Financial Illiteracy and Fraud
by George Hatjoullis
A survey carried out by the Citizens Advice Bureau is reported to have found that whilst 76% believed they could spot a pensions scam only 12% were able to do so. This survey is not surprising but is nevertheless worrying. It has three points of concern. First, people typically do not know and do not know that they do not know. Philosophers have classified this group as ‘dangerous’. Second, armed with the confidence of ignorance they make bold but poor financial decisions. Third, these people (88% of those sampled) are easy marks for fraudsters and con artists. This is very concerning.
I did begin to address financial illiteracy on this blog but stopped when I realised I was casting seeds on stony ground. Either my readership (such as it is) came from the 12% that can handle themselves or most likely it was too ill informed even to grasp when someone was trying to help. I suspect the latter. I have often been asked for (casual and free) financial advice and I invariably decline to respond. One can only discuss financial matters in general. For specifics one must use professional, regulated advice.
The most serious area of ignorance is in what investment returns one can expect and what sort of drawdown or total loss one is risking. The higher the return, it is best to assume, the more risk you are taking. However, it does not follow that for low expected returns you should always assume low risk. Sometimes they are just bad investments. You need to understand the product in which you are investing. If you do not then do not invest unless you have also paid for independent and qualified advice. In the UK this means you have engaged an IFA. This class of advisor is not guaranteed to give successful advice but at least they can be held accountable if they give unsuitable advice. However, be warned, unsuitable has a specific meaning and you should ask the advisor to explain what it is before you proceed.
The problem is that advice is expensive. It is proportionately more expensive the less money you have. I should add that it is not true that the more money you have the less advice you need. In my experience rich and poor are equally ignorant. I once sat in a focus group for a bank with several people considerably wealthier than me. They had made their money doing things and making things and one was an accountant. None of them seemed comfortable managing their wealth and the level of ignorance about basics (well basic for me I guess) was astonishing. So what can be said in general that might help the ill informed (and that are willing to admit to themselves that they are ill informed)?
Pensions are a minefield. Even I paid for advice here and it was well worth it. If you can afford it pay for advice. If you cannot then at the very least look at some free (if limited) guidance services. If your pension is defined contribution then start with Pension Wise. If it is defined benefit then start with the Pension Advisory Service. If these do not suffice then you may have to pay for advice but at least by this stage you may have a very specific question that needs to be answered and this can keep the cost down. Remember to also ask your pension provider to clarify anything that is unclear.
Advice is almost always essential if a transfer is involved. If you are eligible for benefits from a defined benefit scheme (aka final salary, average salary) it is unlikely that you will be advised to transfer. If you just take the benefits it is unlikely to be disastrous. This changes if the benefits approach or exceed the lifetime allowance in value or if you wish to avail yourself of the IHT advantages of SIPPs and Income Drawdown. However, this implies you are quite wealthy and the fund exceeds £1m in value so you should and can pay for advice.
For those in defined contribution schemes and looking at alternative providers ongoing charges and fees require particular attention. The underlying investments are unlikely to be very different so look at the charges that you will incur in a specific scheme very carefully. Cheapest is not necessarily the best but expensive is not necessarily better. Administration is important as is the longevity and integrity of your provider. You need to feel comfortable and this is one area where mistakes are very common because even the sophisticated pensioner has no idea how to assess. If they are not regulated by the Financial Conduct Authority then run away! However, even if they are this is no guarantee of value for money. Due diligence is required and there is no shortcut or advisor that can decide this for you, though they can answer questions if you know what to ask. This was the area I spent most of my time researching. My choice was neither the cheapest nor the most expensive but so far I think it was a good one. However, what works for me may not work for someone else so good luck and be very careful. My only advice is do some research and think about it for a while.
The final big question is do you go for annuity or income drawdown or some hybrid. The annuity is a guaranteed income however long you live but the income disappears when you (and your spouse if applicable) die. Income drawdown is a fund from which you generate income but income can be drawn by your dependents as long as the fund exists and has some nice inheritance tax advantages. It depends upon personal circumstances. If you have enough to care about the inheritance aspect then you have enough to pay for advice (in my view). The question of annuity versus fund, in which you have to invest, rather depends on how sensible you are going to be in investment and drawdown. Investment is my next consideration.
Assume you have pension fund of £100k and are 65 and single. You have a state pension entitlement and maybe some savings. The £100k will buy you a basic pension of around £5300 per annum (reducing as you add bells and whistles). When you die it dies as well whether you live 1 year or 30 years. If you invest the £100k in the FTSE 100 you can (presently) get a dividend yield of about 4%. It is £1300 p.a. less in ‘income’ but your fund is likely to be substantially in place after one year and potentially much greater in 30 years. Year to year your FTSE income is not guaranteed. The dividend payout will vary but over time one would expect both the fund value and the dividend payout to grow. If you can afford to have some degree of annual income uncertainty and start with £1300 less the FTSE 100 is an attractive option.
This comparison actually favours the annuity in my view. Over 30 years inflation will reduce the real value of your flat £5300 income. The FTSE 100 income should grow at least in line with inflation. An index linked (RPI) basic pension would offer around £3000 p.a. initially so less than the initial FTSE 100 income. The case for annuity really rests on how much you need the certainty and the initial income. It is not a strong case as one could keep £25k in cash and invest £75k in the FTSE and drawdown the cash initially. The case for drawdown at the moment is in my opinion quite compelling but specific circumstances may dictate otherwise.
The FTSE 100 is one of the easiest and cheapest indices for a UK investor. Very low cost trackers are available from very low cost income drawdown providers. It is also one of the riskiest investments. In any one year it can drop 20% quite easily. Over time however it offers a positive return and the income from dividends keeps flowing (more or less) whatever the market value. The lesson to draw from this is not to rush out and invest in the FTSE 100 (or any other equity product). If someone is offering you a yield in excess of 4% stop ask, how so? What is the risk? I would suggest that you assume it is proportionately higher than that of the FTSE 100 until someone demonstrates otherwise! Of course the expected total return from the FTSE 100 is greater than 4%. Let us assume it is 6%. If someone offers you a mini-bond paying 7% or more what should you conclude? If someone offers you returns on anything over 6% what should you conclude? Caveat emptor.