“Will you still need me, will you still feed me, when I’m sixty-four?”
The Generation Game
When you were at school were you in the worst class the teachers had ever come across? Funnily enough so was I. Imagine that. You and I both just happened to be in the worst classes our teachers had encountered. But do you know something? When comparing notes with those older and younger than me I discovered we were all being told the same. It was an early lesson that every generation is similar despite what we’re told.
It was a trigger that led me much later to be fascinated by demographics. And the more you study the subject the more you realise that throughout history generations behave the same. We tend to think much the same at the various stages in our lives, and behave the same economically. We’re tempted to invest the same way. No wonder. Our brains were wired over many thousands of years in dangerous Pleistocene savannah lands where sabre tooth tigers roamed. And to eat you had to shoot lunch which sped past at a great rate of knots. That’s why male brains are wired to focus, while female brains were wired so their spatial skills could keep their eyes on Daisy, Rebecca and Justin, while tidying up the cave and cooking what hubbie shot with his bow and arrow as it ran by.
Life wasn’t very kind to contrarians back then. If you spotted a shadow in bushes which just possibly could belong to a sabre toothed tiger it wasn’t a bad idea to run like hell before considering at a safe distance whether you were wrong or not. Experience told you it was a safer bet than saying, “hang on chaps maybe it’s just a funny shape”. That’s how you ended up as lunch. So genes passed down from generation to generation were from the nervous and cautious majorities – hence our herd instincts as investors today.
It’s not a winning combination… behaving during the various stages of our lives as previous generations do and being wired to feel comfortable only within the herd. And that’s why we’re Born to Run, as Bruce Springsteen reminds us. As a consequence we buy and sell stock market investments at the wrong times. Carl Richards in the US puts it better than anyone else with his simple drawing showing two hills with a valley in between. On the first hill it says GREED/BUY, in the valley it says FEAR/SELL, and on the second hill it says REPEAT UNTIL BROKE. Quite.
There’s no doubt that in my lifetime we’ve lived through the wealthiest period in history for most of us. Those like me who were born just after World War Two have had countless wealth building opportunities previous generations never had. Despite this, statistics show the average private pension fund at retirement today lies somewhere between £28,000 and £50,000. Shocking!
Following George Osborne’s latest Budget, which attracted before the event headlines predicting the end to pensions after too many years of political interference and broken promises, his latest wheeze, the so called Lifetime ISA, has drawn widespread praise. Apparently, for the over 18s/under 40s, being able to invest from April 2017 up to £4,000 a year into a tax-free growth fund where HM Government will add a 25% bonus each year until you hit 50 will definitely encourage the next generation to start saving. Fat chance. You will only get people to change their ways when they experience disquiet from within, and when they truly understand the issues. Right now I’d say we’re a long way from that.
Where to Start
In 1975, when I was 28, having failed to become an actuary when they found I had a personality, and after a couple of years as an IFA, I started this company. I had no pension rights. But it was by then possible for self employed/controlling directors to aim for the same maximum pension benefits available to PLC directors and employees. Basic rate tax was 35%. So every contribution to your pension pot was increased by 54%. All the growth rolled up tax free. And when the fund was ready to pay out a fair chunk was tax free too. Plus a guaranteed income for life was available at interest rates way into double figures. That’s what you call a No Brainer. But most twenty-odd-year-olds were too busy spending and living for the day. I bet it’s the same today. Demographics again. Plenty time after all. Mmm.
So despite the constant developments in investment products over the years, the lowering of costs, the never ending tinkering with pension laws and taxes, and the ever changing economic conditions, I’d say planning for retirement hasn’t actually changed that much. People still wait far too long to start and then sit in the middle of the cautious herd. Like the frog that sits contentedly in slowly warming water they only notice their error when it’s far too late. So what do you do?
First of all you need to have a goal – the earlier the better. Next you need to understand the difference between investments and deposits. Then it makes sense to get as many tax breaks as possible on your side. And despite what Osborne said on Budget day about having to understand maths, all you actually need is the Rule of 72. Basic arithmetic sexed up slightly.
Einstein called it Compound Interest when he named it as mankind’s best ever discovery. It’s simpler as the Rule of 72 though. How simple is it? Take the return after tax on your savings. Divide that into 72. The answer is how long it will take to double your money. 1% p.a. in a cash ISA? 72 years! Best of luck with that. The average return net of all costs in the Invesco Perpetual Income Fund since 1979? Slightly over 14% p.a. Long-term investors in that fund doubled their money every five years. Have that invested inside a private pension pot over the last few years… and bingo! You’ve just added a further 30% or more free of charge. Money for nothing, as Mark Knopfler would say.
Starting with a goal is absolutely crucial. It adds perspective. Express your own goal in today’s money. When do you want to be financially independent? Age 55? 60? How many years away is that? If it was today, how much income after tax would you want to have to spend? And would you be happy if that income never increased, or would you like more to spend each year? You get the gist.
Let’s take an example. David is 30 and wants to aim for financial independence (not necessarily full retirement) at 55. He’d be happy with £2,000 a month net in today’s money. He thinks building in ongoing wage inflation at 3% is prudent. Studying interest rates and income returns back over the last 120 years suggests he’ll need a fund of at least £1.25 million to even stand a chance. And it depends how much tax it’s exposed to. Minimising your exposure to tax on savings takes time and discipline. Now do you see the problem? And the less time you have to plan and invest well, the harder it is. It’s not a straight line to retirement, it’s an uphill struggle.
The good news is, no matter what changes they’ve made to the UK Tax System over my lifetime, it’s still designed to tax Income when you’re living and Capital when you die. So if you save using all available capital exemptions, or allowances, and into real asset investments such as investment or unit trusts, especially those protected against tax such as ISAs, you stand a good chance of success.
But pensions are underestimated by too many. They are after all simply tax effective investments with funny rules. Take the example of the Invesco Perpetual Income fund launched 37 years ago. Sitting quietly inside a pension plan for a basic rate taxpayer from then until now, for a net once only £1000 premium you’d have a pension fund today of over £160,000. That’s three to five and a half times the average pension pot today.
When I sit down with new clients who want to review their investment strategy I find it helpful to help them set goals so they can then evaluate how effective their current situation stacks up, warts and all. Invest in the most tax effective areas first, then work your way down makes so much sense. Whatever others say, pensions are still the best starting place for higher rate taxpayers. If the ones you have are disappointing, it’s what you invested in inside them that’s the problem. Poor funds will not help you reach your goals. Change them but watch out for the costs. Outside pensions and ISAs watch out for taxes too. There’s little point losing out when readjusting to better funds. Other plans like VCTs or EIS schemes are useful too. But just like building a structure to last, it’s best to get the foundations right first.
And when I talk of Pensions you may understand them as SIPPs. A common mistake! The vast bulk of individual pension plans should simply be Personal Pensions able to invest in funds like Investment/Unit trusts. Self Invested (SIPP) plans carry extra charges and are only suitable for a few more sophisticated investors in my view. Sadly SIPPS are still able to hide extra charges made by unscrupulous advisers. Be careful.
I have found over the years the bulk of investors aiming for a quality of income and life in retirement achieve it by starting as early as possible, setting real goals, then investing in a mix of Pension plans, ISAs, and if further funds are available, in flexible funds or individual shares taking advantage of Capital Gains annual exemptions. Married couples these days have opportunities to build and protect wealth using their individual allowances.
But what’s a sensible investment strategy in terms of the underlying assets? I’d suggest too many older investors are already over-exposed to property and recent taxes suggests this illiquid investment should be ignored now in favour of an area that has worked perfectly for the last 50 years and more – Equity income Trusts. When I ask newly retired folks “would you like an investment that delivers an income that rises above inflation each year, on average, and that over rolling three to five year periods tends to increase in value above inflation?” they respond favourably. In fact, they tend to be surprised. Astonishing as it may sound, considering the millions of words written in personal finance columns over the last 40 years, there are still people coming into our offices who’ve never heard of Neil Woodford – and that includes one young fund manager seeking our strategic help (but her secret’s safe with us).
So what about the twenty-odd-year-olds? If they have money spare after having fun, or paying off university debt, a simple ISA type monthly savings plan makes sense. Pound Cost Averaging (who thinks these names up?) is an ally if you’re investing monthly, as you should be, into risk equities such as small company trusts with managers like Harry Nimmo or Gervais Williams, to name but two.
But even by that age those with generous parents or grandparents could have been building up pension pots very tax effectively, never mind the compound interest benefits. For ages now it’s been possible from birth for youngsters to have £3,600 a year gross, with only £2,880 outlay thanks to tax relief, invested in a rolling tax-free growth plan and kept away from their spendthrift ways until age 55, when hopefully they’ll be sensible. That’s a 25% uplift by the way. And you thought such a bonus only starts in April 2017.
As Tears (or Years) Go By
Back in the mid 1990s when I believed demographics was the secret behind the best investment strategy, a Sunday Times journalist phoned up and said that while he appreciated my beliefs regarding the positive benefits the Baby Boom demand was delivering to stock market investments, he wanted to concentrate on what thirty-odd-year-olds should be doing regarding retirement planning. Once we’d established he’d once been thirty-odd himself, and reminded him at that age you tend to be a walking ATM with little left over, it highlighted to him the need to start even earlier. So don’t underestimate the impact of starting in your twenties, even if that means just putting a little in the right funds once a month. Once you start it makes it easier to increase your monthly outlay when you hit your thirties and as the superior returns start rolling in.
I should admit at this stage that demographics alone do not explain stock market movements. Think of the severe crashes we saw in 2000-02 and 2008/9. Nothing really to do with demographics. Maybe to do with repeating cycles. Let’s face it: cycles are natural. Night follows day, the tide goes out then in, and there are four seasons. Unless you’re Scottish, of course, in which case there are only two – winter and next winter.
And then there’s sentiment, interest rates, inflation, debt and so on. And it all gets hammered home to you in your forties. All the dreams of early retirement in luxury quietly dissipate. So how do you build an investment strategy at that age bearing in mind a need to concentrate on tax-effective structures first, aim at building your family’s standard of living whether you make it to retirement or not, while protecting against the odd stock market crash?
What about “safety first” strategies? No doubt you’ll have heard of “Lifestyling” and “GARS”. I’ve found over the many years giving advice, that safety first type plans become popular only after the losses and uncertainty of crashes. It’s worth remembering Laws of Averages before becoming too despondent. While the media love painting our screens and newspapers with black and sombre colours, the fact remains that stock markets are in periods of profit at least five times longer than they spend in downturns. So optimism is better for your wealth than pessimism.
How do you build your wealth? Sticking your money in safety first strategies? Go check the numbers over the last 10 to 20 years. And bear in mind that bad news sells much better than good news. Absolute Return funds should be renamed Absolute Rubbish returns in my view. So-called Lifestyling looks more like a gimmick to me. It sounds good in theory to have a fund that slowly turns to caution as you near retirement. In theory, perhaps. Remember what Ronald Reagan said about economists. He said an economist is someone who sees something happening in practice and says “but it doesn’t work in theory”. And what if your retirement was a couple of years ago when it paid to be exposed to equities, not caution?
Over all these years I’ve found that once you’ve set your goals, tucked the Rule of 72 into your memory bank, and grasped the sense of investing in tax-enhanced and protected flexible funds, at whatever stage you’re at – twenties, thirties, forties or fifties – your strategy should be for growth. To protect against the odd fall, it’s not a bad idea to build a core of Equity Income trusts, with an additional emphasis on growth managers with a good reputation. Names like Gervais Williams, Nick Train, Terry Smith etc. I wouldn’t bother with “cheap” UK Index Trackers or Passives unless you want to track the top twenty shares in the FTSE down. Again, go check the numbers.
The closer you get to retirement or slip into it the more you’ll want a regular income, with as little tax as possible, and protection against stormy days in the markets. That’s where my football team analogy comes in handy. And that team of managers and their tactics should have been building for years to put the best tax effective structure in place. Building a plan that minimises costs when switching from attack, say, to defence. In retirement in particular it makes sense to build your team of managers from the back, just like Brian Clough did all these years ago. Start with the best goalkeeper and work up through the spine.
Sticking to the football analogy, why settle for Barnsley if you can have Barcelona for much the same price? And as far as risk’s concerned, have you noticed that while Barcelona has three of the best scorers in the business, they also have a goalkeeper, a back four, and a midfield – and that these defenders and protectors aren’t numpties (Scots word for t****)?
Successful retirement planning is best if you can begin the process in your twenties or thirties. OK, start in your forties but appreciate the uphill struggle. But even if you didn’t plan and find it hard going to decide what’s next, bear in mind that if you’re married one of you could have another 30 years or more to plan for – which brings me back to how our brains are wired and why it represents serious problems for investors, particularly as we head into increasingly long retirements.
Remember our Pleistocene (or reptilian) brains. At the core of our modern brains is the ancient hypothalamus, still in charge of emotions, fighting, fleeing and flocking – as well as the other “f”, associated with sex. So it’s this ancient brain that’s in charge of reacting to all the bad news thrown our way these days by news channels. Breaking Spirits rather than Breaking News. How else do you explain why we consistently buy and sell equities at the wrong times as a herd?
In the US the Dalbar research people have measured for 30 years now the average returns of investors over short and long periods. It makes grim reading. Consistently private investors underperform the benchmarks by as much as 4% to 6% a year. And now we have Pensions Freedom in the UK. Despite eight out of ten retirees saying they prefer an income in retirement guaranteed to live as long as they do, the same percentage don’t want an annuity, which is incidentally the only way to achieve it.
Instead folks are cashing in or opting for Drawdown. I have four things to say about this: 1) Already HMRC have pocketed 30% more tax than they expected in their wildest dreams. 2) There’s been a 300% rise in retirees defrauded out of their pension savings by crooks. 3) Already inexperienced and panicky private pension owners, if they’ve gone for perceived safety and/or Index Trackers, are down heavily since “freedom” was introduced on the sixth of April last year, five days too late for fools. 4) Nowadays Personal Pension pots can be free from the dreaded Inheritance Tax, and can be shared by families possibly free from Income Tax. It’s surely worthwhile taking good independent experienced tax planning advice. The alternative is unthinkable.