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.

Is there a problem with our pension system, or is it just about our expectations in retirement

I have read some fascinating articles of late, and heard different people, all claiming that our pension system is broken. As a father of two children our children are today not going to school because teachers are striking over a number of issues but one of these is their pension. I thought about this, on one hand people are saying our pension system is broken and on the other we have a minority who don’t appreciate what they have.

In this blog I just want to explore whether our system is broken or whether our expectations need adjusting. Only twenty years (perhaps less) ago our expectation when agreeing terms for a new job was that we would have a guaranteed pension at retirement. Many private sector companies offered these schemes especially in the financial sector. Fast forward to today and very few private sector employers offer these schemes and really the only way to get this type of scheme is through the public sector. 

The other thing I remember was that for some of the private sector pensions you didn’t have to pay for the benefit. So effectively in many of our lifetimes we got as part of our employment a free guaranteed pension.

For those unfortunate not to have a gold plated pension they saved into a pension to provide for their retirement. Often with no real knowledge of what that would provide. The expectation of what they would receive was always based on the past. I remember as a rule of thumb £100,000 pension would provide £10,000 pension. 

Fast forward to today and there is only now a realisation that people are living longer (20 years plus in retirement) and this means that retirement income has to last longer. Of course pension schemes have to move their retirement age and increase contributions otherwise they cannot afford to pay the benefits but equally individuals who don’t have these schemes have to take on this responsibility. 

If we focus on the fact that the pension system is broken I think that is just one element. The key as I have argued a hundred times is that of understanding what our expectations are in retirement and how we are going to achieve this. The new state pension is a great starting point especially for working couples; this gives a solid base of £7,000 plus each at age 67. An ISA can deliver a tax free income in retirement, and a pension fund can be part of the mix. Of course these are not the only sources of retirement income; for example buy to let property can deliver an income.

My point is this whether you are in gold plated pension scheme or not the first step is to accept that the norm that we knew has changed. This means that for many of us we have to work longer, retire later and pay more for our benefits. To avoid disappointment we need to be thinking about what we need in retirement and how we are going to achieve this, and more importantly we need to understand that pensions are not the only source of retirement income. 

In summary I don’t think there is a problem with the pension system, I just think we need to adjust our expectations of what to expect in retirement, when this will be and how we fund this.

Cash is dead…….

In recent months I have studied our obsession with cash, and the apparent blindness to the destruction of its value in real terms.

On one hand we are told that cash offers the lowest level of ‘risk’ and yet on the other hand we are being told that any ‘returns’ are effectively being decimated by continued low interest rates.

Picking up on the last point I searched for the best rate and found one plan offering 2.8% p.a. return if you were prepared to lock your assets away for five years. Inflation is expected to be around 3% p.a. over the next 5 years (according to M&G). This means that in real terms investors are losing 0.2% p.a. on their cash assets.

Financial planning is about challenging convention; this is not about taking risky bets but challenging the norm. Just because we have always done it, it doesn’t make it right. A senior economic analyst recently said that cash is fine for the short term (say 6 to 12 months) but any more and savers should be looking to invest in the market.

When cash was alive and well circumstances were different. Now a number of underlying factors have changed. Firstly if we retire at 65 we don’t expect to live 5 years, more likely we will live for 20 plus years. Secondly interest rates have been low for a number of years and will remain low for some time to come; saving rates are not going up any time soon and thirdly inflation will kill returns, a mathematician doesn’t need to tell us that at 3% inflation, cash returns are effectively negative in many cases.

In this blog I want to explore the subject that no-one wants to talk about and start a debate. Whether you agree with me or not, you may come away from this blog and consider that cash is dead (or you may not).

Why cash

We habitually like cash for three reasons:

1. Protection of capital – if I have £100,000, and I put it in the stock market it can go up and down and therefore there appears to be no protection of capital. With £100,000 in the bank I will always have £100,000.
2. Liquidity – if I want to access the capital I can get it at any time and I don’t need to worry about timing the market, the capital is the same whatever the markets are doing.
3. Guaranteed growth – if my account is paying 2%, I will get 2% again irrespective of what the market is doing.

If I ended my blog at this point, we would probably all agree this is a strong reason to hold cash. However, my argument is that this is what we have thought in the past and are attuned to think for the future and herein lays the problem.

Should we be worried about holding cash?

Short term (i.e. 6 to 12 months) no…….

Long term (i.e. 12 months plus) yes……

A recent report by Barclays described cash as a value destroyer.

If we focus on the past……..

In 1990 the FTSE All Share Index was down 9.72%, cash was up 14.89%.

In 1994 the FTSE All Share Index was down 5.85% and cash was up 5.55%.

In 2000 the FTSE All Share index was down 5.90% and cash was up 6.17%.

So the past tells a story, in periods where equities are performing badly cash holds firm. This was true in 2008 where equities were down 29.93% and cash was up 5.52%.

But for the last five years cash has returned around 1% p.a.

You can get higher rates on cash if you are prepared to lock it away, but then you take away the liquidity because you cannot access your funds without some form of penalty. If you are prepared to lock money away for 5 years to get a poor return then surely equities hold the potential for better returns over that period?

Cash as a value destroyer

The figures don’t tell a lie.

If liquidity on cash is important then the types of rates in an ISA we might secure are around 2% (if we are lucky). M&G have indicated that inflation over the next 5 years will be around 3%. This means in real term the capital is declining by 1% p.a.

An investment of £100,000, with 2% increase per annum, will be worth around £90,000 in real terms in five years’ time. (This does not mean that the balance is reduced by £10,000, but that the equivalent ‘buying power’ of this money is effectively reduced because prices have increased)

If the investor wants any type of income and takes the 2% then the value would fall further because effectively there is no growth on the asset and its real value drops to around £73,000.

What about income from cash?

Income is a big issue, in the past where cash was yielding 6% plus it could provide a good income in retirement………this is no longer the case.

If you take the interest it is unlikely to be at a level that delivers the income that is needed. This means the investors get a double hit. Not only do they suffer from inflationary decreases but to deliver the income they have to eat into their capital.

The idea that the capital is safe is gone. So for example 2% interest and 5% income means that the capital is reducing by 3% p.a. without considering inflation.

Equally an income of 5% will have to increase to keep up with inflation.

In summary cash can no longer deliver sustainable returns and provide an income. It is only good for short term needs.

What about equities

JPMorgan recently presented a guide to markets and this showed some really interesting facts.

A 1% increase in interest rates will cause 10 year government gilts to fall 15%; this means the second tier of safety goes. Cash rates will not increase at the same level as interest rate rises.

Equities however are shown to be resilient in a rising interest rate environment. Interest rates are low because an economy is struggling and not growing or at best growing slowly, an increase in interest rates shows an economy is starting to grow and in that environment equities are proved to grow as well.

This means that equities could (for some time to come) deliver good long term returns especially when compared to cash and some fixed interest investments.

Equities can deliver income, and growth. A diversified portfolio can deliver this and keep the risk to the portfolio at a minimal level.

In summary

It’s a hard pill to swallow but for too long we have considered cash to be safe, if we don’t review our approach in this area it will destroy our retirement plans. There are reasons to hold cash but holding for the long term should no longer be one of those reasons.  

So what do you think?