Sequence Risk & Defined Benefit Pensions

 The following snippets are taken from Ian Cowie’s column in yesterday’s Sunday Times.

In the first he reminds us that the sequence in which we experience good or bad investment returns is very important and in the second he gives an example of how generous most Final Salary/Defined Benefit Pensions are, including the Public Sector, when compared to Money Purchase arrangements which are now offered to most Private Sector employees.

Sequence Risk

Leaving the security of a final-salary pension to fund retirement from stock market income is an irreversible decision, which will be right for some and wrong for others. It’s vital that everyone doing so is fully aware of the dangers.

For example, how many have heard of “sequence risk”, or the mathematical fact that the value of your fund will be affected by the order in which gains and losses occur? Here’s a pensions parable in which two investors who each retire with £100,000 both enjoy average annual returns of 7% and draw annual income of £7,000 over the next decade.

Unfortunate Fred suffers losses in the early years and gets his gains later, while Lucky Lucy experiences the same returns the other way round. As a result, despite having exactly the same annual average return, Lucy ends the decade with a fund worth more than £120,000 while Fred has less than £72,000.

The explanation is the way percentages work; if you lose 20% one year, you need to gain 25% to get back to where you started. Or, if markets fall by about 50% — as they have done twice this century — you would need a 100% rebound to recover fully. That’s worth considering while markets trade near record peaks and the next move might be downward.

Defined Benefit Pensions

There are still some 12m active and deferred members of defined-benefit schemes (of which 5.5m are public sector), but the projected cost of providing these pensions has become prohibitive.

These schemes guarantee a pension income as a proportion of the salary earned when the employee retired. All public-sector pensions are defined benefit, although much of the civil service has switched new entrants to “career average” calculations to save money.

The payments are increased in line with inflation every year and schemes typically provide a widow or widower’s pension of two-thirds of the income given to the employee.

What a worker receives in retirement will depend on the scheme. Each is different, but most typically pay between 1/40th and 1/60th of final salary, multiplied by the number of years at the company.

So, if a person worked for 10 years for a company that calculates pension income in 1/50ths and their final salary was £75,000, they would have a pension of £15,000 a year (10 x 1/50th x £75,000).

By contrast, money purchase pensions make no guarantees. A saver builds up a pot that eventually pays whatever pension the market will bear, usually by buying annuities — an income for life. And they would have to save hard to accrue a pension worth £15,000 a year with comparable benefits.

According to the annuity specialist Retirement IQ, a 65-year-old who wants a two-thirds spouse’s pension and payments that keep pace with inflation will receive on average about 2.3% a year from an annuity provider.

To provide £15,000 a year, they would need a fund worth more than £650,000. Imagine trying to accrue that in just 10 years.

If you have any concerns or questions about any finance related matter, please do not hesitate to call me at any time.

With best wishes,

Yours sincerely 

Graham Ponting CFP Chartered MCSI
Managing Partner

Investing when the market is at an all-time high

A number of clients have been asking me over the past few months whether now is a good time to invest? Markets have been reaching new heights which surely must mean that a correction can’t be far away. As you know, I do not believe in market timing but even I have been keeping some cash to one side, in the hope that I may be able to take advantage of any such correction when it does come.

The following reminds us all that if we have a reasonable time horizon, we really don’t need to worry about whether the markets are at record highs or not.

It is a hypothetical example of someone who entered the markets at all the very worst points over the past 47 years; it’s interesting how it turns out.

By Buz Livingston

“In Ben Carlson’s blog, A Wealth of Common Sense, he takes a casual look at the worst market timer for the last half-century, Mr. Bob. Even though bad luck stung Mr. Bob, he devised a good plan, saved prodigiously and, most importantly, had guts. When it comes to investing, your most valuable organ is not on top of your shoulders.

Mr. Bob began work at age 22 in 1970 and planned to save $2,000 annually then invest when the time is right. Every decade he also intended to raise his annual savings by $2,000. In December of 1972, he made his first investment ($6,000) just in time for 1973-1974 bear market. After being shocked, it took Mr. Bob almost 15 years before he invested again, but he kept saving and had $46,000 to invest in an S&P 500 index fund in August of 1987 just before 1987′s Black Monday.

While he didn’t panic and sell his index fund, he kept saving; the third time is the charm he thought and held off buying shares until December 1999. Again, he purchased at the market peak just before the technology bust in 2000 and even put more money, $68,000, in the market. Mr. Bob thought about Buck Owens’ lyrics “The sun’s gonna shine on my life once more ...” and stuck to his plan, kept saving and stayed invested. Almost eight years later, he had $64,000 to spend and made the plunge in October of 2007, or perfect timing for The Great Recession.

When Mr. Bob decided to retire, you might not believe it but he had over $1.1 million saved. Mr. Carlson is Chartered Financial Analyst so I trust him with the math.

Sure, this exercise is purely hypothetical. Sharp-eyed observers likely noted there were no S&P index funds in 1972 and I freely admit a 100 percent stock portfolio is rarely appropriate. Carlson’s exercise demonstrates persistence and patience are your most valuable assets. Time in the market beats timing the market. To invest successfully, be an optimist. Losses will occur, rest assured but being an optimist keeps you on track.”

The main factor at play in this example is the length of time over which Mr Bob was investing, 40+ years, providing plenty of time for recovery after each disaster!

Many of us may not consider we have a 40-year time horizon over which to invest but don’t forget, if you are not planning on buying an annuity with your pension fund, your investment time horizon is probably the rest of your life – I hope it is 40 years!

If you have any concerns or questions about any finance related matter (but not politics), please do not hesitate to call me at any time.

With best wishes,

Yours sincerely

Graham Ponting CFP Chartered MCSI
Managing Partner

The tax system explained with beer

Now, I run the risk of being a little controversial here but I think the following it is quite an interesting (and fun) way of explaining the problems and complexities associated with a progressive tax system. I have seen this before but I have been minded to send it after listening to the various party’s manifestos and tax pledges over the weekend.

“Suppose that every day, ten men go out for beer and the bill for all ten comes to £100 (expensive beer I grant you). If they paid their bill the way we pay our taxes, it would go something like this...

The first four men (the poorest) would pay nothing. The fifth would pay £1. The sixth would pay £3. The seventh would pay £7. The eighth would pay £12. The ninth would pay £18. The tenth man (the richest) would pay £59.

So, that's what they decided to do.

The ten men drank in the pub every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve ball. “Since you are all such good customers,” he said, “I'm going to reduce the cost of your daily beer by £20”. Drinks for the ten men would now cost just £80.

The group still wanted to pay their bill the way we pay our taxes. So, the first four men were unaffected. They would still drink for free. But what about the other six men? How could they divide the £20 windfall so that everyone would get his fair share?

They realized that £20 divided by six is £3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer.

So, the bar owner suggested that it would be fair to reduce each man's bill by a higher percentage the poorer he was, to follow the principle of the tax system they had been using, and he proceeded to work out the amounts he suggested that each should now pay.

And so, the fifth man, like the first four, now paid nothing (100% saving). The sixth now paid £2 instead of £3 (33% saving). The seventh now paid £5 instead of £7 (28% saving). The eighth now paid £9 instead of £12 (25% saving). The ninth now paid £14 instead of £18 (22% saving). The tenth now paid £49 instead of £59 (16% saving).

Each of the six was better off than before. And the first four continued to drink for free. But, once outside the bar, the men began to compare their savings.

“I only got a pound out of the £20 saving,” declared the sixth man. He pointed to the tenth man,“but he got £10!”

“Yeah, that's right,” exclaimed the fifth man. “I only saved a pound too. It's unfair that he got ten times more benefit than me!” “That's true!” shouted the seventh man. “Why should he get £10 back, when I got only £2? The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison, “we didn't get anything at all. This new tax system exploits the poor!”

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn't show up for drinks so the nine sat down and had their beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and government ministers, is how our tax system works. The people who already pay the highest taxes will naturally get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas, where the atmosphere is somewhat friendlier.”

David R. Kamerschen, Ph.D.  —   Professor of Economics.

If you have any concerns or questions about any finance related matter (but not politics), please do not hesitate to call me at any time.

With best wishes,

Yours sincerely

Graham Ponting CFP Chartered MCSI
Managing Partner

Out with the old and in with the new!

It is with some sadness that I am writing to confirm that the old Sage, Roger Moore, has decided to retire at the end of April; his last working day will be Thursday 27th.

Roger joined the firm on 1st October 1998, approximately 18 ½ years ago and in that time, he has worked tirelessly to help us provide the best possible service to our clients. From a personal perspective, he has been (and I hope will always remain) a loyal and trusted friend; I will always be grateful for his unwavering support through the good times and the bad. I am sure you will want to join me in wishing him a long and very happy retirement.

Roger will be difficult to replace but you will be pleased to know that over the past few weeks he has been working with his successor, Adam Gannon, to ensure that the transfer of duties and responsibilities will be as seamless as possible. Some of you may have already spoken to Adam, he is a very capable and personable fellow and we are very excited that he has decided to become part of the team.

Adam joins us from Reassure, a Life and Pensions company, where he was a Team Leader responsible for administering Annuities and Income Drawdown Schemes. At age 36, Adam is somewhat younger than his predecessor (and me, for that matter). I hope that his relative youth will inject some new life into the old firm.

Outside of work, Adam’s interests include socialising with friends and family, watching sport, travelling and listening to rock music.

You will doubtless be speaking with Adam at some point over the course of the next few months and I know he is looking forward to getting to know you all.

Just in case you were wondering, the lovely Denise isn’t going anywhere, well not for a while anyway! 

If you have any concerns or questions about any finance related matter, please do not hesitate to call me at any time.

With best wishes,

Yours sincerely 

Graham Ponting CFP Chartered MCSI
Managing Partner

When is £1million not £1million?

The Residential Nil Rate Band (RNRB) for inheritance tax (IHT) was first announced in 2015 and will be available from 6 April 2017. Initially set at £100,000, it will increase by £25,000 each year until it reaches £175,000 in April 2020.

The standard nil rate band (currently £325,000 each) is frozen until April 2021, after which both bands will increase in line with CPI. This means that in the 2020/21 tax year, each individual will be able to pass on up to £500,000 and a married couple or civil partners, up to £1m. Will everyone be able to benefit this?

The RNRB is only available on death so cannot be used for lifetime gifting, and as you would expect, comes with conditions. So, let us consider some of the key points around the RNRB, when it is available and when it may not be available.

Qualifying residential interest

The RNRB is only available to those who held a ‘qualifying residential interest’ immediately before death. They must have owned all or part of the property at the time of death and this property must have been their residence but not necessarily their main residence. Therefore, ownership of an investment property is not a qualifying interest.

Those who have released equity will be affected, as it is the net value of the home that will be used; any outstanding loan against the property will have to be deducted first.

Any individuals who do not own their home will be unable to utilise the RNRB as they will not have a qualifying residential interest, however, there are provisions for those that have sold a property. For example, if the deceased owned a property after 7 July 2015 which is subsequently sold or downsized because they are moving into residential care.

Lineal Descendants

The property, or cash if the deceased downsized, needs to be ‘closely inherited’; passing to lineal descendants such as children or grandchildren, including adopted children, step-children, fostered children and those under guardianship. A spouse, surviving spouse or surviving civil partner of a lineal descendant, who has not remarried by the time of the property owner’s death, is also included.

If there are no lineal descendants then the RNRB will not be available.

Transferring unused allowance

Similar to the standard inheritance tax IHT nil rate band, any unused RNRB can be transferred between spouses and civil partners and must be claimed within two years from the end of the month in which the second death occurs.

Where the first death occurs before April 2017, an unused RNRB of 100% will be deemed to be available when the surviving spouse or civil partner subsequently dies, regardless of whether or not the first to die owned a qualifying residential interest or not.

Large estates

There is also a ‘taper threshold’ for large estates, which is initially set at £2m, reducing the RNRB by £1 for every £2 over the threshold. So, when the RNRB is introduced at its initial level of £100,000, an estate of £2.2m or higher will mean there will be no RNRB available. This rises to £2.35m for the 2020/21 tax year when the RNRB is £175,000. This doesn’t account for any transferrable RNRB which the deceased’s estate may be entitled to.

When valuing the estate, it is the net value of the assets held on death, it does not include lifetime gifts previously made by the deceased or make allowance for any reliefs such as business property relief and agricultural property relief that may be available.

If you have any concerns or questions about the above or indeed any other finance related matter, please do not hesitate to call me at any time.

With best wishes,

Yours sincerely

Graham Ponting CFP Chartered MCSI
Managing Partner