2012 : The Year of the Churn

In China next year will be the Year of the Dragon - in the UK it looks set to be The Year of the Churn.

The reason? From 2013 IFA's will be banned from taking commission from clients, except there is a loophole as watchdog Consumerfocus notes.

It is particularly galling that existing customers will continue to pay trail commission on their newly written contracts – introduced just before the ban – potentially for several decades.

So there's an immediate incentive to get clients into contracts - or if they are already in contracts to switch them to higher paying one. And this process may may have already started - there's evidence of a pick up in activity in these areas.

Commission based advisors usually get paid a lump sum from companies they steer their clients into, plus an ongoing 'trail commission' of around 0.5% a year. Quite what this is for is unclear. Some see it as deferred fee, others as for 'continuing service'. And it can go on for years and years.

The RDR (retail distribution review) will end trail commission - but in the short term it may have increased it.

There's something weird about Warren

Warren Buffet's annual letter to share holders is out today and well worth the time spent reading it. (http://www.berkshirehathaway.com/letters/2010ltr.pdf).

Well the number one weird thing is the share price. $100000 plus. And part of the reason for that is the way Warren Buffet measures Berkshire Hathaway's (ie his) performance.

You won't find net income given much shrift as a useful figure - in fact it's booted into the long grass. But Warren's favourite metric - growth in annual per share book value - now has a competitor. The rolling five year return.

From 1965-2010 there are 42 five-year periods. Berkshire Hathaway beat the S&P in every period. This is a stellar performance. Not only that: the S&P had six negative periods in that time (nominally at least, the after-inflation picture would be less rosy). Berkshire had none. It was safer and more profitable than the index.

How did they do it?

Here's one quote from the letter:

'At Berkshire, managers can focus on running their businesses: They are not subjected to meetings at headquarters nor financing worries nor Wall Street harassment. They simply get a letter from me every two years and call me when they wish.'

They don't teach that at Harvard.

Pensions: the 10% cashback

So in the end it comes to this for the rich HRT (40% tax) payer: stick £1.5million into your pension fund, and the government gives you 10% - that's £150,000.

It used to be done in the name of pension planning, but under the new rules (from April2011), there needn't be any pension involved. As long as you meet the £20 000 pa minimum income requirement you can take all your cash out of your money-purchase pension scheme at age 55.

25% of that is tax free, and the 40% tax on that £375000 would have been £150000...... The figures work the same if you have £15,000 in your SIPP (self-invested pension plan), but that pensioner may struggle to meet the £20,000 pa income requirement, or pay 40% tax. And while £1500 is welcome, it is scarcely life changing.

it's true that even under the old rules, the 25% tax free cash effectively knocked the 40% tax payer into the 30% bracket. But now the process is more transparent, the income stream (aka pension) can be avoided altogether and the whole lot taken as a lump sum. Whether the rich need to be subsided to the tune of £150,000 under pension laws when there is no pension at the end of the process is a question well worth asking.

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.