23 May 2014, 12:43pm
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  • The subtle way Hargreaves Lansdown make their money

    One of the things I rather admire about Hargreaves Lansdown is the slickness of their operation. It’s a full-service shop, and the Ermine is nowhere near rich enough to fly First Class, use valet parking, or invest with Hargreaves Lansdown.

    Managing your income is an excellent way to stop feeding the Beast of HMRC – as a PAYE grunt paying the mortgage there were only limited ways I could do this, basically pension AVCs and employee Share Incentive Programmes though the latter were only good for sheltering about £1.5k from tax a year. However, it means an Ermine is now sitting in First Class of the investing platform world albeit with a cattle class ticket, and I get to see how HL works.

    One of the things you notice about First Class 1 is that paper is king. Ditto with HL, so the Ermine has this lot on the dining table –

    A single mailing from HL

    A single mailing from HL

    I recently read this article in the Grauiniad, which chimed in with the book Authenticity: what consumers really want I read from the library a while back, that we are increasingly being sold lifestyles rather than specific products. I’m still not sure whether the Grauniad article is really insightful or absolute bollocks, but anything that makes me think has been time well used IMO. A great quote is

    This is how capitalism, at the level of consumption, has integrated the legacy of 1968, the critique of alienated consumption: authentic experience matters.

    And I thought of that when I looked at this wodge of HL stuff. Clearly HL targets their advertising a people of a certain age, preferably people who have more money than I have and therefore can afford to not look a the price ticket too much 🙂 One of the things that struck me is that it’s all about funds. For historical reasons I’ve never been that much about funds and the way the whole market is going I am going to get out of funds all together, because they induce platform fees whereas so far you can avoid platform fees on things like shares and ETFs. Not only that, but funds seem to offer the opportunity for all sorts of indirection and fees upon fees. This is clearly how HL operate. Their fundamental platform fee is 0.45% 2  – bearing in mind the long-term return form stocks is typically estimated at ~5% you’re paying a 10% income tax right off the bat, just for being there. The reason I have left my money there as cash is that this fee doesn’t exist for cash, though obviously you are paying the government about 3% inflation tax to manage the money supply for the benefit of mortgaged homeowners to depreciate the currency 😉 However, since they are giving me back a load of tax I paid in previous years I can eat that.

    However, riffling through the HL paperwork, this is clearly a fund shop, and the fee loadings on the funds are usually over 0.5% so you’re looking at fees of over 1% just to be in the market. Annually. The Ermine is just not used to the concept of being rushed each and every year just to exist. But the words are warm, in the typical vapid style when talking about the unknowable future. Everything is good, and if it isn’t, it’s suffered a temporary setback and is an excellent buying opportunity. There was one chart that made me sit up and go WTF, which was the chart of the UK stock market by CAPE

    The UK stock market - good value right now

    The UK stock market – good value right now

    Now I look at that and think bloody hell, the reason I haven’t yet sorted out what I am doing this year is that the market looks on the upper side of the good value line to me. Better people have suggested that it isn’t so much the headline FTSE100 price level but that earnings are improving, but nevertheless I’ve still got some feeling for the WTF are we doing up here mate fellow, though it’s not as bad as it was maybe. That’s why I am looking at emerging markets, and Russia still draws me, with their PE of 5 nowadays, but I still can’t get my head round what exactly the meaning of the word ‘ownership’ is in a Russian context 😉

    Anyway, the UK stock market – good value by historical CAPE? There are three things wrong with that. The first is look at that great big spike from the mid-Nineties up. That, my friends, was called the dotcom boom. Everybody was charging around like blue-arsed flies buying anything with internet in it. Then anything with www. then any company with an e in the name. Seriously, it was a real case of the madness of crowds. Everybody’s brains fell out on the floor and some people are still looking for theirs fifteen years later. I was there. It really was that mad. I made about quarter of my gross salary in the run-up. And lost half in the bust 😉 The training was excellent value, because I learned not to buy into momentum. You will run out of greater fools, because in general you are one of them.

    Just like Mark Twain said about the unique learning you get from carrying a cat by it’s tail 3there are some things you have to do to learn things in a way you can’t learn any other way.

    A man who carries a cat by the tail learns something he can learn in no other way

    Same with the madness of crowds, You gotta be in it to know it. The trick to success is to retain that knowledge  for future use. It’s always a fight…

    If we lop out that piece of irrational exuberance, the chart doesn’t look quite so wild, and there’s also a general downtrend, possibly because the power-shift from the West means the market may be prepared to pay less for any given earnings because it suspects that profitability is falling. After all, with the level of debt both personal and national, where’s the money going to come from to buy your stuff 10,20 years down the line? We can’t all keep borrowing from the Chinese 😉

    Standard Deviation? On Stock prices? Mr Gauss would not approve, m’lud

    The second thing wrong with this is that the trouble with using things like standard deviation on stock prices is that stock markets do not obey the central limit theorem. Mr Market is not a collection of independent random variables, and every so often everybody decides “Holy shit, the world is going to end”. On the flipside, we all sometimes decide that it’s all different now and we have reached a plateau of permanently increased productivity, which leads to irrational exuberance about stock prices. In priciple a government can row back against that by increasing interest rates, but on the other hand they can promise all sorts of Good Stuff to the electorate to get re-elected. Any resemblance to Help To Buy is of course purely coincidental. As a result, the distribution is fat-tailed and is not typical of a normal distribution, so using standard deviation of a normal distribution is iffy. Companies got into hot water with their value at risk calculations because they were seeing events that typically you’d only expect to see in longer than the age of the universe – in about ten years. It actually staggers me, that, in trying to substantiate this paragraph, I discovered people really did use the normal distribution as the model for financial markets.

    I am sure that once upon a time, the level of general and scientific knowledge in the West was widespread enough that it would have been obvious what was wrong with doing that to people in a professional organisation. We seem to search more and more for stupid metrics and valueless numbers rather than seeking knowledge. The world is complex, it’s messy, and one size rarely fits all. The abuse of the scientific heritage of the West that this represents is shocking. This is not new stuff – Carl Gauss died in 1855. Mind you, to my shame I only scored a lousy 5 on the Grauniad’s science quiz so clearly the rot is spreading. But I’m not in charge of shedloads of other people’s money.

    Have you ever seen what happens in a mass of humans when somebody yells Fire? They all lock into each other and start running the same way. That is not a canonical example of a set of mutually independent variables acting individually, so the central limit theorem breaks down. In crises – at the very time when you need your model to work to qualify the severity of the problem. Maths doesn’t help you in dealing with human emotion.

    The third thing wrong with that chart is the data source: internal, with the data set from Jan 1974 giving a veneer of respectability to something that, basically, HL could have made up entirely. And since they benefit from shifting your cash into their funds there’s always the temptation. You can’t validate that data against anything. HL might well have said “trust me, I’m a salesman”.

    I have nothing but admiration for HL

    HL did serve we well when the Chancellor decided to improve the usefulness of DC pension savings no end – just before the end of the tax year! So I needed a place to stash £2880 with a pension firm, pronto, and HL were the only people who managed to open an account and take the money, within a week. TD, my current ISA provider, demanded proof of identity through the post, because their system isn’t joined up presumably, and Cavendish were also after that.

    Now the ermine is not a million years away from getting my hands on that money back, and in a rare turn-up for the books, I can claim back 20% of the tax I paid on earning that money – by simply leaving it with HL and HMRC will add £720 to my £2880. That’s an effective interest rate on cash of about 12% (it’s amortised over two and a bit years) and I can do the same next year and the year after that, for an interest rate of about 20%. I don’t know about you, but I sure as hell don’t know anywhere you can turn that sort of interest rate on cash. Okay, so it is only the money stolen from historical pay packets being returned to me, but it’s worth shifting an Ermine paw and banking with the might of SIPP rather than the Nationwide. I stand to win about £2000 back from HMRC. The trick, of course, is to manage one’s income and make sure I don’t have any when I hook this cash back out – it’s about £10800 which is currently above the personal allowance, but you can get 25% of it tax-free. By living on this for a year I get to defer my main pension, too, which goes up by ~5% each year I defer. Although actually 4% since HMRC will be tapping me for tax- I’m tempted to save my taxable part of the pension into a SIPP to reduce the tax on my pension to 15% since I can manage the cash-flow. The main challenge is having enough cash reserves to keep loading my ISA allowance each year, which has suddenly got a bit harder with the increased allowance. I may consider taking out an cash loan for the last year, if anybody will lend me some money, simply to fill up that ISA allowance. 4

    The Ermine has been freeloading on the money that fund investors have been putting in for years when it comes to the costs of running a platform. I don’t need the lifestyle stuff, but I’m happy for it to pay for my seat on the boat. Most of HL’s customers have a lot more money than I have, so every so often they may see the flash of white fur and a small black tip to the tail scurrying about, but in the end it’s the rake of their wealth that is keeping this ship afloat and in good condition. I salute my well-heeled fellow passengers and raise a glass of proscetto to their choice of lifestyle, if not their quest for value for money. Perhaps the Guardian article was right. When you have enough, you don’t need to seek value for money. The quality of the ride may matter more. HL is selling an experience – giving you the warm feeling

    “You are a wealthy sort of chap, probably a chap, probably 50+. You are knowledgeable in the ways of the world, so here is a shitload of complexity and a teeny bit of salami-slicing of fees. Needless to say, an experienced individual of your calibre has the savvy to make shitloads of money from these fine opportunities despite the fees, so take it away from here. For those of you into shares, we now offer real time live share prices, so you can ride the markets like a pro. Come on in”

    And they do – HL is apparently one of the biggest retail investment platforms in the UK.It’s a slick operation, and probably a nice ride. just not the cheapest. Except for their okay 0% rate on cash, which will do me fine. I live in hope that the new NISA integrated accounts will actually pay you a return on cash, but it’ll never approach the HMRC rate on a SIPP.

    Notes:

    1. I’ve never flown First Class, though I flew Business class enough for work, and you got a lot more bumph there too compared to cattle. But it’s a long time since I have boarded an aircraft – not because I can’t afford it but the experience is so horrible and I get to hate my fellow humans so much for their screaming brats and inability to follow written instructions holding up the queues. So I really try not to do that to myself, or them.
    2. capped at £200, corresponding to an account value of £45k. Now my ISA is more than that, but I don’t currently pay £200 to TD to hold it. I checked last year’s statement and my platform fee was £2.31, so HL are 8600% dearer. In fairness, I made 9 purchases and zero disposals, and HL are 65p cheaper on share purchases, so the difference of £5.85 should be added to TD. So HL is only 2450% dearer than TD, a much more manageable difference for some chrome trim and a slicker operation, no?
    3. I suspect he didn’t say that directly, it is a paraphrase of  Tom Sawyer’sa person that started in to carry a cat home by the tail was getting knowledge that was always going to be useful to him, and warn’t ever going to grow dim or doubtful” but I’m damned if I’m going to surrender the thought picture on the altar of technical accuracy.
    4. You should never, ever, borrow money to invest in the stock market. However, I have a large AVC fund that is in cash and can come out when my main pension commences. So I am not borrowing money I don’t have, I am borrowing money that I can’t access yet. If you want to borrow money to invest then you may as well go into spread-betting.
    4 Apr 2014, 12:07pm
    personal finance:
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  • Hargreaves Lansdown saves the day at the eleventh hour of the old tax year

    I’ve never had any dealings with HL, because the Ermine is a cheapskate when it comes to platforms, and Hargeaves Lansdown has the rep of being a high-cost full-service shop. However, given that that nice Mr Osborne seems to indicate that we can now draw our pension funds in full subject to regular taxation, I want a SIPP. Held in cash, possibly, though I need to reflect on that at my leisure. The rationale is here – although I can’t draw it as of yet, I’m not far from the 55 cutoff.

    When I researched the original article I looked at Cavendish Online, for a stakeholder, which would be the cheapest. But they wanted me to fill in forms sent through the post with all the money laundering fun and games of certified copies of this and that. There’s not enough time for that given that the end of the tax year is tomorrow so I didn’t fancy my chances with the post. Online is the way to go.I would have thought a SIPP wouldn’t need all that garbage because presumably they go to HMRC and go ‘have you got any records of this geezer with national insurance number xxx name An Ermine living at this address. If it matches, fine, if not the alarm bells go off and somebody sends a SWAT team out. But no.

    So I attempted with TD Direct, on the principle I already have an ISA with them, so all the know your customer malarkey has been done already. Had a go a couple of days ago, they seem to have lost the application, and certainly haven’t asked me for any money yet. In the unlikely event they find it and do something I’ll tell them they’ve missed their chance under the 30-day cooling off rule, basically for gross incompetence 🙂 They know what the end of the tax year is all about, FFS, and although I normally expect people to get their act together about the end of the tax year for ISAs and SIPPs it’s not like Osborne gave us huge amounts of notice to process what’s changed and how to use it.

    Since I am a canonical example of somebody who can use a short DC pension to my advantage I want some. And since I have no income, the most I can lob in in a tax year is £2880, so missing out this tax year costs me £720 (less running costs). As a minor snarl, why is it that whenever I fill in a form and it has status of employment, do they have no entry of Gentleman of Leisure? I am not employed, and I am not unemployed either. I’m not down the Labour Exchange claiming JSA. At least HL had the ‘other’ category.

    So I take a leaf out of Boardgamer’s book, and figure I may as well give it a go.

    Hargreaves Lansdown know the tax year is ending

    Hargreaves Lansdown know the tax year is ending

    Obviously I simulated the effect of their charges; there are no opening charges, but there is a 0.45% p.a. hit on all investments (including shares!!!!) and there is a stupendous £354 flexible DD/exit charge. So be it, there’s still a win from the £720 the taxman lobs into the pot, and since these are savings I will be living on anyway I may as well park them in a pension and get my tax back from them – it beats the hell out of the interest on any cash savings account I can get.

    Now I have to say that as I went through the application I saw why HL gets its rep as a slick operation – they took the cash via a debit card, opened the account, allowed me to defer investment choices to later and the whole experience was a lot better than the un-joined-up mess that TD were offering. They may still manage to make a muddle somewhere but so far so good. Even with that shocking exit charge the simulation indicates I am good for about a 16% ROI on cash over the next three years after costs and assuming 3% inflation. 5% p.a. real return is worth getting out of bed for. Presumably all the know your customer crap is coming my way, but at least that can be done at my leisure after the deadline.

    Using Hargreaves Lansdown’s website brought it home to me just how crappy all the low-cost platform websites I’ve used were. TD Direct probably just about get the wooden spoon award for usability, though I don’t really get on with Charles Stanley that well either. CS looks prettier but I still get lost in it. III’s was serviceable but the funds selection was truly horrible, hopefully they’ve improved it since I told III to sling their hook for ramping charges.

     

     

    31 Mar 2014, 10:10pm
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  • How a short pension can help early retirement around 55, and why annuities deserve a better press

    One of the dilemmas facing the early retiree is how to minimize taxes. The extreme early retiree (<45) doesn’t have much choice but to pay tax on their savings to retire between their extreme early retirement date and the time they can draw pension income. You can avoid paying tax on the way in to a pension, but ISA savings are from tax-paid income. Now that Osborne has made pensions more attractive by improving their flexibility,  people need to start thinking how they are going to phase taking their retirement funds. That’s something you need to think about in you early to mid forties; at least ten years before the planned date of retirement.

    I got a few of these things wrong, because I brought my retirement plans 8 years forward over a period of three years. In particular, consider very carefully whether you want to pay off your mortgage before retiring. Although I did, a mortgage is a flexible and low-cost loan. For most people not paying it off until you receive your pension commencement lump sum at 55 is the correct route, because it lets you smooth your income profile. Pay the mortgage down while you are working and before 55 and you will be better off in the long run but will probably take a severe income suckout in the gap between retiring and 55

    There has to be the usual wealth warning – pensions are still complex, and people’s circumstances goals and risk profiles will vary a lot. DYOR and/or seek independent financial advice.  This is a tour of some of the high-level stuff. the devil is in the detail with pensions, but high-level stuff makes orientation easier.

    Planning for slightly early retirement (55 and up)

    In principle, planning is relatively easy for someone retiring after the Government’s mandated earliest DC pension drawing age, currently 55 but probably rising for anyone who is currently younger than 42. You basically save into a personal pension aiming at your annual desired retirement income * 20 by the time you are 55. I said the planning is relatively easy, doing it isn’t! Then you start drawing down the pension. If you want to leave it to your children after death then you carry on in drawdown, but if you don’t you can get some security against outliving your savings by keeping an eye on annuity rates as you age, and switching to one when the annuity return in terms of annual income gets above your investment return (~5% usually). This is usually around 65-70.

    Planning for early retirement (45-55)

    The planning gets harder for someone retiring before the Government’s mandated earliest retirement date. You have to save up from taxed income, preferably in an ISA. That’s been made a bit easier with the increased limits. Anybody who is in a position to retire early is different from the general working population, usually in earning more than average and probably also in spending less than average. Somewhere you need to open up a spending-earning gap. Unless you can get your spending down dramatically you’ll probably be paying higher rate tax on the money as you earn it to save across the gap

    The same applies to me – all the money I’ve saved into my ISA and all the cash savings I have are from taxed income, and I was under the impression that once you’ve paid tax, that’s it. You don’t get to claw it back years later.

    After the Budget changes, that’s no longer so. An early retiree’s tax status changes from

    status tax NI age income from
    working x x < retirement work
    retired, pre-pension <55 savings
    retired drawing pension x 55+ pension

    One of the advantages of a DC pension is you can choose how much to draw down each year. You take 25% of the total pension capital as a tax-free pension commencement lump sum. Many people blow this on a holiday or other splurge, each to their own.

    That'll be a nice Lamborghini, and to hell with the money

    recommended splurge target these days

    Some use it to discharge their mortgage on retirement, which has a hell of a lot to be said for it. But one of the other things you can use it for is to reduce the amount you draw down from the pension at the beginning, to less than the personal allowance of about £10,000

    Such an individual’s stages look like this

    status tax NI age income from
    working x x < retirement work
    retired, pre-pension <55 savings
    retired drawing pension + PCLS 55-60 10k pension DD + PCLS “DD”
    retired drawing pension x 60+ pension

    That way you get a few tax-free years out of your pension. Note that I have made the assumption of at least a £250,000 pension capital, because drawing > 10k p.a. from any smaller amount would be unwise 1. If you are drawing less than the personal allowance then you aren’t paying any tax on your pension unless you have earned income, in which case why are you drawing down your pension – ask your financial adviser about taking the PCLS from a DC pension at 55 and elect to draw down nil for a bit 🙂

    It’s one low-risk way of improving your income from the pension, though investing the PCLS using an ISA and giving yourself a permanent tax-free increase in income is a good alternative. This is the one I have to take, because when I crystallise my pension I get both the income and the PCLS at the same time.

    A change in tack for a pre-pension retired Ermine

    That retired, pre-pension phase before 55 (or whenever you take your main pension income) is where you are living from savings or ISA income. It is precious, because you are a non-taxpayer. And there’s an opportunity opened now for you to claim some of the tax you paid on your savings back, indirectly 🙂

    Non-taxpayers can save up to £2880 into a pension each year, to which the Government adds basic rate tax of 20%, ie £720 on £2880. You paid the tax when you saved the money in the first place. It’s a straight 25% gain 2. If you do this for four years you will end up with a capital amount of 14400, for an investment of 11520. It’s a five for the price of four offer, though your first year’s contribution will have depreciated in value by about 12% due to four years of inflation 3

    You won’t get a 25% real return because charges are high on SIPPs – these plus the effect of inflation halve the return. I’ve computed this for a TD Direct SIPP. This isn’t the cheapest place you would go – a stakeholder pension from Cavendish is better value but TD already know me and I am hoping they will open the account before the weekend, so I can put in £2880 for the year 2012/13. The extra £720 HMRC will add (less the £345 it will have depreciated due to inflation by 2016) still makes it worth paying over the odds for. If they can’t get their act together then I’ll use the cooling-off period to back out and go to Cavendish with a stakeholder later on next year.

    Charges and costs with a TD SIPP for 4 years

    total
    inflation 3% 3% 3% 3%
    tax year starting in 2013 2014 2015 2016
    pay in 2880 2880 2880 2880 11520
    tax added 720 720 720 720
    TD open charge 0
    drawdown cost
    flex dd reg 75
    close 75 90
    annual (£40/0.5%) 40 71 142 211 704
    running total 3560 7089 10547 13936 13846
    profit 680 649 578 509
    running profit 680 1329 1907 2416 1462
    inflation depreciation 86 86 86 86 346
    86 86 86 259
    86 86 173
    86 86
    total lost to charges 704
    total lost to inflation 864
    roi 13%

    All the charges and the effect of inflation reduce the return to 13%, but it is a return without exposure to the vagaries of the stock market – just open your SIPP and either leave a lump of cash in it or use a money market fund that is sort of like cash. 4 I would be able to take £3461 as the 25% tax-free lump sum and withdraw the remain £10384 as income without paying tax as the tax threshold should hopefully be at £10500 by the 2016/7 tax year.

    There was a load of bellyaching from DB pension holders that they got nothing from Osborne’s changes. If you are a DB pension holder so crazed as to even think about transferring out to DC then stop right now and take a cold shower. To be honest, if you have a DB pension you should STFU and celebrate your good fortune in life and salute any tail wind that can help people out to make a DC pension work better for them. If you want to get the benefit of Osborne’s changes then you know what to do – damn well get out there and buy a DC stakeholder and stop whingeing.

    Which is exactly what I am trying to do. I tip my hat to commenter Boardgamer who clearly located the on-switch of his brain a bit quicker than I did after hearing Osborne’s changes 🙂

    Annuities, schmanuities…

    Annuities have come in for an awful lot of stick recently, much of it unfair. From pensions A-day in 2006 nobody has had to take an annuity on retirement, only after they reach 75, and annuities are a hell of a lot better value at 75 because life firms figure you have one foot in the grave, and they know they’re paying out for fewer years than if you are 55. The screaming about annuities is only because people holler at their financial adviser that they want it SAFE AS HOUSES, not in the BIG BAD STOCK MARKET where their capital value marked to market MAY GO DOWN. CASH NEVER GOES DOWN – I WANT SAFETY.

    Be careful what you ask for. Safety, and insurance, costs money. That’s why annuities are so shit at 55 or 60. So don’t be a nutcase. You entered the stock market over years with your pension savings. You will have lifestyled your pension savings to reduce equity exposure as you come up to retirement. But if you are retiring into a world where the stock market goes down and stays down on its knees from the long-term CAPE10 trend for 10 years then that is a world where you’ve probably got bigger problems than your pension. Starving hordes running through the streets, lack of clean water, that sort of thing. That’s not a country for old men…

    All the scaredy-cats will say BUT THAT’S WHAT HAPPENED IN THE DOTCOM BUST

    even this mahoosive shart doesn't manage to span an Ermine's shortened career

    even this mahoosive FTSE100 chart doesn’t manage to span an Ermine’s shortened career. And it doesn’t show dividend income.

    Well, yeah, but the dotcom boom was way above the CAPE10. People retiring in Feb 2003  had been putting money into the stock market for the previous 30 years 5.

    Yes, they retired with an inflated idea of what their savings were worth, and the guys retiring three years before got a much better deal if they annuitised on retirement. But they didn’t lose out – they got damn good value from their savings, assuming they saved at a high enough rate, targeting the right capital amount. They’d have seen a big overshoot in 1999/2000. Maybe they should have taken the hint and retired then. Or if they had lifestyled their pension savings (transiting to an increased bond allocation and downplaying equities as they approach retirement) they wouldn’t have seen much of the boom, but then even less of the bust.

    In short, do it right, guys. This information isn’t secret any more, and is standard financial advice 101. I lost a shitload of money in the dotcom bust, because I started in ’97. If you retired in 2003 you probably were in your peak earning years from 1993, and were buying tons of cheap shares from the 1973 oil crisis onwards 6. You didn’t lose out that much overall. And you did much better with 30 years of pound cost averaging than a wet-behind-the-ears ermine buying over three years at the peak of the market then running into index ISAs 🙂

    Annuities aren’t inherently bad, just stop buying the suckers as soon as you retire. Consider  a mix of drawdown and annuitise when you’re older. Nobody’s had to buy an annuity on the date when they retire for a long time. People say annuity rates keep on dropping. Yes, annuity rates for a new annuity at 60, say, are dropping. If you know a way to be 60 this year and still be 60 next year you’ve got hold of a secret that is worth a hell of a lot to a lot of people, you don’t need a damn annuity. The annuity rate for YOU as an individual will improve as the years roll by ‘cos you ain’t getting any younger 7. You can test this with any annuity calculator. Tell ’em your age and see the rate. Then tell ’em you’re 10 years older.

    People often blame annuities for a very different problem. Not saving enough money. We are starting with a capital value of roughly 20 times the annual desired retirement income, yes? If not, you’re gonna have to stay at work until State Pension Age or start robbing banks until it is 20 times your desired income…

    The trick of delaying annuity purchase only really works for people who retire normally, say at 60. If you retire with a pension capital of 20 times the desired annual income and your age related annuity rate improves enough to save your tail at 70, then you’ll have half of your capital left. You’ve been running it down for 10 years if your capital keeps up with inflation and you use a safe withdrawal rate of 5%. Do that for 20 years starting 50 and you are outta cash by the time an annuity can help you. Early retirees have to be more conservative with their withdrawal rate because they are exposed to risk for longer. They need to avoid running down their capital too fast.

    Annuities are a tool, often used in the wrong place – at retirement. You are swapping stock market risk for inflation risk if you do that, because few people have saved up enough to eat the answer of “what is the rate if I tick the inflation-linked button”. The value of money halves about every 15 years due to inflation, so most people will get to see that.

    The other place annuities get a bad rap is you can’t leave them to your kids when you die. Diddums. One of the few benefits of a DC pension compared to a DB pension is you could leave the unused capital to your kids  if you croaked before 75 and hadn’t taken an annuity. Now you can leave it to your kids even if you live to 105 or more. Your job now becomes saving up enough money that you can live like old money – off the income from capital, not running it down. You need to work for longer to save up more if you want to feather-bed your offspring, it’s as simple as that. Osborne has given you the possibility, Now do your bit – spend less than 1/30th of your pension capital in retirement and you have a better chance than the 4 or 5% commonly regarded as a safe withdrawal rate..

    Your Risk Profile

    FinaMetrica sums up the problem space well

    Many financial decisions are made in situations of uncertainty, and so risk is involved. Different people are comfortable with different levels of risk.

    Unlike, say, height or weight, there is no unit of measurement for risk tolerance. A person’s risk tolerance can only be measured relative to others on a constructed scale, in much the same way as IQ is measured.

    By using the FinaMetrica Risk Profiling system, you obtain an accurate assessment of your risk tolerance in terms that are meaningful to you and your advisers. Your Risk Profile report will guide you and your advisers in your financial decision making. In particular, the report provides the basis for your instructions to your advisers on the level of risk you would prefer.

    The reason annuities matter is that when people come to retire and take a DC pension, they are faced with a major life change. I have been through some parts of this, but many things are softened for me because I have a DB pension that I could live on if I took it now.

    You retire in your 50s at the earliest, well, as far as retiring on a DC pension and getting to take it. For many people in their 50s, if you give up your salaried job you will find it very hard to find another one at the same level of pay. The reasons for this are complex, but generally

    • you have experienced notable career progression
    • 50 is an early time to retire, not many opportunities arise where firms would want to replace someone of that age with someone of a similar age
    • you are more settled housing-wise but still often have dependent children, so moving is more of a wrench, meaning you have to look locally, restricting opportunities
    • your experience fits a particular organisation, for instance although my general knowledge of engineering has a wide application elsewhere in industry a lot of my skillset is specific to The Firm, which is busy trying to get rid of its old gits. It’s definitely not hiring any more on the payroll 🙂

    So retiring is a big move, it’s often a one-way ticket, and it’s stressful, even if you have enough money. People get fearful and conservative when in an unfamiliar stressful situation. And then your independent financial adviser walks along, glad-hands you, and sits you down with a cup of coffee. Then he says to you, right, Mr Retiree, how do you feel about risk? Say I were to tell you that the value of your stock market investments could fall 50% in one year, but it would probably not stay down. Well, he doesn’t actually do that, he opens his PC and gets you to do something like this online risk asessment or this Finametrica test

    So there you are, you’ve just had the send-off from your workmates, you are going to enter a new phase of life, you have butterflies in your stomach, and now someone asks you how you feel about losing money, bearing in mind you aren’t going to be earning any more for the foreseeable future and probably the rest of your life. And what most people say is

    HATE IT HATE IT, NO WAY.

    What is this stock market you speak of that can chew through my money like that? Why would I give it house room?

    So the IFA closes the laptop, looks you in the eye with an easy smile, and says Right Mr Newly Retired, that’ll be an annuity for you, Sir. Then goes through the spiel, looks on the open market and off you go with an annuity, and almost zero stock market risk. And I find that for an Ermine, for every £100,000 pension capital I can buy about £5000 as a level annuity payable annually from age 55.

    No I don’t actually think that rate is too bad. It’s not a billion miles away from the 5% safe withdrawal rate from a stock market investment, and you’ll never outlive it. Trouble is, that every 15 years the value of this pension will halve. There again, 12 years after I am 55 the state pension will kick in, so the first bullet will be dodged 8, and that is inflation-linked to some extent. Now if I tell them I am grizzled of fur, 10 years older and I’d like it paid from 65 I get £6000 as a level annuity. Take a spin round the clock again at 75 and I’m good for £7500. Which was roughly the logic of why you had to buy an annuity at 75 at the latest; it’ll still be a damn good idea if you are a little bit short of money.

    Talking about the risk assessment, in the interests of honest journalism I took a couple. And discovered I might have been rather too hard on the scaredy-cats, because it is possibe this looks very different to me. You can take the Finametrica test yourself at no charge. FWIW this is my result

    An Ermine's risk profile

    An Ermine’s risk profile I’m not having you on with April Fool – Finametrica is an Aussie company and they are 10 hours ahead of us

    It’s lethal, more than one standard deviation away from the norm. I took the Scottish Widows one

    1403_ermine

    Your Details

    Name : An Ermine

    Results

    Attitude to risk: Very Adventurous

    Score : 84

    The chart on the right shows where your attitude to risk fits:

    About Very Adventurous Investors

    Very Adventurous investors typically have very high levels of investment knowledge and a keen interest in investment matters. They have substantial amounts of investment experience and will typically have been active in managing their investment arrangements.

    In general, Very Adventurous investors are looking for the highest possible return on their capital and are willing to take considerable amounts of risk to achieve this. They are usually willing to take risk with all of their available assets.

    Very Adventurous investors often have firm views on investment and will make up their minds on investment matters quickly. They do not suffer from regret to any great extent and can accept occasional poor investment outcomes without much difficulty.

    Yeah, right guys. Flattery will get you everywhere. FWIW I tried to be reasonably honest with the questions, though I did veer a little on the steady-as-she-goes when in doubt. It amazes me that I am such an outlier, more than one standard deviation off the mean. People normally get more conservative with risk as they get older, according to FinaMetrica.

    The important thing here is that you should take one of these before your IFA does your pension, so that you have some chance to inform yourself about the options. Because otherwise our newbie testee, when faced with a whole load of questions where he doesn’t understand the question never mind the answer, will always go for the safe option. It may not reflect his views if he were better informed. This is a big decision, and if what you say points at the annuity way, you only get one shot. There’s absolutely nothing wrong in that, but it should reflect your view of the world, not your unawareness of the concepts. Oh and don’t pump up the answers just to make yourself look hard. It’s you who is going to have to live with the consequences. IFAs reckon that most amateur investors invest way above their risk tolerance. They would say that, wouldn’t they as they are talking their book. Nevertheless, when you look at the way private investors run for the exit just after a market crash they may have some point.

    There’s probably also a good case to be made for you having run an ISA or a SIPP for about ten years before your retirement date, where you have some skin in the game – ie losing half the value would spoil your week, though not ruin you.

    That way you get to see what a market crash looks like. You may think that you’re hard and can sanguinely whistle a dancing tune while there’s red all over your screen and where it said you had £200,000 yesterday it now says you have £100,000 and would Sir like to sell? If your feverished hands reach for the YES, DO IT NOW before I lose any more money button then you are not the Right Stuff. If it’s the ‘away with ye,  take me to the screen where I can add more money from my debit card and take advantage of this mayhem to buy low’ then you are probably the Right Stuff.

    That’s the long story of why annuities have such a terrible name. They’re still right at times for the timid and may help those who are a little short of savings.

     

    Notes:

    1. The PCLS takes it down to about 200k, and 1/20th of 200k is 10,000
    2. the missing fifth that the taxman stole from you when you earned the money is returned, which is 1/4 of what you pay into the pension, hence a 25% bump-up
    3. my illustration is a bit pessimistic on that because it doesn’t discount end effects. For instance if I put in £2880 at the very end of the 2013/14 tax year, ie now, then presumably that cash has been earning interest for most of the year, so there are only two years and a month for inflation to erode it to mid-April 2016 when the operation ends. Likewise my last contribution goes in after April 2016, as soon as it’s gained the 2016 tax bung I close the SIPP and take the cash out
    4. That is a stupendously crazy way of using a normal SIPP over decades, but for something that’s only going to be there for three years I don’t need to take stockmarket risk, though I will if a market swoon presents itself in that period
    5. probably using ghastly with profits funds and shocking fees, but that’s a different problem, and has been largely solved now by regulation
    6. Current savers should note there is a school of thought flagging up that expected stockmarket returns may be lower in coming years than historically. The FCA has mandated change to low, mediaum and high projected returns on pensions from 5,7 and 9% to 2,5 and 8%
    7. it is possible to invent scenarios where this doesn’t happen, but your personal annuity rate will increase at an accelerating rate as you get older, the cross-point may shift from 65 towards 70
    8. How much that will help you depends on your pension income. If it’s £5000 then it’s a massive uptick. If your pension income is £100,000 then it’ll be lost in the noise
     
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