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.