowledge of that next bust that should make you say “I will not take the money I gain from remortgaging and use it for anything other than buying an investment which will go towards buying this house”. For most people that investment is reducing the total amount of the next mortgage, which is tantamount to saying “never withdraw equity from your house, unless you are trading down”. There are some people who can do better than that. They are few and far between. Otherwise that bust is just round the corner, waiting to bite you.
Red Flag # 2 – your house is not your biggest cost!
This is awesome. If you really are middle class, and buying your house, then that house is nearly always your biggest cost. If it isn’t, you are either not middle class, you are rich/wealthy. Or you are in deep, deep, trouble. Nowadays it’s pretty marginal for the ‘middle class’ to be able to afford the typical ‘middle class’ three or four bed detached family home in the ‘burbs. If your house isn’t your biggest cost and you’re not rich, you’re skint.
Let’s take a look at what Shona spent the money on.
In our defence, we weren’t spending the money on expensive designer clothes, luxurious holidays or flash cars.
So glad to hear it. So what exactly was it that you overspent on then?
Much of it was going on school fees and upkeep of the house.
If you’re withdrawing equity from your house to keep the damn thing standing then you have got too much house for your income. However, that’s not really your problem. It’s the school fees. According to the ISC the average termly fee at a day school is £3655, about 11 grand p.a. A cursory look at your family photo puts three of those kids in school, ie £33k p.a. Assuming for sibling rivalry you aim to do that for all of them, you are looking at paying 4 * 11000 * (18-11) = £308,000 if you just pay school fees for secondary school 11 to 18 and £572,000 if you pay from 5 to 18.
That’s more than your house was worth at the peak. The house is not your biggest problem. It’s a combination of having too many children and looking down on the sort of education that dragged up scumbags like me. So for all the mawkish whingeing about losing your home, Shona, you have failed to clock the real problem with your finances. ‘Tis the fruit of your loins and the style in which you’d like to keep them. With their own rooms, if you please, nothing else will do for Shona’s little ones Since humans come in two genders and it is apparently not acceptable for brothers and sisters to share a room these days you actually only need three bedrooms if the family is boracic lint, fixed that for ya.
Get real, Shona. You were on a middle class income but living a life not commensurate with your means. It’s hard enough for the middle class these days to buy one house in 25 years. To aim to do that and spend even more than that on the nice things in life on that middle class income is taking the piss. It cannae be done, and you’ve just found that out the hard way. To my eyes you’ve cut the wrong thing, but I respect it’s your call.
Shona shows me I need a financial Distant Early Warning Line
I learned something from Shona. Her family fell foul of slow changes that gradually overwhelmed them. Many things get imperceptibly worse day by day, as global imbalances right themselves but they’re resisted by the structures we have already built. The creeping rise of Digital Taylorism making the professional and technical job a stressful and unrewarding experience is an insidious change, little by little. I didn’t realise that until it became too much and my defences were overwelmed, hence the crash course over the last three years in becoming finacially independent as a counterattack.
In the 1950s the US instigated a distant early warning line to scan the northern skies at the 69th parallel north of the Arctic Circle. It was standing sentinel for the signs of incoming Russian nuclear bombers, and was located in the harsh North to give enough early warning to mount a counter-attack.
I need something analogous to stand watch for slow insidious creeping costs and sound the early warning. I plan to instigate an annual review of financial commitments as a percentage of resources. If I see a non-negotiable cost starting to rise proportionally I will consider that the alarm is sounding and it is time to attend to it. It is always easier to launch a counter-attack before it is upon you overwhelming your defences, and this annual review of commitments will be my distant early warning line against stealthy creeping costs.
Shona’s family could have used something like that. Okay, the alarm would probably have sounded as soon as it was set up, but certainly on the second child’s school fees. It would have been an easier call to make at that stage – do we want a big house, or do we believe in the value of public school education* makes it worth getting the girls to share a room?
While I am working I’ve generally lived sufficiently below my means that I didn’t need that sort of thing. Though I aim to have over 50% income in hand once I stop working, I’ve still got several decades, decades in which I believe living standards in the West will decline in a big way. Though I may be resistant to wages being eroded, I won’t be immune from inflation and its evil twin, rising prices and taxation. A financial DEWline will help me marshal resources ahead of time, and shift them to minimise taxation. Particularly with significant holdings in shares, it’s good to have as much advance warning if changes are needed, to average out the horrendous temporal volatility.
*NB for non UK readers, bizarrely schools that you pay fees for, those that Americans rationally call private schools are called ‘public schools’ in the UK, because we’re strange like that.
Why the Demise of the Interest-Only Mortgage isn’t a bad thing
So you walk into a shop, and spot that nice new flat-screen TV you want. £500 to you, sir, or you can buy it interest-only for £2 a month. Wouldn’t you smell a rat somewhere? The rat is, of course, the small print that says you’ll have to pay £500 at the end of the interest-only loan.
Now I know that some people, particularly in the United States, buy their cars like this. It is called leasing, and the name gives it away, you never get to own the car. It’s a long term rent. It looks absolutely and stupendously daft to me, but if the image of driving a nearly new car is that important to you, well, ‘you pays your money and you takes your choice‘.
So what the heck makes buying a house on an interest-only mortgage any different? You still never get to own the house. What it the point of that? The interest only mortgage was a clever wheeze to ramp up house prices and for banks to make more money. The beautiful part of this game is that the buyers go all gooey-eyed and think the mortgage company is doing them a favour by lending them more than they can afford. Hey, that Mr Interest Only Bank can lend me £200,000 whereas Mean Old Prudent Bank will only lend me £150,000. Isn’t Mr Interest Only Bank such a nice guy?
Two words. Northern Rock. It didn’t work out well, even for the lenders.
A history lesson
1960 – the Repayment mortgage
When my Dad borrowed his first £500 mortgage, way back in the early 1960s, it was simple. He told them his income, they looked up in a table what they could lend him, and armed with that knowledge he could look for a house. He borrowed the £500, and then paid them the interest plus a proportion of the price of the house, the latter proportion increasing with time.
Repayment mortgages were all that were available, based on the simple premise that you pay your instalments for 25 years and when the last one is paid the house is yours.
1990 – the Endowment Mortgage
Fast forward thirty years, and I get to go to the Abbey National, and bamboozled by the choice of endowment and repayment I foolishly go for an endowment mortgage. This is still on the principle that I pay interest only to the mortgage company, but simultaneously to a life-insurance policy which supposedly grows with time till after 25 years it is worth at least the price of the house. So although I was only servicing the interest on the mortgage, I was in parallel accumulating an asset that matched the cash price of the house, which when paid to the mortgage firm would discharge the debt. And the house would be mine. The mortgage company took a charge over the endowment, so I couldn’t sneakily stop paying it without them knowing.
2005 – The Interest Only Mortgage (Don’t Bother with the Capital, it’ll work out somehow)
Like an endowment, but endowments got a bad name, for not paying enough to match the price of the house. So just do away with the need for an endowment! How does that work? Well, you get to the end of your 25 year term, and you still owe for the house! Okay, so inflation hasd probably halved the real value of the debt, which is all to the good, but you still don’t owe your damn house at the end. It is a leasing arrangement. Why not just rent instead?
The assumption is that rampant house price inflation means that your house is worth so much at the end that the increase covers the total. But you still can’t sell off the chimney or your third bedroom to discharge the debt, and you are likely to be coming up for retirement. I wouldn’t want to have to stick my hand in my back pocket to come up with what I paid for my house over a decade years ago, though as it is I could just about do it.
increasing complexity, decreasing security and honesty
There’s a lot of bleating about interest only mortgages, because about a third of firt-time buyers bought their houses on an interest only basis.
Shockingly, I heard a father talking on Money Box about how it was so rotten that his son couldn’t find an interest only mortgage to buy his first house. David from Sussex said (13:45 on the iPlayer)
a bit surprised and disappointed to hear they’re only looking to offer capital repayment mortgages, and with my son’s circumstances, which I’m sure is the same for a lot of other first time buyers, the intention is not to stay in the property for that long
So how does that work, then, David? Are you saying your son doesn’t need the house after a while, can sell up, pay back the capital from the proceeds and stick a tent on the pavement? Or do you want him to be able to overpay for this house, so he doesnt’ spend the excess on booze and fast cars? Why exactly is it that you want him to borrow more money for a house he can’t afford the buy, only to lease? Do you realise, David, that your son is in an auction for houses, and if mortgage companies don’t let people borrow so much money then the auction price will fall?
It’s too late to save the people that did overpay for houses by going interest-only to the max, but we can at least not propagate the mistake. If you are going to buy a house, then buy the damn thing, don’t lease it for 25 years and then wonder why it isn’t yours…
Overall, look at the changing mortgage proposition over the years. My Dad was offered an honest and straightforward service. Pay this much for the next 25 years, and you will own your house.
I was offered a less honest service but at least one that in theory would end up with me owning the house. It didn’t work out that way because the complexity of a with-profits endowment hid untestable assumptions and I was stupid enough to buy a product that didn’t match my circumstances. In all fairness to my parents, they told me a repayment would be better for me, they told me why, and educated me well enough to be able to see why, but I was a damn fool and had eyes only for the potential gain, without the wisdom to look for the potential loss. That’s what being 28 did for me, I knew everything and nothing, so greed trumped wisdom.
Unlike my parents, David is failing his son in giving him only half the story. If he actually told his son, “look, you are taking a very serious risk here by going interest only, but you are in a profession where your pay will increase dramatically and as long as you start saving for the capital from then on you may consider this a calculated risk” then that would make all the difference.His son would still be taking a risk and would probably be just as cocky as I was, but at least David would have discharged his duty as a parent
He sort of alludes to the early years being hard, but wage profiles may be flatter nowadays and young people start out with more debt, so the assumption that money will be easier after five years probably doesn’t hold. David needs either to underwrite his son’s migration from interest-only to capital repayment with the Bank of Mum and Dad, or not encourage his son to overpay. Because it’s simple to summarise the issue
if you can only afford to pay an interest-only mortgage on your house, then you can’t afford to buy that house.
Although I think the demise of the interest-only mortgage has been exaggerated, its death would be no bad thing at all.
personal finance: budget complainypants spendthrift welfare reform
by ermine
33 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
14 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.