“HMRC gives tax relief when pension contributions are made and allows pension capital to grow tax free but then recovers the tax revenue foregone by levying income tax on the stream of payments made when the pension capital is eventually withdrawn. If you retire on capital saved outside a pension scheme, you will have less capital but it will be very lightly taxed. If you retire on capital saved inside a pension scheme, you will have more capital but most of it will be taxed as if it were income, even though it is only your capital coming back. There is some proportion of the pension capital subjected to this conversion to taxable income at which the two forms of saving are roughly equal in terms of the present value of after-tax amounts. For high earners, that proportion works out as about 75%. So, with 25% tax free cash, there is equity between different generations of taxpayers.”

The effect of the conversion of pension capital to taxable income (which is what ensures the next generation gets a a ‘dividend’ for providing tax relief at the point of saving) often gets overlooked when making savings choices, including by many accountants and financial advisers. The maths favour pensions clearly only where there is a lower expected tax rate in retirement than in employment – something you will not be sure of when making the choice.

As part of their initiative, Citywire asked me last week, as one of ’a group of seasoned investors’,  to come up with three pieces of advice I would give to investors who are starting on ‘the long term savings journey.’ As if a few nuggets of pithy wisdom or practicality could break through the defences of the wilfully disengaged! As if they will even be among the 1.5 million annual unique visitors to Citywire Money’s website!

My first thought was they really only need two: ‘wake up’ and ’smell the coffee’. I really do believe the wilfully disengaged, whether or not part of the ’something for nothing’ brigade, will respond better to the stick than the carrot - and probably not until the stick, too late, has struck them hard where it hurts.

My second thought was that you can’t fight resignation with resignation. Maybe even amongst our own clients there are some who had been previously disengaged or lazy. What worked for them? That prompted three nuggets which I duly sent Citywire.

1. Visualise your past, from the future: imagine yourself in the autumn of your life looking back and thinking what would make you feel ‘job well done’ and what would have caused you most regret. Anything involving  money!
2. Ask for help: everything is easier with a plan but turning your ‘no regrets’ future into a plan requires professional help. Go see as many IFAs (not your local bank, please) as it takes to find the financial planner who ‘gets the visualisation thing’.
3. Pay up for planning and pay down for products: this is the opposite of what people think (and the industry wants you to think) but planning is your key and products are really only commodities, so keep them basic and low cost.

“In the particular circumstances the world economy finds itself in, we clearly cannot exclude the possibility of either deflation or high inflation. One of the greatest bond bull markets ever has left conventional bonds extremely vulnerable to both risks. 

Governments may not be able to prevent the forced liquidation of excessive levels of debt, causing a vicious cycle of falling prices and incomes that mean debts cannot be serviced or repaid in full. Ten-year gilt yields of around 2% have almost never been this low. They imply a high probability of this ‘debt deflation’ but the additional 2-3% yield on the small population of high-grade, sterling-denominated corporate bonds is not enough to guard against its consequences. To the extent that monetary policies aimed at averting debt deflation eventually lead to high inflation and currency collapse, we might even experience both, in sequence.’

Bonds without guaranteed inflation protection cannot hold out these possibilities of high nominal and real loss and at the same time act as ’risk reducers’ in a portfolio.  Yet this is how bonds and bond funds are being used across the industry and by self-directed investors.

Related posts

Money Marketing Magazine : The bond illusion November 2011

New Position Paper: Bonds: a false market October 2011

The shadow Chancellor is wrong because less austerity would almost certainly have translated into a weaker pound, even higher inflation and higher borrowing costs – for home owners as well as HMG – which would have left us in a worse place than we are today. This is the realpolitik of the Coalition’s economic strategy and it was essentially what George Osborne needed to say today. He will be saying it a lot more.

Politicians do not dare to put it so bluntly (although Alistair Darling, to his credit, did) but the way out of a debt-induced crisis is always some form of ’workout’ and that needs time. Coalition policies have bought time. 

The rest is piffling – including helping aspiring home owners to get into a bind they would be better advised to avoid, amongst other measures we could similarly criticise as pointless or perverse.

The one thing we have consistently said to our clients from the moment the credit crunch hit is that it should, and probably will be, a long drawn out affair. Whereas companies can shift the make-up of their balance sheets very fast, households cannot – and indeed need to move slowly to avoid beggar-my-neighbour effects on other households. Actions by governments may in these circumstance have important validation effects (‘burden sharing’, for example) but they are relatively powerless to alter the course of market economies when driven by balance sheets. That causes me no concern, but I have more confidence in markets than I do governments.

Our clients, whatever the relative strength of their faith in markets and governments, should be glad that their Defined Outcome Portfolios assume that markets can stay hostile for a long time and that their exposures are tested, against personal time horizons, to survive that. Not to plan on this basis would be irresponsible, obviously.

In this conference for institutional fund managers and trustees, Stuart provided insights from private wealth management, where most investment objectives are defined in terms of purchasing power at future known or uncertain horizons. This being the case,  inflation risk is one of the most important sources of risk to manage. Traditional ‘balanced management’, which is focused above all on short-period nominal return volatility, does not address this risk well and the main instrument of risk control, bond exposure, involves an unrecognised or unstated substitution of equity risk by inflation risk which is highly inefficient. Stuart explained how Fowler Drew uses two assets, diversified equity exposure and horizon-matched index linked gilts, to control the range of outcomes in purchasing power at the planning horizon.

This audience was familiar with the concept of ‘portfolio separation’ and using hedges, rather than constantly trying to find more (and less correlated) risky asset classes or strategies, to control risk. It is the basis of Liability Driven Investing (LDI) that has so successfully challenged traditional diversification, or ‘balanced management’, in UK occuaptional pension funds. But Stuart suggested that applying LDI successfully assumes you have correctly defined the nature of the liabilities, the hedging assets and the right priorities for different risk sources. Whereas for private wealth there is a clear definition for purchasing power objectives, and a clear risk free asset in the form of index linked gilts, the typical LDI hedging solution relies excessively on non-indexed bonds (because of the prescribed ways they measure liabilities) and the typical risky portfolio solution focuses excessively on smoothing return paths (which sponsors care about) at the risk of poor matching of purchasing-power outcomes (which is a problem for the next generation of trustees or managers). Whereas individual plans may be acting rationally, the society-wide effects are not ;at all rational.

Stuart also challenged this institutional audience to consider why, when most actuarial consultants believe in mean reversion of equity returns (which is implicit in their assumptions about the persistence of common, ‘normal’ means for real returns) , they do not make their future return assumptions specific to current market conditions and asset values or indeed specific to the planning time horizon. Both dependencies are part of a mean reverting return model whereas so-called ‘normative’ assumptions, blind to time and deviations from trend, clearly are not. Fowler Drew’s own model of real returns, also built on reversion to sustainable trend returns, does not rely on normative assumptions.

Though we have learnt much from the institutional market, perhaps we also have something to teach it!