13 Jan 2012, 8:38pm
personal finance:
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  • 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)

    23 Dec 2011, 12:28am
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  • 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 😉 It is far more widely held. I didn’t have this experience, but then perhaps something is anomalous about my lifestream. Note also that I will have a working life of about 30 years, and of those years I have only experienced unemployment for the first 6 months. Your risks of spells of unemployment are probably higher, so although compound interest isn’t necessarily a reason to start young IMO, those periods of involuntary unemployment stopping you saving enough in total is.

    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 thisthis 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.

     
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