On pensions, part 4: building a strategy

So you’ve got your Stakeholder Plan and a simple online management tool. How do you use them? Here’s how I do it: a simple investment strategy that takes barely an hour a month to administer.

It relies on three principles: a) the market knows more than you; b) retail pension funds have two good years; and c) charges are your enemy.

First , work out what you want, so you can spend the next couple of decades getting it. A £350 monthly contribution, rising by 10% each year will, over 25 years, grow to a £1.6m pot if you keep an 8% return over costs and inflation. It can be done – but you’ve got to be active about it. Here’s what I do.

Choosing your funds

Risk-taking and yo-yo’ing may produce great returns by chance over a short term, but we’re looking for long-term growth here. Hence my rule: don’t bother with company shares. As a retail investor, you’re there for one thing: to absorb risk on behalf of institutional investors (i.e making sure they make money, not you). No retail investor ever makes money consistently over time.

The vehicles to invest in are pension funds, a spread of investments packaged together (usually on a theme, such as mining companies or technology businesses.)

If you’ve opened a Stakeholder or SIPP, your provider will have a wide range of funds to invest in. They’re sold in “units” (you can buy fractions of a unit, so you never have money sitting there uninvested) and the better fund providers let you choose and swap your investments online. It’s a liquid and transparent market, with unit prices published in places like the FT.

The list of funds offered may run to over 100 entries, so let’s narrow it down using two parameters. First, only go for funds marked “Acc” – accumulators, where any returned income (such as dividends) is automatically re-invested in your fund. (This is a pension; you’re looking to build it up, not withdraw from it.)

Second, only go for funds offered by your pension provider, not “external” funds it offers on behalf of other providers – these will carry “external fund charges”, and it only takes a couple of those to seriously eat into your growth. (One thing pension fund providers aren’t good at, for obvious reasons, is making clear how much they’re skimming off your fund each year.)

I choose my funds on a simple algorithm: whatever’s been doing well over the last year, I invest in. My feeling is that a pension fund has a couple of good years in any investment cycle. I try to catch that fund as it’s warming up, with a few quarters of solid growth behind it and a few more ahead. It means I’m never buying the cheapest, but usually the most solid. The returns you can make here can run above 12% consistently, if you pay attention.

Deciding how much to invest

Remember that £1.6m pension pot that’ll provide an upper-percentile income from age 60+? To get it, you need to invest about £350 a month gross, and get an 8% return over inflation and fees, every year. Realistically that means a gross return around 13%. Keep about half a dozen funds in your pot, and the fees will be around 1.5% a year (the maximum they’re allowed to charge – some providers charge less. Just remember there’s a fee per-fund which may drive your total fees higher. Sometimes it’s pleasantly cheap, though: one UK fund charges an annual management fee of just 0.15%.)

There’s another thing you need to do: tie your contributions to your earnings as they rise over the years. That £1.6m pot needs that £350 to rise by 10% every year. About 3% a year will, over time, only keep pace with inflation. About 6% a year will make your contributions double in a decade… and wages rise at about that rate, so you’re keeping pace while being able to afford it.

The younger you are, the more flexible you can be here. If you’re under 30, that £1.6m pot costs less than half as much each month to build. The moral? Start young.

Keeping it up!

In the private pensions market, a huge percentage of people simply stop making contributions after the first year or two. It’s too hard, too expensive, and they lose faith in something they won’t see the benefits of for decades. (It’s easy to understand why. Many Stakeholder pension providers choose rather low-risk, and therefore low-return, funds for you. That’s why I want to have a say in the choice myself.)

So the last part is keeping your pension top-of-mind.

First, set aside one Saturday morning each month to review your portfolio and make any changes. It only takes two hours and can be fun. Simple rules – like mine, which sums up as always keeping the top 4-6 funds, whatever they are, in the portfolio – work. I tend to keep 10% or so in something solid and stolid, like UK Gilts (which only return a few percent) but over 80% of my portfolio is in moderate-risk funds like smaller companies. That suits my risk profile; yours will be different.

Second, watch the numbers over time. You’re not a momentum trader; you’re looking at long-term performance, not short-term dips. 2011 has, of course, been pretty awful. Look at the graph over the last year; you’re looking for smooth and steady above-inflation returns with a reasonable chance of continuing. There are plenty of websites that’ll track your investments for you. Use them. (Morningstar is among the most complete.)

Third, know what they’re charging and what inflation is today. Add these numbers together and you’ve got a figure – possibly as high as 7% – and that’s the amount your pension provider and the invisible hand of economics are taking out for themselves. And they take it out every year, whether your investments have grown or not.

This is the biggest pitfall in the pensions biz, and it hugely affects your longterm projections.

On my plan, a two-percentage-point difference in overall return is the difference between my pension pot lasting a couple of years and lasting… forever. By “forever” I mean that taking out my planned income, an amount that rises with inflation each year, only reduces the pot by a proportion of its growth over inflation – in other words, I’m living off the interest after inflation, keeping the capital’s buying power constant.

(Think it’s stupid to have a pension pot that lasts “forever”? In today’s world, the fastest-growing demographic is people over 100. You could be living off that pension income a long time. So you need to make sure it’ll last.)

And that’s how I do it. Make your own decisions – but remember, it’s all up to you.

On pensions, part 3: setting things up

So you’re ready to set up your own pension plan. Here’s what I did.

1. First, look at your employment situation. There isn’t much point in being a one-man limited company any more; if you’re a service provider charging a day rate or similar, go self-employed instead. The reason: it makes you eligible for Class 2 National Insurance Contributions for the Basic State Pension. While the Basic only pays out a small amount per week (currently £105 from age 67) it costs a self-employed person as little as £2.50 a week (for 30 years) to secure it.

(You pay Class 4 on top, but only at 9% above a certain level of profits, and it tops out with a marginal percentage of just 2% when your profits exceed £40k.) Being government-provided and linked to average earnings, it’s a great deal (who wouldn’t appreciate an extra four hundred quid, index linked, every month in a few decades for just a few percent downpayment?)

So check you’re eligible for Class 2 Contributions. If you’ll build up fewer than 30 contributing years before you hit 67, apply to catch up. (Having spent part of my life overseas, I’ll only pass the 30-year requirement in my 60s.) Bear in mind an average-salaried individual will pay £200 a month in NI to get the same basic entitlement; if you’re self-employed, that money can be going into your private pension pot instead.

2. Next, talk to a financial advisor if you like, who will advise you to open a private pension plan. If you’re in my situation – self-employed UK citizen with your own business and wild income swings – there’s only one choice: a Stakeholder Pension Plan. They’re designed for people on lower incomes, but since the contributions ceiling is £50k/year – around twice average household earnings – the “low income” bias isn’t relevant in practice.

(If you’re an employee, the first £3,600 per year is eligible for tax relief, so if you pay up to this out of your after-tax income, an £80 monthly investment will be topped up to £100. The self-employed of course don’t get this, but other benefits balance out.) The other great thing about Stakeholder Plans is that money managers’ fees (the killer) are capped at 1.5% per providing company. There are fancier alternatives, like SIPPs, but if you’re looking for a tax-efficient wrapper for financial assets, a Stakeholder is all you’ll ever need.

When choosing a provider, look for three things:

Web-based account servicing. You want the Web because you’re going to be looking at your funds regularly; make sure your provider’s web services are up to scratch. Look for a provider the same way you’d look for a new bank – secure web access and the ability to conduct business entirely online. (I haven’t been into a bank branch in years.)

A broad choice of funds to invest in. The UK’s bigger pension providers, like Legal & General, have a choice of over 60 funds that fit into a Stakeholder Plan. It’s less well known that Stakeholder Plans let you self-invest, but it’s one of their biggest advantages. Make sure the choice of funds your provider gives you covers a broad array of geographies, business sectors, and financial instruments from index trackers to government bonds.

Fee-free fund reallocations. Make sure your provider allows you to flip and switch your money between different funds as often as you like. Some providers even allow an unlimited number of switches per month. At minimum, you want the option to completely re-allocate your pension pot four times a year.

3. Check and recheck. Make sure your employment status is correct; make sure your Class 2’s are being paid by direct debit; test your Stakeholder Plan’s online servicing features. And you’re set up. Next:  my investment strategy.

On pensions, part 2: understanding the concepts

There are only seven concepts needed to understand pensions. First, the two types of pension. Then a word on funds. Then the four mathematical concepts to see them in context. (Remember the basic rule: this stuff ain’t hard. The financial industry just wants you to think it’s hard.)

There are two basic types of pension: defined-benefit and defined-contribution.

Concept 1. Defined-benefit includes those gold-plated final-salary and the slightly-less-golden career average schemes in the public sector. Pay in throughout your career (usually not very much; your employer coughs up too) and you’ll receive a proportion of your salary at retirement. Forever. Not subject to how long you live, not subject to the ups and downs of the markets. Since such deals often rise with inflation too, they’re a great deal.

So great that they’re bankrupting every country that offers them.

Because defined-benefit is inherently unsustainable. Imagine a senior manager retiring at the public-sector average of 58. His employer may have to stump up two-thirds of the salary he earned in her last year … bumped up with inflation… every year for the rest of his life. With today’s lifespans, that might mean paying his pension for more years than he worked. That’s defined-benefit, and it’s killing both our public finances and the finances of private companies offering such schemes.

(So why does the public sector continue to offer them? Simple politics. Promising a pay rise costs money now; promising a pension costs money after the next election. Both are effective in buying public sector workers’ votes and sending the bill to future generations. And in countries like the UK, which has a large public sector, there are many millions of votes to be won that way.)

Concept 2. Defined-contribution. This the only reasonable way to run a pension fund without storing up trouble. You have an individual retirement account, it grows or shrinks with whatever you invested in it, and what you get out relates to what you put in. (A simple savings account is a defined-contribution plan.)

Defined-contribution plans tend to pay out far less than defined-benefit, largely because you’re taking all the risk instead of outsourcing it to your employer.

While it might be great to have someone else taking all your investment risk, it’s happening less and less for private employees; defined-contribution is now all anyone outside the public sector can expect. Taste the difference: a senior civil servant on a defined-benefit retiring today, on £85k at the age of 60, will receive a pension exceeding £5k/mth. That sum will be adjusted upwards for inflation, risk free, for the rest of his life. To get the same through a defined-contribution plan,  you’d need to have north of £2 million in your pot.

Defined-contribution isn’t generous. But it’s sustainable.

(There is one lump of sugar: with defined-contribution, you get to be in control. If you’ve got a taste for risk, you can dial your preferences into your fund and enjoy wild growth if your investments have a good year. I don’t need to mention the corollary, of course.)

However, most defined-benefit plans from employers make it hard for you to exert a great deal of control over them, which is why this blog is mostly about defined-contribution. It’s about what you can do to maximise your pension.

Concept 3: the investment fund. Whether you’re defined-benefit or defined contribution, you pension is part of a fund, a sheaf of investments (shares, bonds, cash) chosen to increase in value over time so the pensioners can be paid. Big companies and public sector organisations might have only one fund for all employees; individual self-investors might buy slivers of many funds bought on the markets. (There are thousands to choose from.)

The only thing worth remembering is that funds are aggregated. One fund may bundle together many investments (such as shares) and sell the bundle as units. (Imagine a basket of vegetables: that’s the fund. Your pension pot contains a bite of carrot, a slice of cucumber, a peck of peas, and so on.)

A £100 unit may contain slivers of a telecoms giant, an oil startup, and government bonds, weighted by the fund manager to produce maximum return. Funds on the markets are very liquid; if your pension pot isn’t in nice multiples of £100, you’ll simply own relevant fractions of a unit too.

Now for the maths: compound interest, pound-cost averaging, weightings, and Projected Value. Relax; it’s all simple.

Concept 4: Compound interest is what you learned in school. Put in £100 at 10% interest, get £110. Leave it there, and next year you’ve got £121. Investment funds carry other goodies like dividends and coupons, and if you reinvest these back into your pension plan (you should) the compounding just works harder. Compound interest is simple.

Concept 5: Pound-cost averaging is the reason you should invest a set amount in your pension each month, before any other expenses go out. It’s a way of smoothing out the stockmarket. Let’s say you’re in Fund X whose component companies did well this month. Their share price is high, so you’ll get fewer shares, but they’re doing well, so you don’t mind. The next month, when the company hits the skids, your regular payment buys a lot more of their shares, so you own more shares and reap the benefits when the company starts growing again.  Pound-cost averaging is simple.

Concept 6: Weighting. Your pension plan is probably in more than one fund; how they’re mixed or “weighted” is a key concept to understand. Fund Y is making 20% and your fund contains its units; why has your pension fund lost money? Because Fund Y comprises just 10% of your portfolio and the rest of it is toxic waste. Weighting is how you balance your pension pot with your appetite for risk. Adventurous young males in good health choose funds in emerging markets and new technology; sozzled greybeards stick to bonds and index trackers. Weightings are less simple but more fun.

Finally, concept 7: Projected Value, or PV. This is how you plan for the future: given average returns of X percent a year (long-term stockmarket returns are surprisingly stable) with n years of contributing N pounds rising at Y percent a year…  accounting for inflation, charges, and risk by Z percent… and you’ve got your pension pot, from which you can work out what you can afford to draw as your monthly pension. Projected value is simple and fun.

That’s all you need. Next: setting things up.

On pensions, part 1: getting the mindset

I’ve worked for myself for over a decade, and spent a lot of years outside the UK or on non-paying projects like an MBA. Wild income swings are normal to me and my risk profile is off the scale, but I do have two fears: a) Getting old, and b) Being poor. Both can be influenced if you take the right actions in good time.

This blog’s about setting up a pension if you can’t rely on anyone else providing one.

(First, a disclaimer: I’m not a financial advisor, and this isn’t financial advice, nor should you take it as such. I’m just sharing what I do on my blog which helps me.)

Financial advisors go out of their way to make pension provision sound complex. Well, there are hard aspects to it – but the hard parts aren’t where you’d think. The hard part is simply getting the mindset: looking at your pension fund as an asset like your house or car. Except that it brings you benefits later on instead of tomorrow. And nudging yourself into that mindset can be surprisingly simple.

The first concrete thing to do is bring your pension into your life. (I have the login page of my account as a browser home page. This daily “nudge” keeps it top-of-mind.) What this does is negate the feeling you’re throwing money away.

(Deferred benefits, i.e pension payouts several decades away, will always feel harder to pay into than your new car or computer that brings pleasure TODAY. But by keeping your pension top-of-mind, it feels an asset like any other. Many providers offer web-based portfolio management tools; make sure you get a plan with decent online services.)

The next thing is to make a regular contribution on your payday, NOT when you’ve “got other expenses out of the way.” Even if you’re in an employer’s scheme, make sure you know how much you’re contributing and ask to increase it if the projections don’t give you what you want when you turn 60+.

(Working for myself, I don’t get the tax relief formally salaried people do, but I treat my monthly gross contribution with the same importance as paying the mortgage. I’m a spender, not a saver; this is the only way I (and most people) can ever save.)

Last, have a monthly ‘money day”. The third thread – whether you’re a hands-on self-investor or leave it to others – is simply to keep yourself informed. Know what your contributions are being invested in, know the weighted return over the last 12 months, know the inflation rate and charges that are eating away at your nest egg.

This is part of the habit-forming needed to get the mindset: I’ve set my pension fund tracker to be among the start pages for my browser, so I’m constantly reminded what’s working and what’s not. The same applies if you’re in a company scheme: are they making investments that give returns, or are they investing mainly in the same sector as your employer? Let’s just say we can all guess which oil and gas company was the primary weighting in the pension fund of… Enron. Know what’s going on.

That’s the mindset. In forthcoming days I’ll be blogging my takes on understanding the concepts, setting things up, and building an investment strategy. Next: understanding the concepts.

Tesco credit cards: a case study in consumer finance

I’m not a rate tart; opening card after card to take advantage of 0% periods has always been more trouble than it’s worth. But I’ve just taken out a credit card with Tesco – and scorched across the small print is reminder after reminder of the difference between a consumer finance company and a consumer focussed company. Say what you like about the supermarket giant; it knows how to treat consumers. In a way pure-play finance companies don’t.

For starters, it leverages the rest of its business to my advantage. Double ClubCard points on petrol means nearly two pounds back every time I fill up – for no effort. With ClubCard’s regular 5p/litre off promotions, that means almost a fiver saved – and that’s substantial. Unlike most banks, whose credit card marketing aims at new customers in a way that alienates existing ones.

Secondly, the interest rate’s simply lower – in more ways than one. The T’s & C’s state your payments are applied to the balance in a manner very few card companies operate: they pay off the highest-interest (i.e. most expensive) debt first. Most cards push any cash withdrawals (the most massively expensive use of a credit card) to the bottom of the pile, meaning that if you roll over your balance from month to month (as I did for a decade) the priciest debt sits on your balance forever. Tesco don’t do this; somebody, somewhere focussed on what was best for consumers, and realised that the standard way of doing things was wrong.

I’ll pop in a disclaimer here: I don’t work for Tesco, but do have one of its advertising agencies as a client. Doesn’t stop me being a fan. Anyway, off to the filling station for a fiver of payback…

The trouble with comparison sites

I’ve discovered an unfortunate rule of consumer finance: the best value is often from the chavviest, most embarassing, most insultingly infantile providers out there. Gritting my teeth, I checked out GoCompare for my car insurance, and it was instantly £30 cheaper with a far lower excess than the next-best quote from another comparison site … perhaps because it let me specify my situation in greater detail. I mean, surely it makes a difference that my vehicle’s kept overnight in a private street with an electronic gate and CCTV, but most sites only let you state whether it’s in your garage, on your driveway, or out on the street at the mercy of roaming lowlife.

Given thought, it’s hardly surprising: “chav” providers cater to the section of society that likes bargains best and is quickest to complain, so the sites that appeal to them have to be red hot. It’s a bit sad that the quality names – First Direct is an example; its fees and interest rates for everything from mortgages to share dealing are on the high side – can’t compete on price, when their customers tend to be higher income and less concerned about saving that last quid.

I’ve always thought “comparison sites” were a scandal waiting to happen – none of them actually offers a consumer service; they are paid referrers, arranging their listings in order of who pays them the most commission. (Nothing wrong with that.) But hey, they work. I’m sure I’m now in for a month of spam, but bringing down a first quote by nearly £1500 is worth a lot of junk mail.