Planning for retirement is sooooooooooo easy…….

For those who feel that they can plan their retirement without advice it may be worth stopping and reading this blog. With all my blogs I put a proviso on them, for some who plan without advice they already know this but for others just going ahead without advice, investing needs some planning.

I recently read the HSBC Report ‘Life After Work’, one statistic is a sobering thought - 12% of working people expect never to be able to afford to fully retire. I suspect over the next few years this will increase considerable.

The report provides four practical steps towards a better retirement.

1. Don’t rush into retirement
2. Don’t rely on one source of retirement income
3. Be realistic about your retirement outgoings
4. Plan your retirement with family in mind

In this blog I want to focus on action point 2, and touch briefly on action point 3. I have mentioned previously a spreadsheet I have developed which looks at your budget now and your budget in retirement. The budget in retirement is then projected forward to give the value when you wish to retire. When you set up your investments there is no point saving £50 per month if this is not going to touch what you need so this has to be the first step.

Action point 2 to me is the most important. I recently read the Barclays Gilt Edged Study and this stated that “cash is likely to remain a value destroyer, in real terms” and this to me emphasises the need to take care when considering the source of retirement income. Even with a cash ISA paying 2% tax free this is being destroyed by inflation. So the first question has to be what you use to deliver what you need for retirement.

Traditionally we have turned to pensions, and I suspect a lot of people saving for retirement still use these as the main source for income but although there is tax relief on the way in there is tax on the way out as well as a restriction on what you can do with the money. ISAs on the other hand don’t offer tax relief on the way in but more flexible tax-free income on the way out. Equally non-ISAable assets can be tax-free using CGT allowances.

Below is an example to show the benefits of not using one source of retirement income, and looking at different ways to provide the income.

Male age 40, retiring at 67.

New state pension of £7,800 p.a. (assuming no increases to age 67).

Pension Fund £50,000, Stocks and Shares ISA £50,000.

Currently Paying £3,000 p.a. Gross to a pension and £3,000 p.a. to an ISA.

Target income £2,000 – with inflation this would be £4,215.45 at 67.

Breakdown of income assuming 5% payable from pension and ISA:

Income source	Monthly Income
State Pension	£650.00 p.m.
Pension	£1,461.17 p.m.
ISA	£1,461.17 p.m.
Less tax	-£247.24 p.m.
Net income	£3,325.10
Shortfall	-£890.35

If we assume the client is a basic rate tax payer and the tax relief is added to the ISA so the client pays an extra £600 p.a. to the ISA this increases the net income by nearly 5% to £3,461.77. Interestingly if the client stops paying to the pension and pays all the money to the ISA i.e. £6,000 to the ISA the result is a net income of £3,461.77.

This is based on 5% p.a. net return after charges, fees etc.

Recently I saw an article encouraging people to ditch their pension and save into a cash ISA. Assuming a cash ISA returns around 2% a year gross and assuming £3000 to both the pension and cash ISA this would deliver an income of just £2,661.34. More importantly over a five year period in retirement the value of the investments would fall by around 5%.

If a client ditched pension’s savings and paid into a cash ISA then the income would fall again to around £2,556.48 but worse the investments in retirement would fall by nearly 10% in a five year period in retirement.

Summary

The point of all of this is that planning for retirement is not that easy, firstly you need to consider what you need in retirement and you need to be realistic. In this example I have assumed a single person, adding in a second person changes the figures. Some people may have a final salary scheme which changes the figures. So when planning how to deliver the income needed you need to consider all sources whether this is the state pension, an ISA, a pension or other sources. Then you need to consider the most tax efficient way to receive the income.

And finally don’t just sit back, constantly review and monitor.

I haven’t talked about how to invest the money that is for another day. But if you are comfortable with making a plan and the investment aspect then of course go direct. If you are not then this explains why you would approach a financial planner and why their fees in many cases are worth paying.

Are we focused on the wrong goal…..

When I grew up I remember the Thatcher years more than the decade before. One thing I remember vividly was this sudden shift to home ownership and the ultimate goal being the owning of your own home. In the early nineties I bought my first house, and I felt that I had made it. I sold it a few years later at a loss.

I was 23 when I purchased my first house, my parents were 40 when they purchased they first house. If we fast forward to today, it is expected that the average person will get onto the housing ladder at the age of 40 and as an economy we should be doing everything to open up affordable housing to a younger generation.

This has made me think, are we focusing on the wrong goals?

Go back a few years, we lived abroad when I was growing up and in many of those countries the idea of home ownership was alien and in fact this continues even now. Renting was the norm and for many they would rent the same house for their lifetime. This didn’t seem to cause problems for the economies and in fact some of those economies are stronger than ours!

So I have come through that and can understand that perhaps home ownership is the wrong goal, however for people born in the eighties they will know nothing other than the desire to own their own property as being the ultimate goal.

If we save everything we have to achieve this goal and that takes until we are forty, then we hit a problem because in reality we do little saving after that as we settle into the house, buy things and do it up to our standards. So we can find that by the time we are 45 we may have a house but have no savings for retirement. If we consider it in this way is the desire to own a house the right goal or the wrong goal?

Of course we are under amazing pressure to own a house, and that is why I bought my house but is that pressure creating a dangerous time bomb?

I don’t know the answer to this but it is worth considering. Do we as a nation need to reconsider what our goals are, and if renting should be the norm then perhaps we need to focus on making long term renting more accessible (even lifetime renting) and then people can focus on the right goals.  

The future for financial planning is bright……

I don’t want this to sound like sour grapes but it is something that has been playing on my mind for some time. Let me explain…..

We have just started out on a new business venture, we have run portfolios for clients for nearly five years and we are looking at whether we could offer these to other financial planners. There is nothing new in this but the focus for us is on the communication aspect and developing this alongside the financial planner so that it effectively becomes their proposition.

In putting this together I didn’t want to consider the past but I wanted to consider what the future might be and this is important. I am not saying I have a crystal ball but I am trying to understand the challenges people may face.

My feeling from meeting people is this; financial planning in many cases has changed. It is about goals, planning and delivery of goals. Around the edges firms do slightly different things but essentially the offering is similar. So the delivery of service, the clients financial planner and their fees are going to be key going forward and from the people I have met they are already addressing this.

The bit which I think will accelerate this further is the investment proposition – at the moment over 50% of financial planners outsource this, and this will increase. The problem is that the clients can easily see this is not part of the financial planner’s proposition and therefore outsourcing drives down the fees that people can charge so that the client doesn’t suffer double charging. That seems fair in my eyes.

If you flip that round and take control of all aspects of the proposition, then the value of the service is greater and that is what distinguishes one financial planner from another. If financial planners take on the investment side they need to be able to communicate that and be prepared to be open and share their thoughts. My gut feel is that in ten years those who do this will be in a much stronger position than those that don’t.

The problem is we tend to be backward looking rather than forward thinking. Now I could be wrong, I have been in the past and I could be in the future but this is what I think.

Taking this line of thought to the direct market and Hargreaves, I admire Hargreaves and I can see why their shares are so sort after. Any investor will look at various factors when buying shares and one of those is barriers to entry. To be honest for Hargreaves this is something that they have. For anyone to enter this arena it will take them time and money to develop something that even comes close to Hargreaves. If you listen to them now they talk about driving down the costs of funds, taking the proposition abroad, etc etc. They have ambitious plans.

Now this is where my sour grapes come in - possible, but I don’t think so. I have studied their model for some time and there is a flaw (or perhaps more than one flaw). The average client has £40,000 invested and the average fee for these clients that they receive is around £300 to £400 a year. Now the client doesn’t see this and Hargreaves have always marketed their free service. So where do they come in charge wise?

If they charge 0.25% then their fees reduce significantly and this will impact on the share price long term because this is pricing in past profits for future profits. So this is a massive challenge for them.

The second point is that Hargreaves remind me of a company called Skandia (shortly to be Old Mutual), ten years ago you would never have considered that Skandia would be overtaken by other companies but they have been. I suspect that this was because they didn’t look forward, and I think personally Hargreaves is in danger of this.

If we consider my point around financial planners, Hargreaves may have a dig at financial planners but many of the people I have met are already looking at the future and trying to model around that and not consider the past. I suspect Hargreaves know that and that worries them because a new breed of financial planners could be one of the biggest dangers to the Hargreaves model. The other danger is that Skandia for whatever reason didn’t consider anyone could replicate their model, the point was that the successful businesses didn’t replicate their model they produced something that was different and Skandia didn’t change to reflect that. This is the second danger to the Hargreaves model and that is that we and they don’t know what the new breed of direct platforms will look like but they are in danger of being hit by this.

In summary my feeling is this, financial planners are already considering the future and are prepared to adapt to this. This new breed of financial planners could be one of the biggest threats to the Hargreaves model, the second danger is this. Hargreaves and others are considering the past and not the future; they just need to look at Skandia to understand the dangers of this.

Fast forward ten years and look at this blog and see how close I was………

If you follow the crowd, you will fall off the cliff………

Over the last few days I have come to the conclusion that the potential for strong equity returns over other perceived safe investments has never been greater, and in this piece I want to explore this further.

A lot of my thoughts centre around perception and in particular the perception of risk.

We all know that cash and bonds are seen at the lowest end of risk and equities at the highest. Regulatory bodies, despite what is plainly obvious to all, continue to promote cash at the lowest end. Of course this is because risk is defined as the permanent loss of capital. In theory investing in cash means your capital is never really at risk unless of course you invest in Iceland, Cyprus and others! Whereas with equities there is always a risk that capital could be lost and this is one of the greatest fears for investors.

Crunching the numbers

From 1950 to date globalised annualised returns on equities was 6.8%, from 1980 this was 6.4% and over the last 13 years just 0.1%.

Bonds over the same period were 3.7%, 6.4% and 6.1%. In fact from 1980 to date bonds just outperformed equities and this was no doubt helped by the performance over the last 13 years.

Cash from 1980 has returned 2.7% p.a.

But by 2012 bond yields in many developed economies had hit all-time lows and nominal interest rates were turning negative so effectively investors were paying for the privilege of safety.

Going forward real bond yields remain low, 20 year real yields in the US are Zero and -0.1% in the UK. Real cash hasn’t fared any better, the real return on treasury returns in the US was -1.7% and -2.7% in the UK.

Recent research has predicted real returns on cash over the next five years will be zero and government bonds will be

-1.5%.

Clearly these are no longer low risk ‘safe’ investments and evidence indicates in real returns investors will lose money.

The great reversal

If cash and bonds are no longer safe then how can you achieve growth and income? Obviously there are other asset classes like property and that is a whole separate subject but high property prices, and low yields may not make this accessible to the average investor.

So the place to go appears to lead you to equities, but clearly investors will want to be rewarded for taking that higher degree of risk.

On the same assumptions used for bonds and cash it is projected that the real return of equities after inflation will be in the region of 3 to 3.5% over the next 20 to 30 years. This possibly isn’t what people want but it is still considerably higher than cash and bonds. It is projected that real interest rates will not return to a positive position for 6 to 8 years and even then it will be projected to be around 0.9%.

Clearly investors face a challenge; low interest rates and bond yields mean that the idea of ‘safe’ investments no longer exists and therefore equities have to be considered as an alternative, but long term returns could be considerably lower than in the past.

What can be done?

Where investors are considering moving from cash to equities they need to either accept this lower level of returns, or be prepared to take a higher degree of risk to achieve greater returns. It is important to stress that risk for us is about volatility. Investors don’t need to invest in high risk products which potentially lose capital but they can invest where volatility is low, the degree of volatility depends on the client’s ‘attitude to risk’.

The research assumes all markets behave the same, so we assume all emerging markets are the same - whereas the likes of Mexico, Brazil, South Korea etc are very different to the likes of India and Indonesia which have suffered from the withdrawal of foreign currencies. Therefore to win in this new world investors need to be prepared to diversify and consider actively managed investments.

Not all markets are the same

It can be argued over the last 3 years investors would have got stronger returns from a fund which tracks the S&P 500 compared to an actively managed fund. I would argue to achieve 3 to 3.5% a year, a fund which tracks the index should deliver this but there are considerable dangers.

Funds which track an index consider that all components of that market are the same, and perhaps in certain periods this is the case but long term it is not. Over the next 10 to 20 years we have indicated that frontier markets offer the potential to be the new emerging markets, and equally this will feed into the potential for emerging markets as economies start to become more mature. What is important is that not all the economies within these areas are the same.

Choosing an active manager who can diversify the portfolio and identify the economies they feel will succeed will be key to success. A fund that tracks an index will not be able to do this.

Equally some developed economies over the next ten to twenty years offer incredible opportunities which of course feed into frontier and emerging markets.  The US is predicted to be the largest oil producer by 2017; this is a game changer. Now investing in an S&P500 fund which just tracks the index will not necessarily give investors the opportunities to invest in companies that will benefit from the growth in the US. The type of companies which are likely to benefit are small to mid-cap companies, that is not to say large cap won’t do well but the real drivers are like to be further down the market capital share because they are more closely involved.

Equally Japan is facing a final roll of the dice, we have heard it before but this time it has a mandate for reform and this cannot be ignored. The Prime Minister controls both the upper and lower houses of parliament, the new head of the central bank is in favour of the new policies and there are much younger leaders behind companies who have the ear of the Prime Minister.

We should also not discount the UK which has been coming out of the recession over the last 12 months, there is still some work to be done but investing in the right companies could provide significant returns over the long term.

In summary not all markets are the same and different markets offer different opportunities.

Should we just ignore bonds and cash?

Bonds as part of a diversified portfolio remain an important part but these markets are not the same either. Many managers will claim that emerging market debt is not the place to be, these managers tend to be managers who manage large portfolios of UK debt and would be mad to say anything else. Could you imagine if they said you should no longer invest in their funds, it would be falling on your sword!

As I do not manage UK debt I will say it, the evidence from Credit Suisse and Barclays would indicate just that. However as is the message of this piece, not all bond investing is the same. We remain of the belief that emerging market debt will outperform the developed market. There has been a strong correction and this was mainly due to QE and the sell-off in US treasuries, Chinese growth worries and weakness in commodity prices.

But emerging market debt is different in that the economies are growing faster than the developed world, they have lower debt levels, their fiscal positions are getting stronger and their current accounts are improving.

So developed market bond investing may offer little opportunity and actually offer the potential for negative returns however some emerging market economies offer the reverse. There is of course more volatility than UK bonds but it is about the same as global bonds.

It is not a homogenous group and different economies are doing better than others so again the key is good active management rather than a fund which just tracks the index; so careful bond choice should not be ignored.

Where now for cash? We have seen accounts offering higher rates if investors are prepared to lock their money away for five to seven years with no access to the capital. If an investor is prepared to do this for this period of time then I would argue that they would be better to place it in a diversified portfolio of investments where they would always have access to the money. Again it depends on your ‘attitude to risk’.

Where next

Of course investors will always want to hold cash because of the perceived safe nature of these investments but in time investors will start to find that savings are dwindling and by then the damage may be irreparable.

The argument for equities is very strong but it will take investors time to see this, with the drive to lower costs the danger is that investors invest in the wrong way and this will be damaging for the long term.

The key is diversification, using active management and identifying where the growth areas will be going forward. It doesn’t mean a portfolio is stacked high with frontier markets or US but it means it favours areas where the greatest potential growth is and then managers who can exploit that growth. Bonds can be part of that but again it may mean breaking with convention to generate returns.

In summary it’s time for regulatory bodies, journalists and others to change their mind-set and accept that investing has changed. For investors, diversification and active managers are key to achieve long term success but there has to be an acceptance of greater volatility to deliver greater returns. 

We feel there is a choice for investors, they either follow the crowd and they will fall off the cliff or they can break with the crowd and go against the grain and this will deliver long term success.

Source: NAPF Investment Insight: Equities vs Bonds, Credit Suisse Global Investment Returns Yearbook 2013 and Barclays Equity Gilt Study 2013

Please note: These are the personal views of demystifyadvice and do not constitute advice. Any reference to a share is not a recommendation to sell or buy that share / fund. You should carry out your own research before making any decision. You should also note that past performance is no guide to future performance and investments can fall as well as rise.