A slight change in focus can produce a profoundly different understanding

Pension Saving and the Lifetime Allowance

Grim warnings about inadequate provision for old age abound. For the typical 30-year-old trying to make rent and save for a deposit on a home, such warnings will most likely have the effect of persuading them to ignore the whole pension saving issue entirely. They will do nothing. This a shame and rather unnecessary. It is all in the presentation.

Pension saving is a specific example of saving. The difference is you are targeting a pot to provide income 38-40 years hence ( I stick with my 30-year-old). Pension saving can get help from an employer through employer contributions and own contributions are relieved of tax. The amount invested on your behalf can be significantly greater than you give up in disposable income. If say you earn £25k and your employer contributes 3% (£750 pa) and you contribute 10% (£2500 pa) tax relieved at 20% (£2000 pa) then £3250 pa is invested on your behalf and you disposable income is reduced by £2000 pa or £166 pm. This is still a substantial sum for someone on £25k pa but not impossible. Moreover you could start with a £100 or less and increase later. The important thing is to start and get into the discipline.

The amount £3250 pa invested on your behalf might, on reasonable assumptions, enable a pension of £19500 pa in today’s money. This is worth having. The important thing to note is that it is not necessarily worth saving much more through a pension scheme. This is because of the lifetime allowance being set at £1m. If your pension pot exceeds this figure in 38 years then penal tax rates are imposed. To achieve £1m in 38 years may be easier than one might think. On my assumptions this would be achieved by investing £398 pm for 38 years. On more conservative assumptions it might require £617 pm for 38 years. Bearing in mind nominal salaries increase this could be achieved by starting lower and increasing saving over time. The message is there is not much point in saving more than say £500 pm through a pension scheme, including the employer contributions, as long as the LTA is £1m.

This does not mean it is not worth saving. ISAs provide a very useful savings wrapper. This is because everything within the wrapper is free of tax. If your pension contributions have you on course to achieve £1m LTA by retirement it is fruitless to invest more in a pension even if contributions yield tax relief. If you exceed £1m the excess will be taxed back. The constant complaint one hears is that people do not make enough provision for retirement and specifically through pension contributions. But the rational amount of pension contributions is logically capped at a fairly low-level. General saving still makes sense but this is subject to current needs.

My advice to young people is think about achieving a pension pot of £1m. You have a 40 year or so time horizon so you can start small. The important thing is to start and keep going. Invest in assets that have good growth prospects (not cash). Low cost passive equity funds are ideal. Keep the costs low. Keep saving and make sure you use an employer scheme, if the employer makes a contribution. Increase your contributions in line with income but remember you need only increase up to the point that makes £1m over the 40 years likely. If you have the correct investment strategy and are consistent then it is unlikely that you will need to contribute much more than £600 pm into a pension plan and part of that will be an employer contribution. And once you are a 40% tax payer (which happens quicker than you might imagine if inflation picks up), every pound you contribute only costs you 60p in deferred disposable income. Do not let sensation seeking journalists put you off saving for retirement.


Collective Choice and Social Welfare

The title of this blog is taken from Amartya Sen’s book. It was first published in 1970, the year before I became an economics undergraduate, and has recently been expanded. It addresses how societies an make social choices and how social welfare connects to the welfare of the individuals that make up society. It is a difficult area of economics and some argue it is not a legitimate part of economics. The relevance to current affairs is very evident. The HS2 rail link, the expansion of Heathrow, and, of course, Brexit are all collective choices that impact the welfare of individuals and thus of our society. Do these projects improve social welfare?

All three above decisions have been made through the democratic process. The UK has a specific example of representative democracy known as parliamentary democracy. Representatives are elected by constituency on a winner-takes-all basis. It is a pluralist system so each member of parliament has a duty to represent all constituents even if they did not vote for her/him. Campaigns are based on political parties which offer a particular political ideology and often make specific promises prior to election. The parliament elects a government based on the support in the House of Commons and the government can continue as long as it has the support of a majority on key legislation. There is a huge distance between the voter and what the government ultimately chooses. It is the government that makes the social choices that impact social and hence individual welfare.

The UK system allows for a government which may have only directly received a minority of votes. Moreover even those that voted for the party that formed the government may disapprove of specific social choices. It is possible in the UK system for substantial social choices to be made based on the preferences of a small minority of the population. The government of the day should take into account the impact on the whole population but is not obliged to do so. If it commands a simple majority in the House of Commons it can more or less do what it wishes. It can be harassed and delayed by the House of Lords but ultimately it can make the social choices it wishes to make. The population’s only legal defence is to vote for parties that promise to amend or reverse the unwelcome choices of the present government. Occasionally the public can resort to public disorder in order to assert the majority preference (Poll Tax Riots).

The Brexit outcome is a particularly interesting example of this process. The government of the day decided to take direct advice from the population on whether to leave the EU. The result was a (very) small majority of the votes cast in favour of leaving but a minority of those eligible to vote. The government of the day was happy to proceed to leave on this basis but was forced by private citizens to ask parliament through a vote. Parliament approved the government’s action even though there was a substantial majority of MPs that had openly supported remaining in the EU. This odd outcome validated the decision to leave. The government of the day decided to have another election and was allowed to do so by parliament even though the fixed parliaments act was designed to stop opportunistic general elections. The result was the two largest parties in parliament both being committed to leaving the EU even though there is strong evidence that most MPs did not, and the majority of the population no longer, support this commitment. The UK parliamentary system can throw up some social choices that are self-evidently suboptimal. Moreover, the cost of Brexit is high and reversing it is very difficult.

Social choice through voting systems does not make interpersonal comparisons. In all choice situations there are winners and losers. There is no attempt to compare winners and losers and say, for example, the winners gain more in individual welfare than the losers give up so it is a choice that increases social welfare. One of the purposes of Sen’s book is to explore the conditions under which such comparisons are possible. Economists have typically shied away from such comparisons. At best, they have applied the compensation principle. If the winners could compensate the losers and still be better off then social welfare is improved by the choice. This ignores the significance of wealth distribution in social welfare. Moreover, it reduces welfare to money values.

Interpersonal comparisons are not impossible. If a social choice will make a few rich people richer, and a great many poor people poorer, it could be argued that social welfare is being reduced even if compensation is possible. The welfare increase to the rich from getting rich is relatively small compared to the welfare loss of the poor from getting poorer. It might work if the poor are actually compensated but then the rich might not want the change. The point is, who is winning and who is losing is not unimportant in collective choice and social welfare but the electoral system alone may not take this into account. Indeed the system is inevitably biased towards those that have the most political power and know how to exercise it. They tend to be wealthy.

The purpose of this blog is to remind you that democracy is not a panacea. It can lead to outcomes that reduce social welfare. In particular all voting systems ignore interpersonal comparisons. It is possible to consider who the winners and losers are in all collective choices and this will influence the welfare judgements on such choices. It is important to look at each case carefully and not hide behind process and vague words. In particular, ” I’m alright Jack”  and ” Not in my back yard” need to be exposed and held up to scrutiny every time.

Tax, Inflation, and Yield

The recent pick up in inflation has been met by central bankers and politicians with a certain amount of relief. Deflation has many characteristics which politicians in particular dislike. It impacts tax revenues negatively. Inflation allows a surreptitious increase in tax revenue known as ‘fiscal drag’. As inflation picks up, nominal values adjust upwards, and so even with constant tax rates, tax revenues rise. If your pay goes up because of an inflation adjustment and the rise places you in a higher tax bracket then you are clearly worse off after tax. In effect, tax revenues are automatically inflation-linked whilst government expenditures are not, so inflation increases the net tax take without any change in rates. Nice!

Many investors also seem to welcome the rise in inflation, even those that typically hold nominal assets (like cash in the bank). This is because it raises the prospect of a rise in interest rates. This is of course somewhat naive as it is a rise in real interest rates that investors should welcome not simply nominal interest rates. If inflation and nominal interest rates increase at the same rate, the real interest rate does not change. However, the investor may be worse off because of fiscal drag. The investor may be dragged into a higher tax bracket because nominal income has increased. This can create some interesting investment quirks.

Gilts are a popular low default-risk asset for investors seeking a stable income and security of principal. Fixed coupon gilts pay a coupon twice yearly up to a fixed maturity date. They are issued in nominal amounts of £100 (which is what you get back at maturity) but on any day will trade above or below 100 depending on how bond yields are moving. If bond yields rise a lot, say because inflation is rising, then prices will fall and possibly a long way below the nominal or par value. During the recent period of very low yields prices have moved a long way above par. The return from a gilt can be looked at in two ways; the running yield and the yield to maturity (ytm).

The running yield is simply the annual coupon payment divided by what you paid for the bond. The ytm is a bit more complicated but think of it as the annual interest rate or return if you hold the bond until it matures. One of the quirky aspects of such gilts is that whilst the coupon is taxable as income, any capital gain or loss from buying and selling the gilt incurs no capital gain tax. This means that which issues it makes sense to buy depends on your tax bracket. The effective after-tax ytm on each bond may be quite different. In a rising inflation and  yield environment this creates problems and opportunities.

The Debt Management Office website offers closing prices on all gilts. Consider two issues. The UKT 1.5% 2047 and the UKT 4.25% 2049. The running yield on the UKT1.5 is 1.66% and the running yield on the UKT4.25 is 2.71%. The ytm on the respective bonds is 1.92% and 1.88%. The prices of the respective bonds are 90.47 and 157.11. They will both get £100 back at maturity. The buyer of the UKT4.25 makes a loss at maturity but has effectively been repaid every year in a higher coupon and running yield. In a zero tax world which bond one chooses rather depends upon needs and circumstances in relation to cash flow. But the world is not zero tax.

What if the investor is a 40% tax payer at the margin. The after-tax running yield on the two bonds is now 0.99% and 1.62% respectively but the after-tax ytm is 1.28% and 0.61%. The low coupon bond offers a much better return to maturity. The reason is that £9.53 per bond is returned at maturity tax free. The high coupon bond effectively has £57.11 returned over the 32.5 year period each year and is taxed at 40%. A 40% tax payer is thus well advised to avoid bonds trading above par and seek out bonds trading below par. The interesting thing is that as inflation and bond yields rise, there will be more such bonds (as prices fall) and the discount to par will get deeper and deeper creating even greater tax advantage for the high rate tax payer. The deeper the discount the more of the bond income is returned at maturity free of any tax.

The latest CPI reading is 2.9%. The highest one year fixed rate interest rate I have been able to find is 1.7% (Masthaven) so we are looking at -1.2% real, at best. The latest RPI is 3.7%. This index is discontinued as an inflation measure but is still used as an index in index-linked gilt calculations, on Index-linked certificates, and many pension and insurance contracts. If you have a NS&I Index-linked certificate you can roll it (no new certificates are being issued) at essentially the RPI rate, which compared to the CPI gives you, bizarrely, a positive real yield. Similarly, index-linked gilts which post real yields based on RPI are, compared to CPI, less negative than they might seem. If your pension is going up by the RPI then you are getting real pension increases. Of course, this presupposes that CPI is a better inflation measure than RPI.

The period of deflation and low-interest rates has been good for the wealthy. Not only has it inflated nominal asset values but it has enabled the wealthy to hold wealth in nominal assets (like cash) without the risk of surreptitious inflation taxes. A jump in inflation with a lagged jump in interest rates is particularly bad for wealth. However, even if real rates are stable, fiscal drag will hurt nominal incomes. The tax treatment of gilts and the CPI/RPI difference creates some interesting opportunities for the watchful.


I used the Candid Money yield calculator and adjusted coupons down by 40% to obtain after-tax yields.

Origination, Trading, and Investment

Consumers spend a great deal of time researching durable purchases such as cars, computers, and white goods. They read reviews and articles by independent consumer organisations such as Which? magazine. Nobody goes into a car showroom and buys the car the salesperson pushes. When it comes to durable consumer goods people seem pretty savvy. Why then, when it comes to financial products, are people so careless? At best they pay for expensive independent advice and leave the judgement in the hands of someone who assesses their needs and risk profile from an intrusive questionnaire. They let someone else tell them who they are in financial terms. At worse they take the first financial product they come across without much thought. They do not buy the first computer they see so why the first mortgage or ISA?

Part of the problem seems to be lack of ability and/or willingness to think about personal finance. You earn £x after tax and NIC. You have liquid savings of £y (where y might be negative). You have net assets of £z ( again z might be negative). This defines your basic budget constraint. You have fixed outgoings each month (things you must pay, like mortgage payments, rent, food etc). Is it really so challenging to sit down and put this all all on paper (or a spreadsheet) and look at it. I suspect most that do not do this fail to do so not because they are incapable but are frightened of the reality it presents. Denial is the most common cause of financial myopia.

Another problem is fear, specifically fear of making a mistake. Occasionally this is overtaken by fear of missing out which can lead to even more catastrophic decisions. This fear is compounded by the plethora of financial products available and the alien language in which they are presented to the public. A systematic and patient approach can overcome these psychological problems (because that is what they are) and put you in control. Step one is to eschew the visit to the pub or club one weekend and sit down and write down your basic budget constraint and non-discretionary outgoings. This will define what you need and what you can afford. You may not like what you see (95% of the population will not) but it is the starting point of being in control.

Once you have determined what you need then, and only then, do you begin a search of what is available to find the most suitable product. This search must be a continuous exercise and not something you just once. Not only will your circumstances change but so does the range of products and the terms on offer. It is a continuously evolving market place. The purpose of this blog is to explain how this market place evolves in simple terms in the hope that it might help those that can help themselves. The example to be used is the mortgage market.

The range of mortgage products is huge and this has to be multiplied by the number of providers. You can go to a broker and present your budget constraint and outgoings and the property you wish to buy and let the broker present you with options and even recommend one. The broker may not of course look at all providers (they should tell you this). Moreover, once a product is selected the process may end there (to your relief) but if the house purchase is delayed a review might be expedient. Things change and in particular the lender that blanked you one week might be keen the following week. Why is this so?

The mortgage market should be seen as consisting of originators, traders, and investors. The originator is the institution that initially sets up the mortgage loan and that you deal with directly. However, the originator may not want to keep the loan on its balance sheet and may include it in a package of mortgage loans which it sells into the secondary mortgage loan market. Traders buy and sell these loan packages as a business (it may be another section of the originator organisation) and investors buy mortgage packages from traders and directly from originators. The three agent categories overlap and the distinction is made only to emphasise that the functions exist in some form. Secondary trading is very important because it provides investors with liquidity and the existence of investors helps originators offer mortgages beyond their own capital base. The world of finance, of which many are so contemptuous, is what makes your mortgage possible, and the choice available.

Mortgages involve interest rate, prepayment, and default risk. Packages are often sliced up into these risk categories and sold to different investors. So whilst you may pay Barclays a mortgage payment each month, the money may end up in many different hands. Barclays may have sold off the mortgage in a package and have no beneficial ownership or liability, beyond servicing the cash flow. Barclays, and other originators, are constantly reassessing the demand for mortgages (and demand for the individual component risks) and this drives the product range and mix on offer. The mortgage terms are not determined solely by the Bank of England base rate. To understand what is on offer you would need to know the sterling swap curve out to ten years and this moves continuously.

Banks no longer make loans which simply sit on their balance sheet until you repay or default. They act as originators and managers of packages which are sold on and make secondary markets in these packages. This has greatly increased the flexibility to offer mortgages though as we saw in 2007, it can go horribly wrong. One assumes lessons have been learned and it will not all go wrong again (and least not in the same way). This is the regulator’s problem. My concern is with the borrower.

Denial and fear do not help. The best way to be in control is to confront your finances and face up to their reality. If you need advice you will need to do the basic arithmetic in any event to inform the advisor and lender. You may as well think about what you need at the same time, as this will help you understand the advice and outcome of attempts to borrow. If you understand what you need it may be you can check the market for yourself and you can keep checking it to see if terms are changing. This will confirm if you have a good deal or can get a better one. Actively engaging in your own finances is the most important thing you can do. It will tell you if you afford the car you spend so much time researching.




Wealth Inequality and the Production Function

Wealth inequality as a subject is sadly absent from mainstream economic theory. It is regarded as an ethical issue and one to be settled by political choice. Economics manages to develop a complete theory of choice without saying much about wealth inequality. Indeed the theory of choice takes the form it does (in my view) in order to avoid the subject of wealth inequality. Much of this is understood and forms the basis of many critique of economic theory. What is less well understood is that the absence also has implications for production theory.

Economics likes to treat production as essentially an engineering issue. A (closed) economy has so many people, and so much capital, land, natural resource, and a given state of technology. One can conceive of a surface that delineates the maximum amount of every combination of goods that it is possible to produce. The economics problem is then set as to how to ensure the economy operates at this surface. To operate within would be suboptimal, states every textbook, as if using up every natural resource as fast as we can is a good thing! In a world of man-made climate change these textbooks could do with some revision methinks. However, this is not the central issue of this blog.

The engineering solution to the maximum (not optimal) production surface ignores wealth distribution. It assumes maximum production levels are independent of wealth distribution. The only textbook in which I recall this was acknowledged is Theoretical Welfare Economics by J. deV. Graaf. This was first published in 1957 and reprinted in 1971, when I bought a copy as an undergraduate. Unusually I also read it and noted this observation about wealth distribution and production surfaces. It is not difficult to see the point. Better fed people with medical care are likely to be more productive. The principle that wealth distribution must affect maximum production is not difficult to establish. Hence there is no single maximal production surface. There is one for every possible wealth distribution. It is not hard to see why economists assumed this problem away. It is a shame that they did as it must have some profound lessons for developing economies.

A related concept to maximal production surfaces is potential output. This is likely to be within the physical limit of production (for a given wealth distribution) and is defined as the point of GDP growth when inflation begins to accelerate. If production surfaces are wealth distribution dependent then it is most likely so is potential output. This is a profound observation. It has always been understood that wealth distribution affects aggregate demand and hence the economy’s location relative to potential output. If it also affects the level of potential output, the problem of macro demand management becomes more complex but also much more interesting. If it is possible to raise the level of potential output and demand for this output simply by varying the distribution of wealth, then redistributive policies become macro economic tools and not simply ethical or political judgements. One can definitely see why conventional economic theory ignored wealth distribution.

This said it is as well to add that pursuing maximal growth may not be socially optimal. The issue of man-made climate change is one consideration but also the welfare benefits from more work and more consumption should also be reviewed. Maybe less is more…

A Rock and a Hard Place

Parliament now consists largely of MPs from two parties, both equally committed to leaving the EU. Irrespective of the views of individual MPs and individual voters, this is the democratic reality. Somehow an illegitimate and unconstitutional referendum has been legitimized and made constitutional. Parliament endorsed the triggering of article 50. However this process began, leaving the EU now has constitutional validity.

During the general election I had some ‘debates’ with Remain supporters about the logic of tactical voting. They seemed so overwhelmed with their hatred of May et al that they managed not to register the position of Corby and McDonnell. These two visibly sabotaged the Remain position during the referendum campaign. They enabled the triggering of article 50. They enabled the general election. The Labour manifesto is quite clear in its commitment to leaving the EU. A vote for Labour was not a vote against austerity or more social justice. It was a vote to leave the EU. Many tactical Remain voters appear to have lost sight of this.

The EU offers a pluralist liberal democracy. It offers social justice. It offers equality before the law and upholds consumer and human rights. It is clumsy and slow and could use better public relations, but it is basically a good institution. It offers a huge single market, a customs union, and various other institutional arrangements. It is moving towards a common, non-aggressive, foreign policy. Each state has a veto over big issues and there is a qualified majority voting system in place for lesser issues. The European Parliament is democratically elected, more so than Westminster in some respects. Otherwise, how is it UKip has so many MEPs and no MPs? The EP is also becoming increasingly powerful. The European Commission, the bête noire of the leavers, is just the civil service. It’s only real power lies in introducing legislation. it cannot pass it or impose it.

Events are about to remove us from this set up and leave us between a rock and a hard place. The two polar extremes of my youth have returned. A fascist, racist, Tory party and a Stalinist Labour party. During the campaign of the 1975 EEC referendum (I was 22 and a recent economics graduate) I watched Enoch Powell and Tony Benn argue against the EEC on a common platform. One of my arguments in favour of remaining in the EEC was that these two unsavoury characters both supported leaving. The political heirs of Enoch and Tony now run the Tory and Labour parties. After 43 years of liberal, pluralist, democracy, and prosperity (albeit unevenly distributed), we have arrived exactly where I feared we would end up in 1975. Well, I guess we will always have the last 43 years (here’s looking at you, kid).

The LibDems seems on the verge of electing Vince Cable as leader and he is edging towards accepting the need for freedom of movement restrictions. The LibDems typically adopt a what-is-best-for-the-country approach but the electoral consequences have been devastating. They will now put the interests of the party first, it seems. Remain voters have nowhere to go even if they have sufficient intelligence to go there (though few, it seems, do). So what hope for remaining in the EU?

Probably better than anyone realises. The election has left the Tories hostage to the Democratic Unionist Party. This unsavoury alliance, and its price, has cost the Tories popularity. The momentum (pardon the pun) is with Stalinist Labour. The Tories will not be calling another election anytime soon (Labour would love that) and Labour cannot force one. This parliament will run for 5 years. This means the exit negotiation will be conducted by a very weak government with the clock ticking. Either a very bad deal or, more likely no deal, will emerge in two years, when the UK falls out of the EU. If the country is unhappy about leaving on these terms then these self-serving power seeking political parties may think again. Never say never….

Monetary Policy and Financial Stability

Yesterday (29/06/2017) we saw a minor perturbation in the asset markets. It was a response to a series of coincident but somewhat ‘hawkish’ statements from central bankers. Hawkish, for the uninitiated, is market-speak for inclined to tighten monetary policy and raise official interest rates. There was, as many noted, a whiff of coordination about the statements. This is unlikely in the strict sense but central bankers do talk to each other. Moreover, they all play from the same rule book and tend to react in much the same way to environmental stimuli. The implication is that they all see the same environment. If they are coincidentally all talking hawkish the environment that they perceive has changed. This is the interesting take from this otherwise small perturbation.

Cheap money has been the rule since 2009. It has not however necessarily been easy money. The central banks have flooded the system with liquidity but this has not led to a credit explosion. This is because banks have tightened credit requirements in response to the 2008 crisis. In part they were required to do so but it has also been a prudential response. Those deemed a good credit have had access to plenty of cheap credit. This has channeled the liquidity through specific routes and had some very noticeable outcomes. Those with capital, the already rich, have been able to expand and get richer.The expansion of pay-day lending, charging usurious interest rates, car loans, and mortgages, are all symptoms of a distorted credit structure. In the UK we have also had huge expansion in peer-to-peer lending and challenger banks. Things are not what they were.

The challenger banks are particularly interesting. They need a banking licence and as such must come within the FSCS compensation scheme. This has expanded the availability of risk free assets. Each separately licensed bank offers a secure deposit facility up to £85k. One of the consequences of the 2008 crisis was to focus attention on the fact that deposits above the protected amount (it varies) are not secure. They are not the same as cash in hand. The deposits may be easy to access but they are no more secure than the bank and the willingness of the state to bail it out. After 2008 bank credit worthiness has become an issue and the willingness of the state to bail out banks has diminished somewhat. The only case of unsecured depositors being ‘bailed-in’ (losing their deposits) is Cyprus in 2013 and this was in exceptional circumstances (the state could not bail-out the banks) but the principle that bail-ins are possible is now well understood. Leaving more than £85k in a bank is risky. The proliferation of challenger banks has increased the number of the £85k deposits that is possible.

It has been my contention that the newly perceived insecurity of large deposits effectively reduced the money supply and contributed to the deflationary forces evident since 2008. The demand for risk free or near risk free assets such as government debt has grown dramatically just as states were working hard to contract supply through tighter fiscal rules (aka austerity). The central banks exacerbated this excess demand by buying large quantities of government debt in the open market as part of the so-called quantitative easing programmes. This has increased liquidity (cash) at a time when what was required was (risk free) assets. The result was that risk free interest rates fell to zero (or negative). Cash has sought a return and a safe home and has typically found it in property.

Property values have exploded since 2008. The idea that inflation has been low is nonsensical. The cost of accommodation, the largest single cost in any household budget, has risen dramatically. The owners of accommodation have done well. The users have done less well. The monetary policy has had distributional effects. It has increased wealth inequality. A small two bed-room flat in a shoddy ex-council estate in Islington might set you back £19200 per annum. The median gross annual wage in inner london is circa £34k. Take home pay after tax and national insurance is £26,334. This means two sharing are paying 36.5% of disposable income each in rent alone. Not everyone earns the median and those living in this kind of accommodation typically earn much less. How does one save for a mortgage in these circumstances? The cost of credit to those on low insecure income and with little capital is also much higher than the headline interest rates. Someone is doing well and it is the already wealthy.

Another group that has been disadvantaged by the low yields and low-interest rates is the retired. Those in defined benefit schemes are arguably much better off because they have secured pension incomes, typically index linked. The transfer values of these pension benefits are very large. The problem is that, outside of the public sector, these schemes are the liability of corporate entities. The low yield has made it very expensive to fund the benefits. This has led to a threat to the continued provision of such benefits. Those in defined contribution schemes understand the issue very well because they have to generate the income themselves just like the corporate plan sponsors. Low yields have made annuity levels pitiful and forced retirees into risky assets, or property, to generate an income. But many have simply sat in cash in order to preserve capital. This has not been too serious as this group typically have homes and the cost of living has been contained through low goods price inflation. But this has changed.

Inflation has picked up. In the UK this has been exacerbated by the Brexit induced decline in sterling. The phenomenon is however more widespread and relates in part to some bounce in oil and commodity prices. It is unclear how far this bounce can go and it has recently reversed somewhat. The central bankers have the capacity to look through such cyclical events so it is surprising how much the pickup in inflation seems to have shaken their easy money resolve. The implication is that there is more going on. Employment has increased sharply though wages have yet to follow suit. It may be the expectation that wages will pick up that is being signalled. This has some validity as, with increased barriers to labour movement, the flow of cheap labour to high demand areas may abruptly cease. Mexico walls, Brexit, and increased resistance to refugees in Greece and Italy speak to this.

It may also be that central bankers speak with false bravado. They speak of looking through inflation trends but when confronted with higher inflation they become unsure of themselves. It may be that in all the years that they have claimed to adopt easy money to return inflation to target what they were really doing was pursuing easy money for other reasons and could do because goods price inflation was below target.  Now they must either move the goal posts or back-off the easy money. Maybe the other objective was financial stability and restoration of the capital adequacy of banks. This, it seems, has largely been achieved and with goods price inflation now a little uncomfortable they are getting nervous. They were quite happy to see asset price inflation when bank stability was in question and this has had consequences for the standard of living of many (distributional effects). I surmise that the coincident hawkish tone of central bankers is signalling that financial stability is no longer an issue. Expect the more conventional reaction function of central banks to return.

If financial stability was the central issue and is no longer sensitive then we should expect monetary policy to be tightened more quickly than might be expected simply from observable macro variables. Central bankers are not comfortable with low nominal interest rates. Expect the word ‘normalisation’ to increase in incidence. It has already had a good outing in the US. Expect such ideas as ‘preemptive’ to pop up more often. The financial markets may continuously be surprised by monetary policy developments and this could shake asset prices some. There will be real economy effects. They may not all be negative though. The easy money era made the rich richer and the poor poorer. If this is reversed it may actually boost aggregate demand. Nothing is ever quite what it seems when partial static analysis is applied to general dynamic equilibrium systems.  But I may be wrong…

How to Redistribute Wealth

A constant criticism of the Quantitative Easing and low-interest rate policy of the Bank of England has been that it has favoured those with assets. By implication it has favoured those already rich. This is slightly inaccurate as it has primarily favoured those that have been able to acquire assets on a leveraged basis. These people were not necessarily rich when they started out on their leveraged investment. However, the BoE programme has certainly improved their net worth somewhat. These people are of course often house owners.

The corollary of this criticism is that one way of redistributing wealth is to raise interest rates and reverse the QE programme. Wealth distribution is not normally a consideration in setting monetary policy but perhaps it should be. If the redistribution takes cash out of the hands of those with a low marginal propensity to consume and places it in the hands of those with a higher marginal propensity to consume then the net effect may be what the monetary authority desires, albeit from an unconventional transmission process. But then what is monetary policy today if not unconventional.

To be clear, the concern of the Governor of the BoE, that the recent spike in inflation might be just that, a spike, with the long-term prognosis still deflationary, is not without foundation. However, the UK is already experiencing a labour market shock. The Brexit situation is deterring the inward flow of labour in a material way. Whatever the long-term outcome from free movement of labour, an abrupt loss of supply will have a price effect, at least for a while. Wages are set to rise. The rise may not last very long or be large however as, in the physical absence of British alternatives, the response may be to move straight to capital-intensive labour-saving alternatives. Robots appear to be able to pick strawberries and lay bricks. Nevertheless some wage effect is to be expected in the short-term. The conventional case for a rate rise may thus soon look a little better and whatever the spin, looks matter in monetary policy as much as in fashion.

The initial impact of a rate rise will be to hurt those that have leveraged investments and are funding the leverage through floating rate loans and, specifically, base rate trackers. Well, they have been the main gainers so far so redistributing away from this lot is perhaps ‘fair’. Of course, this category may have relatively high net worth (via their home) but may not have particularly high income. Moreover, if they are budgeting on the basis that current base rates will last for ever they might be in for an unpleasant surprise. There will be casualties. People that live so close to the edge in their finances are always vulnerable to change. It is possible to gain some certainty using fixed borrowing rates.

Five year fixed mortgage rates are quite attractive at the moment. Of course to get the best rate you must have a high value to loan ratio, but with so much equity now in property a great many can probably fix for 5 years at the best rates. Interestingly, 5 year rates may be proportionately less affected by a base rate rise than floating or tracker rates. It depends on what the yield curve decides to do and this in turn depends on how far rates are expected to rise and for how long. One should recall that although lenders may offer a 5 year fix they typically fund off floating rates. Unhedged lenders would suffer as rates rise. Of course lenders do hedge using interest rate swaps. If they have fixed rate assets and variable rate liabilities they can convert the liabilities to fixed rate via the swap market (they swap a variable rate stream of liabilities for a fixed rate stream). They make money via charging a higher fixed rate than the one that they can swap into. Swaps are priced off the yield curve so if the curve does not change much nor will swap rates and nor will 5 year fixed rate mortgages. There are a lot of ifs and buts in here but the point is that it is not obvious what will happen to the structure of mortgage rates if base rates rise from here.

So we know some mortgage holders might suffer if base rates rise but the group as a whole has a lot of equity, much of it gained because of the monetary policy regime of the last 8 years. Not all are individual householders. Many are landlords and no one much cares if they suffer do they? Moreover, they can all alleviate the distress somewhat by thinking ahead a fixing their mortgages. The next issue is who gains?

The simple answer is those trying to acquire assets, like a home, or sitting on cash. There appear to be a quite a few of these albeit more in the older age group and redistributing in favour of this group may not be so popular. Wealth is in their home and this may end up funding their care. Despite the spin most of those of pension age have less disposable income than people seem to think. Any extra interest is likely to be spent. Interestingly, even younger savers might spend more if interest rates rise. It means less needs to be saved to meet a specific saving target (like a house deposit). One of the problems is that cash is still the favoured investment for most people and the return on cash has been poor for many years. A rise in the base rate will significantly boost the disposable income of many and thus spending. It is time to redistribute wealth away from those that have gained so much in the last few years and in favour of those that have been left in rented accommodation and/or are cash rich but income poor.

How much should you save?

The more relevant question for most is; how much can you save? Few can save enough. Nevertheless it is worth understanding something of how much you need to save in order to achieve specific objectives such as retirement income. Nutmeg, the Robo-adviser, offers a neat little calculator to enable you to work this out. Of course, it all depends on what assumptions you make. So let us make it real.

You are 30 years old and expect to retire at 68. You want to save for a private income of £25k pa in today’s money. You will be saving monthly and continuously. If you assume average inflation of 2% (the BoE target), a nominal return of 5% (so real 3%) and a 75 basis point fee (0.0075 typical), you must save £591 per month. If you do this through a pension scheme you should get tax relief and an employer contribution so the amount you actually give up from disposable income should be a lot less. How you fund and wrap savings is a separate issue. Here we will concentrate on what the invested amount needs to be irrespective of how it is funded. Let us look at the assumptions.

First, the fee. If the fee were zero you would only need to save £504 per month. You are paying the manager £87 per month, which is rather a lot. If you can avoid or reduce fees this can make a huge difference. Passive management is normally much cheaper than active and frankly, over the long-term, no worse. If you are in an employer scheme, the employer may subsidise the fee. It is advisable to look carefully at the fee structure and your options. If you opt for passive funds you may be able to get total fees down to 35 basis points (or even less), so let us go with this assumption. Your monthly saving need is now £543.

Second, the inflation assumption of 2%. The assumption is the Bank of England will be successful on average over time. The compound average inflation rate since 1997 (when the BoE was made independent) is about 2.75%, somewhat higher than the target. However, over the next 38 years it is not unreasonable to assume the BoE will hit the target, on average.

Third, the return assumption. The evidence for equity returns over very long periods (over 100 years) is that 5% real is not unreasonable. The initial assumption is thus quite pessimistic compared to the past. The investment will occur continuously over 38 years so there is good reason to expect a result that converges on the long-term expectation. Hence we can risk raising the return assumption. Bear in mind that dividend yields are quite high at the moment (3% plus common) and the strategy involves dividend reinvestment a 5% real equity return assumption is not absurd. This gets us to the 7% nominal often used in projection.

If we assume 7% nominal (5% real), 2% inflation, and a fee of 35 bp, we get an invested amount needed of £351 pm. This sounds much more manageable. If we deduct £100 pm for tax relief and employer contributions (arbitrary) you could get a pension of £25k pa in today’s money by saving a mere £251 pm or £3012 per year in deferred disposable income. This is still a lot for many 30 year olds that need to make rent but it is less daunting than number we began with. So what is the purpose of this blog?

My experience with people and money (all ages) is if the amounts seem impossible then people do nothing. In this case they do not save anything. If however the numbers seem manageable and can have meaningful outcomes they are more likely to respond. What is required is consistent saving over a long period rather than a lot of saving right from the start. One can always step it up as income rises. It is also vital not to fall for the hype of the financial services sector. Low cost passive equity investments will do just fine. Finally, tax relief and employer contributions can reduce the amount of disposable income. Look at the possibilities.

Finally, and my coup de grace did you know that you can invest up to £3600 pa even if you have no income and pay no tax and that it will cost you only £2880? This is almost enough to get £25k pa in today’s money in 38 years.


Protest Votes and Null Votes

On November 12, 2013, I published a blog entitled None-of-the-above: innovations in democracy. It was a response to Russell Brand urging people not to vote. I suggested that a formal null vote (none-of-the-above) might meet the needs of the emotion driving Brand’s call and avoid the potentially disastrous consequences of protest voting. The original blog post is well worth reading (even though I do say so myself). The key paragraph is reproduced here:

Many have responded by making protest votes. We vote for a minority and somewhat extreme party which we do not expect to be elected (and would be horrified if it was). It is a protest! However, the minority party will be encouraged by this and draw strength from the vote. It will not interpret it as a protest vote but as a statement of support. It might even encourage a few voters with latent extremist views to support such parties. The protest vote does not necessarily communicate to the ‘political system’ about what we are actually concerned. It is barely better than not voting at all and in some respects more dangerous.

The events of June 2016 and June 2017 would appear to have borne out the observation. The referendum was less about desiring Brexit and more about punishing someone. It was about giving some ill-defined elite, symbolised by David Cameron, the finger. Unfortunately the result  was to poke ourselves in the eye. The success of the Corbyn Labour Party was down in part to many young voters seeing Labour as the most effective way of removing Theresa May’s Tories from power. It was a protest vote. Many young pro-EU Remain supporters voted for Labour even though Labour clearly committed to Brexit in the manifesto and no one that had been awake since last June could be in any doubt how Corbyn and McDonell feel about Brexit. Now we are being told over 80% of the country voted for Brexit and many of these young Remain labour voters are upset.

Not only did I warn about the danger of protest votes in 2013 but I screamed loudly (on Twitter at least) about the folly of Remain voters choosing Labour. The LibDems offered a clear commitment to avoid Brexit or at least provide a second referendum. These young voters ignored me (and the others) and proceeded to vote against May rather than for a Remain party. Voting against things is not a good idea. And if you cannot find something you are for, what does it say about you?

The Brexit stance of Corbyn was quite clever. He managed to attract enough UKip voters (probably formally Labour) in key marginals, and still win the lions share of the pro-Remain youth vote. He was able to achieve the latter because the contempt for May’s Tories overwhelmed rational thought. The two main parliamentary parties are both pro-Brexit. They are both committed to leaving the single market. The claim that over 80% support Brexit is now de facto true, whatever the polls say. the reason is that voters keep voting againstt things and not for things, which, frankly, is dumb. This might be easily resolved by introducing a null vote to the ballot paper.

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