Jam today or jam tomorrow?

OK, any jam right now is wishful thinking. But what should you wish for? There is an answer to this, and it depends on who you are. Savers want one thing, and pensioners another. Because savers are accumulators, and pensioners de-accumulators. Both want maximum return at the moment they hold the maximum amount of money - which is at retirement. So if you faced 7lean years, and 7good years, savers want the lean years first. So its jam tomorrow for them.

For pensioners - as they run down their stash - they want the good years first. So for them it is actually jam yesterday. They want the best years to have happened at retirement.

But what about someone who invests a fixed lump sum and leaves it untouched? For them the order of returns doesn't matter.

Which is odd, because it means no one really needs jam today.

A pension on £10 a day

The simple pension question 'How much will I get?' is rarely answered succinctly.

If you save £3650 a year for 40 years, you will end up with £250 000 (assuming 2.5% interest rate).

£10 a day gets you £10 000 a year at 65

How reasonable are these assumptions? The cost for the same product in 2050 is unknown - if interest rates rise you could retire earlier. If lifespan increases you might have to wait until you are 69 to get the same pension. But right now a 65year old man can get an index-linked £10000 a year for £250 000.

Interest rates? The vanilla benchmarks are 1% for safe and 4% for risky assets. - gets you to 2.5% for 50/50 mix. And 40 years will take you from 25-65. So not completely unreasonable. By the way this a 'real return' benchmark. Your '£250 000' in 2050 will be worth £250 000 in todays money - even though the cheque might actually say '£1million'.

Given UK median income of around £25000 then the savings rate is about two months income per year.

So stashing £300 a month into an ISA can be a simple sensible option. There are far more complex options available - but they are not necessarily any better.

Factor30 and the 10k pension

The warming glow of low interest rates is intended to make the economy bloom. It makes pensions shrivel.

If you have a defined benefit pension you can skip the rest of this. You don't have to pay cash for your pension. But those on defined contributions (aka a pot of pensions savings) do. A 60year old women now needs to reach for Factor30 before heading to that retirement beach. Factor30 means she will have to multiply her desired pension (aka annuity) by thirty to get the cost.

£10 000 RPI linked pension at 60? That will cost you £300 000 madam.

Men have it easier (because they don't live as long), but a return of 3.35% for men aged 60 v 3.2% for women is nothing to write home about.

What to do? Should she hand over her £300 000 now? The choice is even more varied because the new government says you won't have to buy an annuity by 75 (actually you didn't have to before, but the alternative was so unattractive few people chose it).

First off our mythical 60year old pensioner - lets call her Alice - can increase her pension by 75%. All she has to do is forget index linking and go for a flat rate. The return jumps from 3.2% to 5.55%. For handing over her £300 000 she now she will have a fixed £1400 a month for life.

She could wait another five years - the current RPI-matching rate for 65year olds is 3.75%. Or she could continue to invest her pension pot and drawdown an income from it.

In an earlier blog we came up with a rule of thumb for drawing down from your savings: 4% a year (of that years total), rising to 5% in you sixties and 6% in your seventies. It meant your annual income would jump around as share prices went up and down, but there are ways of smoothing it.

So lets look at the various returns Alice could get on her money from annuities and/or drawdown.

Return rate 3.2% 4.7% 5.5% 5.0% from drawdown

Growth rate RPI 3% 0%/fixed ?/income could drop

income* £800 £930 £1400 £1250

*(monthly from £300,000)

I have thrown in an additional option of 3% growth. This may be better value than pure RPI, because the insurance companies at least have the certainty of knowing what their future payments are. Companies don't like uncertainty, and it's the consumer who ends up having to pay a hefty premium if they want the absolute certainty of RPI indexing.

What should Alice do? There is no single right answer here. Let's assume she needs £800/month immediately, and she has a pension pot of £300 000.

She could get £800/month by paying out all her £300 000 pension savings for RPI protection, or by paying out £175 000 to get a flat rate.

Alice makes her mind up: half annuity, half drawdown. She pays out around £80,000 for a flat rate annuity that gives her £400/month, and she draws down £400/month from her remaining savings (£220 000). Thats a drawdown rate of 2.2%.

Under this plan her monthly income will decline as inflation kicks in. But she still has her £220 000 fund to draw money from . How she should invest that £220 000 is another question.

note: go to calculators section at

http://www.moneymadeclear.org.uk/hubs/home_pensions.html

to check out annuity prices. Its not a complete list but it is a useful indicator. The rates quoted above are for a 'vanilla' pensioner: non smoker with no kids/spouses benefits, and no benefits/payback if you die the next day.

The Graham formula

Benjamin Graham wrote a 700 page book on security analysis - so two paras from his November 1963 talk may not do him justice.

'Buy definitely 'bargain issues'. Typically these would be shares that sold for less (than) their value in working capital alone, with nothing paid for fixed assets or goodwill. These were quite numerous up to as late as 1957...'

Looking at the market as a whole, Graham valued it based on:

'average earnings of the 30 stocks in the Dow Jones industrial average for ten years past, capitalised at twice the interest rate on high grade bonds. For example at the present time the average earnings for the last ten years are about $33 on the Dow Jones unit and the present value on high grade bonds is 4.3%. If you capitalise at 8.6% - which is a multiplier of about 12 - you would get a Central Value on the old basis of about 380, as compared with the present price of about 750'.

Never mind the forecast, feel the philosophy.

Benjamin Graham also says

I was about to chuck out the Benjamin Graham lecture notes - I mean who keeps 47year old typescripts , even if they did originally cost 50c?

But in a handful of pages Graham not only discussed the weight of asset classes in of a portfolio [risky v nonrisky, see last blog], he also looked at what you should buy and when to rebalance.

'Use a 50-50 division between stock and bonds. When the market level of the stocks rises to a point where they constitute 55% of the total or maybe 60%, you would then sell out enough to bring your proportion back to 50% putting the proceeds, back into bonds or saving banks.'

Graham goes on to discuss various similar 'formula plans' -

'The main need here is for the investor to select some rule which seems to be suitable for his point of view, one which will keep him out of mischief and one, I insist, which will always maintain some interest in common stocks regardless of how high the market level goes'

Graham's point being that if you missed out on a bubble (my word) your disappointment (his word) would have been so great -

'as probably to ruin you from the standpoint of intelligent investing for the rest of you life.'

A final word on stock selection:

'there is no indication that the investor can do better than the market averages by making his own selection or by taking expert advice.'

When Graham wrote this in 1963 the first index funds were years away.

Benjamin Graham says

Benjamin Graham was a professional investor, wrote Security Analysis and taught Warren Buffett. His book is heavy going for the uninterested, so how to sum up Graham's advice for the nonreader? Luckily Graham did it himself. I am looking at a typescript of a talk he gave in 1963 (literally a typescript, no powerpoint in those days)

In my nearly fifty years of experience* on Wall St I've found that I know less and less about what the stock market is going to do but I know more and more about what investors ought to do..... the investor is required by the very insecurity ruling in the world of today to maintain at all times some division of his funds between bonds and stocks (cash and various types of interest-bearing deposits may be viewed as bond equivalents). My suggestions is that the minimum position of this portfolio is 25% and the maximum should be 75%.

For comparison the suggested range for the vanilla investor is from 20% equities up to 67% equities (the 'bouncy' bit of the portfolio); giving a range on the 'boring' side (gilts/cash etc) from 80% to 33%. The Graham prescription is riskier (but potentially more rewarding) but even on the 'bond' side he urges caution:

nobody can assume he can get exactly the same degree of safety and dependability in [an] investment yielding 5% as in one yielding 4%.

Wise words as the junk bond era was still to come.

*His career spanned some turbulent times:

I would like to point out that the last time I made any stock market predictions was in the year 1914 when my firm judged me qualified to write their daily market letter

The lecture notes originally cost 50c but you can get them, free, here: http://www.jasonzweig.com/documents/BG_speech_SF1963.pdf

In the mix: annuities, bonds and SIPPs

Let's change the numbers for once. Anna has a SIPP of £133,333. Now she is 60 she would like to draw a pension from it. She is a cautious investor (the C portfolio is 75% boring, 25% bouncy; in her case index linked gilts and global equities).

She can't decide between keeping it invested and drawing an income, or buying an annuity. Access or stability? That is the choice she is faced with. So she goes for a bit of both.

She figures that her investing in index-linked gilts is not that much different from buying an annuity. So if 75% of her SIPP was going to be in bonds, why not just buy an annuity anyway? Sure she says goodbye to the money, but it will give her that certainty she is looking for.

So Anna takes her 25% tax free cash - and pays £100 000 for an annuity. But she is not done yet. She is still earning and saving (and has £33,333 in cash in the bank). So she starts another SIPP and starts paying into that. And, thanks to her regular annuity income, she thinks: 'maybe I am not such a cautious investor any more'.

The moral of this story is that once you reach pensionable age (55) you have the option of swopping the 'bonds' side of your portfolio for an annuity.

Remember a 'pure' annuity actually returns all your money to you over your expected lifetime, meanwhile investing it in gilts. Hence the low-return on your 'investment'. ( A real world annuity does much the same, except it keeps back 10-15% for profits/expenses and holds corporate bonds too).

So annuities have two big drawbacks:

• you lose money if you die early
• your savings are invested at low yields (gilts), possibly for decades

but if your savings were invested in gilts anyway, one of the drawbacks is eliminated.

Anna takes one more decision - she decides to go for the maximum, flat rate annuity. (£475 a month, versus £260 for RPI linked).This 'front loads' her payments from the insurance company and it will help her save still more into her SIPP. And with that income secured she feels she can be a bit more adventurous in her new portfolio.

Vanilla smoothie

Despite the vanilla approach - keeping things as simple as possible - choosing a withdrawal rate from your pension pot is tricky. You can see why most people don't bother trying, and just opt for a standard annuity. It's fixed, it's guaranteed, it will last as long as you live.

But here's ways to smooth your usp (aka unsecured pension, or income drawdown).

1 Invest in government gilts in your SIPP (self-invested pension scheme) or even index-linked gilts. This is a good choice for someone who wants a secure and stable return, but is not ready to lose control of their savings by handing them over to an insurance company for an annuity. This is an option that doesn't get much publicity. The returns are likely to be unspectacular - as are the fees to advisors.

2 Smooth your return by taking the average of last year's payout, and 4% of this years fund total. So if your fund is £115,000 - and last years pay out was £4000- you only pay yourself £4300 and not the £4600 that the basic 4% rule would have given you.

And because last years payout was calculated the same way this simple rule weights your return by your long-run return. (The weighting for the current year is 1/2, and for the preceding years 1/4, 1/8, 1/16 etc).

3 Increase payout with age: 4% in your fifties, 5% in your sixties, 6% in your seventies.

By the time you get to your mid sixties, this is quite conservative (especially for men - their life expectancy is several years shorter than for women). But it might feel scary - your pension pot might be going down. This is not just living on income - it's eating into capital too

So is a SIPP preferable to an annuity? It comes down to personal choice - but one big factor is that you can always change your mind and buy an annuity - but you can't change it back again.

Three kinds of 4%

Nowadays you don't have to buy an annuity with your pension pot - you can invest it and draw an income instead [often known as income drawdown]. This pot can still be used to buy an an annuity later [up to age 75] if you want.

So how much can you safely withdraw each year? Well the answer depends on your life expectancy and your future investment returns. Both are very uncertain, so much attention has been given to finding the 'safe withdrawal rate' even allowing for poor stock market returns, and increased longevity.

The standard answer is around 4%.

But there are three kinds of 4% withdrawal on - say - a $100,000 pot. (We are talking dollars here because its in the USA that this has been studied most).

1 Take $4000 a year index linked. So it goes up with inflation.

2 Take $4000 every year - flat rate.

3 Take out 4% of your pot whatever its size.

Option 1 is the toughest to maintain, option 2 is usually what is meant by the 4% rule, option 3 is the 'safest'. Where safety means you will never run out of money (although you might run short of money).

The vanilla pensioner goes for option 3, despite its drawbacks which are:

• your income will bounce up and down with the value of your fund; and
• it doesn't allow for the fact that as you get older, you should be able to withdraw a higher percentage from your fund

We will look at ways to fix this, without straying too far from the underlying philosophy: the size of the pension you can take depends on the amount of money you have - not on the amount of money you used to have.

And that is the serious drawback of options 1 and 2 - blithely taking $4000 a year even though your fund may have dropped to $60 000.

Will half a million cover it?

This article puts the cost of retirement for a pensioner couple around £500 00 (£600 000 in London).

the average household needs £564,227 to cover the cost of the first 20 years after quitting the workforce. The calculation is based on annual household expenditure for those aged 65 to 74 at £23,107.

Quite what happens in year 21 of retirement they don't say. You'd think they'd know, especially as they can calculate expenses over 20 years to the nearest pound...

http://uk.finance.yahoo.com/news/couples-must-budget-600-000-for-retirement-tele-78e6abbbac10.html

Sweet seventeen

Think of a number and multiply it by 25. Thats a rough guide to the cost of an inflation linked pension. For a woman in her mid sixties, or a man a couple of years younger. So £10 000 pension will cost you £250 000.

Or if you want to retire on two-thirds of your salary, then multiply your salary by 17. That's how much you will need to save.

So what does it take to save an amount equal to 17x your salary? There's a lot of variables here - but it shouldn't put you off working out a ball park figure.

Let start by assuming you save two months of your salary, every year for forty years. And your salary stays fixed in real terms. Take real annual growth as between 1-4%: 1% definitely, 2.5% probably, or 4% possibly (with a lot of your savings in riskier shares).

What do you end up with?

Amount of salary saved after 40 years with growth of

1% 2.5% 4%

8x 11x 16x

So despite continual real growth of 4% for forty years and saving two months salary every year, you still come up short. Just.

Let's up the amount of savings to three months a year.

1% 2.5% 4%

12x 17x 24x

And suddenly we are there, even with only medium growth. With the high returns (4%) you can practically retire on a pension equal to your salary. (It will certainly feel like it, because you won't be saving 25% of your income any more)

But who saves three months money every year?

Shouldn't the government do something? Well they have - they have set the contributions level for the new default pension scheme (now called Nest) at around one months salary [employees pay half of it].

How much would that give you?

1% 2.5% 4%

4x 5.5x 8x

Saving one month's salary a year isn't enough. But the government obviously sees this as a glass half full. Tell people they need to save at least double that amount and they might become too dispirited to even try.

Bolton and vanilla

Hot fund in a hot sector. A friend asks 'I was thinking of putting money into Bolton's new China fund....'

I guess this is how most people begin. Not with boring, but sensible, asset allocation. But a punt on something a bit more exciting. He knows very little about investing. Is this really a good place to start? Surely it would be better to start by having half your savings in global equities and half in index linked gilts? Simpler and less risk.

But the reality is: savers don't start out as vanilla investors - and then move onto more complex savings instruments; they actually move into vanilla investing after having been stung, burnt, or just plain caught by surprise by the vagaries of real world investing.

Back to Bolton. The attraction is his fantastic track record at his Special Situations fund he ran from 1979. Hence the hurry to get into his new fund launching now. 'What do you think?' Hmm. Where to start.

First off: the three big savings choices are house [pay off mortgage]; ISA and pension [company plan or SIPP].

Then you can figure out how much you want to risk in global equities. Then you can have some emerging markets. A subset of that are the BRICs [Brazil, Russia, India China] - and finally we get to China on its own. 'So you don't think I should put all my money in it?' No.

'But the offer closes in a few weeks'. Well, you can still but the shares after the offer closes. 'Really. I didn't know that'. Yup, and then you can buy as little as you like - instead of being forced to buy a minimum of £2500. Or you could wait ten years and buy some then. 'Ten years! The people who bought Bolton's first fund from the beginning did fantastically well'. Yes, it did fine for the first ten years, but it was only in the early nineties, around 1992 that it really took off. And the first five years of its life gave little sign of the fireworks to come. Here's the picture.

'Well I can't risk that - Bolton may only hang around for a couple of years.' Some people would see that as a reason for caution. Besides, you may be able to pick the shares up at a discount.

'Discount?'

Ok, we'll deal with the discount later. Meanwhile I couldn't interest you in a global equites tracker?

'Nah. Too boring.'