The DIY Annuity

An annuity is a death pact with your money. You both exit at the same time. With a  DIY annuity..

DIY  ... I didn't know there was such a thing.

Stick around, you may learn something. Stan is 60, he has saved £100000 in cash under his bed and decides on a DIY annuity. He's got a life expectancy of 25 years, so every year

Wait...

Every year he takes out 1/25th of his money.  4%. That makes £4000 a year.

But surely...

But surely he could put it in a bank for all those years, even as he is withdrawing it? True. And guess what - at 2.5% interest that money now lasts 38 years. Half as long again.

No no - suppose he lives longer than that... then his money runs out.

Yup - at age 99 he is in big trouble.

So that's not a proper annuity.... a proper annuity goes on until you die.

Ah, for that you have to go to a proper insurance company. And they do the same kind of sums. They will return  your money to you over your expected lifetime with interest, less a bit for their expenses. But the interest ain't great, because they invest the money in government bonds (gilts).

But it's better..

It's a better deal if you live longer than average. It's not if you die earlier than  your average life expectancy. Because your money is gone.

I get it... and it's an average deal if you live to exactly your life expectancy.

Nope - it's a poor deal, cos the insurance chops maybe 10% off for their expenses, commission to independent financial advisors and profit.

Hey - that's my money - can't I get that back.

Some of it. Try searching 'annuity, commission, rebate' on the internet. My search came up with Cavendishonline who will rebate around 1.5% of your annuity payment. 

About the DIY annuity...

It's useful to help you understand  why

• delaying buying an annuity increases your pension - because your life expectancy drops
  
• why income from an annuity seems poor - because it is invested in government bonds
  

It means a 55 year old woman in good health who wants to buy an index-linked pension is going to find it expensive: in October 2008  a payment of £100000 delivered her an annual pension of £3200. 

Isn't index-linked what we all  have to buy?

Not necessarily, certainty is expensive. If she bought a level pension [not index linked] her pension would  double. Or she could wait another 5-10 years. Or she could split the purchase, half now and half later.

Can't I do something else with my pension money?

You could have a self-invested pension plan, but that's another story.

STOP! Don't pay into that pension plan

Whoa!- I thought saving for a pension was a good idea

Well it can be - you just don't want to be saving into a pension plan too early...

Are you mad? I thought the whole point of pensions..

Let me finish. You know you get a tax break on pension saving

Yeah, sure

25% tax free cash on retirement

Oh that - I wasn't thinking about having to wait until I am 65

55

... I can get tax back today. £80 becomes £100 in my pension fund. Nice perk huh?

Not really. It's only tax deferment going in. You'll have to pay tax on the money when it comes out

Oh

But maybe when you are older - middle aged - you will be paying tax at 40%?

Hope so

Then £60 paid in effectively becomes £100. [Actually you still have to pay £80 in - but you get that extra £20 repaid at the end of the tax year - outside your pension fund]

But what shall I do with my savings in the meantime? That could be 10-20 years away

Stick 'em in an ISA or pay off the mortgage.

So delaying is worthwhile is it?

Yeah, it increases your pension by over 50%

Stop right there - that can't be right

OK - lets take this slowly. Compared to saving in an ISA the basic pension route [20% tax rebate in, 20% tax on the way out] gives you a 9% boost.

Hang on if I end up with £80k in an ISA and £100k in my pension scheme [thanks to the tax rebate] - and I take £25k tax free out of both. Then I will have £55k in ISA, and £75k in my pension pot. The pension is far better.

Yeah - but we are assuming your pension is taxed at 20% remember. So net pension pot is £60k and ISA is £55k. That's only a 9% boost. And the ISA is tax free money you can get at any time. Pension money is locked away. You get the income from the £60k, but you can't get at the £60k. Many people would rather have an ISA, despite the 9% uplift.

But if I am paying tax at 40% when I save into my pension plan...

Then if you pay [net] £60k into both: the ISA ends up at £35k after £25k tax free cash is removed, and the pension pot is at £60k [again assuming you pay only 20% income tax in retirement on the £75k thats left in your pension pot]. That's a 70% up lift over the ISA.

And you reckon a 50% uplift compared to a standard pension by waiting until I pay higher rate tax

Actually its 57%. A pension pot that once cost you £55k, only costs £35k if you can save it out of highly taxed [40%] earnings. That's after taking out your £25k tax free cash, and applying a 20% tax rate to what is left.

Why didn't anyone tell me this?

You can't run a business telling perfectly good customers to come back in 20 years

But there must be a catch right? - I mean 50% extra is so amazing...

Well if you never pay higher rate taxes you won't have gained anything, but you won't have lost anything either. And if you don't have any income at all that year, you are limited in the payments you can claim rebates on [currently £3600 per year]. Also, you might be tempted to spend all your ISA savings - pension savings are much harder to get at. And the comparison only works if you are paying into your own money purchase pension scheme. If you have one at work that your employer pays into, it would be foolish to turn down free money. And if you have a defined benefits scheme [where you can buy extra years] then check it out. And if you can get your National Insurance payments rebated...

No - its just me and my personal pension plan. And I am going to switch my savings elsewhere until my tax rate changes. Thats a killer fact

Killer Vanilla fact

saving into a pension too early can damage your wealth

How to double your money

You invest it at 1% for 70 years.

But that's just stupid.

Or 2.5% for 30 years,  or 4% for 18 years.

Is there a point to this?

Well one period is a lifetime, one a generation and one a childhood....

So?

Have you no poetry in your soul? Well how about this Mr Pragmatic:  they are roughly in the area of returns you might get from government bonds (gilts), corporate bonds and shares.

I'm not impressed - my financial advisor reckons  if shares return 7% then...

That's not real money - try knocking 4% off for inflation.

Oh - that's only 3% then. Even less than you are predicting.

I'm not predicting. And neither is he.  7% is one of the figures they have to use in their illustrations. 7% projected for 20years looks terrific. 9% [another mandatory figure] looks even better.

But that's meaningless surely - if you completely ignore inflation?

Yes

Figures in a landscape

It is useful to have a feel for expected returns in the financial landscape. Corporate bonds are expected to do better than government bonds, and shares better than both. The downside is that the risk of losing money is greater.  And 1%, 2.5% and 4% happen to be handy numbers when looking at the time it takes to double your money. 

The actual historical returns  of these three asset classes differ from a simple 1%/2.5%/4% split - but not by that much if you happen to pick the right 20year period. (In other words by picking the right start and end date you can usually get the outcome you want. Remember that  next time you see an advert  praising a product's fantastic performance).

So are you saying I should invest in shares?

I am saying that the chance of better returns come at a greater risk, that the only return worth talking about is your real (after-inflation) return, and if you can squeeze an extra 1% return a year it's well worth doing.

Didn't I already know that?

No - judging by the fact that all your savings  seem to be in a fund that just owns shares, the 7%growth illustration that so impressed you becomes ever more meaningless as inflation increases, and what little is left is being whittled away by the annual 1.5% service charge.

Does an annual 1.5% really make that much difference?

It could mean an extra 12 years of waiting.....

Because at 4% I double my money in 18 years; but if they knock 1.5% for annual charges it will take me 30 years?

You got it.

Why vanilla?

Vanilla investing is about doing simple things with your money in a complex world.

Investors are bamboozled by the finance industry and end up giving away too much of their hard-earned savings to unnecessary transaction charges and ineffective fund managers.

But the good news for vanilla investors is that their profound ignorance and indolence will serve them well.

Profund  adjective: of the greatest intensity; [of sleep] deep and complete

A deep respect for one's own ignorance stops you trying to outguess the market [ie buying the latest hot tip]. And complete indolence saves you the cost of endlessly trading - buying and selling as the next hot tip comes along.

Vanilla investing is for everyone who wants to spend less time with their money.

Where to stash your cash

There are only half a dozen places to invest your money. The Big Three are shares, property and loans [corporate bonds and government gilts]. 

The other three are cash, commodities and 'other' [mainly derivatives, like futures and options].

This may seem odd; the fact that your investment choices narrow down to just six categories. After all, at the back of the Financial Times there is a double-page spread listing thousands of share prices. And before that there are even more pages listing investment funds and unit trust prices. There are more funds than there are shares.....

This is how the personal finance industry makes its money, and relieves you of yours. By repackaging shares into their branded portfolios and charging the investor a fee. Every year. Usually around 1.5%. And yet the finance industry as a whole doesn't add any value. Some will do well one year, some won't. And you can't tell in advance which is which.

In short the investor is faced with a business model that has so many unattractive features than many regard it as broken. [Not my words, but those of the chairman of the Financial Services Authority in 2007].

So here's vanilla recipe no1.  You put half your money in shares [the risky bit] and half in loans [the safe bit].  Government gilts are considered safe.  A tracker fund or ETF should have lower charges than the usual unit trust. Taking  ishares as an example [not the only provider of ETFs but Barclays ishares brand is a big one] the final mix would be half in ishares FTSE 100 ETF and half in ishares £ index-linked gilts.

But isn't this too risky/too safe?

Yup - it might be.  Deciding what level of risk you are willing to live with is a key question for the vanilla investor.

No it isn't - my key question is how do I double my money?

Ah - that's easy. We will cover that next time.