Can you blame the government for getting it wrong on pensions again?

This week the government announced a review into pension charges, something I support but somehow I think the government has got it wrong again. The problem is that they seem to assume that auto-enrolment plus lower charges = perfect retirement.  And to be honest who blames them when leading industry spokespeople support their thinking.

I read a fantastic report by Dr Ros Altmann and it highlights some important facts that the government seem to have missed in their thinking. The key point is that in the past individuals didn’t have to worry about their pensions (where their employer provided a scheme), often this enabled them to retire early. The reality is that this golden age is over unless you are one of the lucky few.

Individuals now have to take responsibility for their retirement and for many they are not able to understand or comprehend this. It doesn’t help when the government tells everyone that auto-enrolment and low charges are the perfect solution.

Consider

An individual age 25 paying £100 per month into a pension under the new pension scheme, this would provide a pension fund of around £125,000 in retirement (assuming retirement at age 67). This assumes the investments increase by 4% p.a. after charges. 

In the calculation I assumed the new state pension increases by 1% p.a. to age 67. 

Roughly this would give a pension of £1,300 p.m. assuming inflation of 2.8% this would be worth around £430 p.m. in real terms. 

The flaw in the argument 

Obviously this doesn’t reflect contributions increasing but it gives an idea of what to expect. The problem with many of the schemes is that the investment choices are limited; to keep charges low many choose passive funds (passive funds track an index like the FTSE 100).

Passive funds can work but I would argue by their nature the returns will be lower than a good active fund. To be honest when Barclays talk about returns of 3 to 3.5% p.a. I expect these to come from passive funds. 

If you start getting these types of returns then you are facing a very miserable retirement. 

Understanding the risk

We know people don’t understand the risks, I have seen countless times people not understanding what they are investing in and not understanding the differences between pensions and ISAs. 

Without getting into detail pensions and ISAs are two different things but they can form part of the retirement income. You don’t get tax relief on contributions in an ISA but you do get tax free income, with a pension the reverse happens. 

With the pension the fund is locked in whereas with the ISA it is not. 

Then we need to understand the risk when it comes to investing, my job is to manage portfolios for funds. I spend time understanding about different investments and how they might work together. Some years they do well, some years like 2011 they don’t but smoothed out the returns should deliver somewhere between 5 to 8% after charges over a five to 10 year period. The extra charges provide extra benefit which you wouldn’t get with a fund tracking an index.

End of contract

I met somewhere the other day who was reaching age 55 in the army, he liked to think he was ending his contract. I thought about this and he is spot on. Longevity has changed the way we look at retirement. 

For many we may slow down but living into our eighties or nineties may mean we work well into our seventies. This needs to be factored in.

So what should the government do?

Personally I think they are listening to too many yes people……

I am not saying the report by Dr Ros Altmann is the Holy Grail when it comes to solving the problem but what it does is look from the bottom up. The government thinks people will engage with their pension planning because of auto-enrolment, I’m sorry but they won’t.

We are facing a massive train crash over the next few years and now is the time to avoid this. Reverse thinking is needed - pay people to educate people, make people consider about budgets, target income and ultimately have a plan. Planning for the future is not hard, it just needs a plan and acceptance things might change.

The challenge

Does the government have the strength to stop the road crash and go back to basics or will they just hide their head in the sand on the basis that it’s not going to win them the next election.  

Past performance – a guide to the future

In my final blog looking at pension charges and investments I want to consider past performance. I have recently received a report from Dr Ros Altmann called “Pensions: Time for Change” – I am slowly making way through this. The report is excellent and covers a lot of information but one point I want to focus on is having a plan and being realistic in our expectations. 

In my last blog I mentioned that in the past I based my investment decisions on past performance. During the late eighties and nineties we became used to double digit returns. We didn’t need to be investment experts to achieve these returns. Towards the end of the nineties some funds achieved triple digit returns. Without understanding those funds, you have to ask “why have double digit returns?” 

Of course we all know what happened. It was a bubble and bubbles burst…….

Over the last couple of years we have seen double digit returns from our more adventurous portfolios. If I listen to various fund managers they state we are in a bull market and shares will go one way……and that is up. 

I listen to lots of fund managers speak and their arguments are compelling but going back to the report we have to be realistic about our expectations. If I assume that I will achieve 14% return p.a. on my investments for the next 20 years then you have to ask is this realistic. If I am honest I would say not. 

Some fund managers are now saying many equities are “fair value” this means they don’t have much growth left in them. Of course it’s not as simple as that as some stocks will perform well, some will become unloved and sectors and geographic regions will do the same. Some could argue that there is still value in small and mid-cap stocks. The point of all of this when looking at investments, is that past performance is a guide but realistically it is just that; we need to be thinking about what can be delivered in the future.

Diversification can help because not every region, sector etc will perform well at the same time. So when one slows, the other can take up the slack. 

Going back to realistic plans, clearly just because we have had a couple of good years we cannot expect that to continue (well we can expect it to continue but we might be disappointed). If we look at the Barclays report they expect equity returns to be around 5% p.a. for the next 25 years. So if we can achieve 5 – 7% p.a. (after charges) then that would be higher than cash (which they expect to be flat) and bonds (which they expect to be negative). 

The question is do I believe that is achievable, I am a great believer in good active managers. In this environment it is these managers that will deliver because they identify the areas which can drive returns. I also believe that diversification can help. Therefore when I look at my financial plan I use a rate of 5%. If I achieve more than that, I will have more in retirement. But being conservative and realistic is important. If I based it on past performance (especially one year) I would almost certainly miss my target and be disappointed. 

In summary past performance is a guide, but understanding what might happen in the future and being realistic in our expectations is the only we will achieve our financial plan.

Understanding our investments…..

In my last blog I explored the dangers of going direct, and I want to explore this a little further. 

The scenario which I painted took an example of someone who is very skilled in making “investments” into cash, and I think would be fair to assume thought they could take it a step further. 

I have used many times before the example of a car or general DIY. With a car I would like to think I can drive the car (some may doubt this), and I can fill the car up with diesel. When there is something I don’t understand I can check the owner’s manual or go online but I know there is a point where however skilled I think I might be actually I need an expert to step it. 

Investing is no different, I spend every day (almost) analysing the market, monitoring the portfolios we manage for our clients and testing what we think is right, is still right. 

This is important because most people when asked how they select a fund will say it’s on past performance. To be honest I would put my hand up and say a few years ago for me that was the only measure I could base my decision on. But actually there is a skill to selecting funds, those who do it will use different measures but past performance is only one measure. 

Think about gambling on horses, you bet five times and win five times. You are of course a genius or are you? Gambling is about luck, we can study the form and people do make a living from it but those who make a living follow a process. 

Investing is the same, going back to my example I had a quick look at the cash fund the person invested in and it clearly states “the fund invests in the short-term money markets, such as bank deposits and Treasury Bills” and it goes on further to say “if the interest earned by the fund’s assets is insufficient to cover the product charges, the value of your pension will fall”. When making an investment this is the first thing you need to be reading.

The other point is around past performance, prior to 2009 the fund possible had delivered fairly good returns but from 2009 onwards it hasn’t and this is about understanding the future. We are currently assessing fixed interest investments, i.e. bonds. This is the second tier of risk. 

Bonds have posted pretty healthy returns recently, but scratch beneath the surface and the future doesn’t look so bright. Without going into too much detail some of the performance is driven by what the market thinks interest rates will do in the future. If they think interest rates will go up then the bond fund might fall. There are of course ways to protect this but clearly from speaking to professionals they feel that bond funds will struggle to deliver anything but flat returns going forward. In fact a recent Barclays report indicated this would be negative. 

Of course some bond funds may deliver short term positive performance and there are other ways to invest in the bond market but understanding this is important. 

I am not sat here on a throne saying what a genius I am because sometimes we might feel something is wrong and move too early but what we have been able to do is deliver solid above average returns. The point is this we do this day in day out, and we are constantly learning and being challenged. Some direct investors will do the same, but as highlighted others will dabble with disastrous consequences. 

My advice is that like our cars, understanding the limit of our capabilities is the first step and if we feel we can do the research then do it but if we have slightest doubt then pay for help. Despite what others might say in many cases this will be one of the best investments we ever make.

A step into the unknown………

I recently read a brilliantly crafted blog complaining bitterly about pension charges and how these charges had eaten up any growth in the plan. When I started reading this I assumed we were talking about an old style plan but to my dismay this was a plan started in 2009.

As I read this article, it made me realise that actually the problem was not necessarily in the charges but in the decision that the person had made in making the investment. For me this highlighted the dangers of going direct.

Painting a picture

We have a couple in their fifties who, in 2009, after taking early retirement decided to save money in a personal pension (they already had some pension benefits which I assume were funding their early retirement).

The reason they decided to invest in a personal pension was due to to the 20% tax relief. The argument seems to make sense; £2,880 is grossed up to £3,600 (so £720 put in the pension for free).

The aim was to save in the pension for three years and then access the money I assume as an annuity (income) and receive the 25% tax free cash. Their investment strategy was to invest in a low cost cash fund.

Returns on cash funds over the last few years have been poor and actually as this couple discovered the charges were higher than the returns……..

The argument of the blog is that the fault lies in the pension system and there should be some sort of free pension system. There is also an argument that if the money had been put in a cash ISA they would have got more money.

Reading this blog, although I have sympathy for this couple, I think it highlights the dangers of going direct.

The questions

Firstly this is all about what is the financial plan. The assumption here is that two years contributions into a pension will provide them with a pension in three years’ time. However, my first starting point would be this – what income do you want in three years’ time? Once you know what income you want then how will you achieve that?

A pension may be a route – interestingly one point the blogger doesn’t make is that actually even with the charges they received £1,440 in free money which they wouldn’t have got from the ISA. Effectively this is a massive amount of ”interest” - if this is what they want to call it.

The pension gives a 20% uplift but on the downside the income will be taxed (assuming they are a tax payer) and in reality a pension fund of £8,000 is going to provide a tiny pension income after tax. Even with the uplift was it right to invest in a pension or were they always going to be disappointed with the outcome because there was no financial plan in place.

Secondly my concern is about understanding how you are investing. So the assumption is that possible because of their age and their time to retirement the only option is to select a cash fund. A cash fund is not the same as ISA cash account. Often they invest in the markets so the returns will be less than a standard cash account. Understanding your investment is crucial, I have recently done research around low cost investments like bonds and cash and to be honest it frightens me more than equities.

Also it also highlights the dangers of past performance; cash prior to 2009 was probably producing good returns. Post 2009 well…….

So here we have someone who appears to have no real financial plan, has made a decision based on the tax relief (which might be right) and then chooses a fund which at best will provide minimal returns.

The alternatives

So they then complain about the pension when compared to the ISA, the two are not the same. To start with – with the ISA they would have had £5,760 invested. With the pension, after tax relief, £7,200 was invested; an uplift of £1,440. To get that from the ISA over 3 years would have had to have seen amazing interest rates………

The other thing to consider is that with the ISA although there is no tax relief any income is tax free. Interestingly in the article the person talks about a 3.2% instant access account for her cash. Again I am not challenging this but these accounts are incredible hard to find and normally come with restrictive conditions.

Summary

I have seen too many people have a go at charges on pensions and my conclusion is that too many people are stepping into the unknown. Ultimately you must have a plan, you must know what you want and ultimately you must know what vehicle is best to deliver on that plan and how you invest to achieve that.

The blog I read highlights the danger of DIY investments, saving money is great but get it wrong and it will cost you significantly more in the long run.