The financial press is full of dramatic stories about saving and investment. People do not save enough and are doomed to die in poverty, if the stories are to be believed. The headlines list the enormous sums necessary in order to avoid this dire fate. If anything puts people off saving and investment it is these ‘helpful’ press stories.
The financial professions work off lots of assumptions which may not apply. The judgement of what you need in retirement is usually based on what you earned in your working life; the assumption of continuity of life style. Investment returns are assumed based on past experience. Regulatory and tax conditions are assumed stable. Life expectancy is assumed stable. The NHS is assumed to be there forever. Yet nothing is said about the one constant we do know about the future; uncertainty. This blog brings together many issues discussed in earlier blogs in the hope it may help planning. If nothing else it may serve as an antidote to the tosh you find in the financial press and even promoted by independent advisors.
Uncertainty is the key concept. I can recall the future I expected at retirement when I graduated in 1974. It did not look like today. Interest rates, annuity rates, and inflation rates are all much lower. Life expectancy is much higher. The tax regime is quite different. The state pension is quite different. So the fairly obvious conclusion is that planning over 40 odd years cannot assume much. Yet everything is assumptions.
The problem with uncertainty is that it is not amenable to probability calculations. Uncertainty deals with consequences. If the consequence is serious you must plan for the contingency irrespective of the probability of the event occurring. This is why we buy insurance. Unfortunately one cannot buy insurance for all possible outcomes and if we could it would cost too much. The best insurance for uncertainty is a slab of cash held in a risk free form. The instinct to hold cash is thus sound. The opportunity cost may be high, but the opportunity cost is the cost of insurance. It should be high.
The issue for most is how to accumulate cash or near cash equivalents. Not everyone is born expecting an inheritance or a subsidised loan from the Bank of Mum and Dad. One can save out of income and invest for return. One can also take risk by borrowing to invest (this is what house purchase with a mortgage amounts to). Leveraged investment offers large potential gains and large potential losses. If house prices fall you could find yourself insolvent and if you cannot make the payments you may have to resolve the insolvency. If you think house prices cannot fall check out 1988 to 1994. It may not be probable but it can be life changing if it occurs.
Saving is a good habit. It is more important to save regularly than to save a lot. Save what you can but save something. It mounts up and when you have a windfall or abrupt change in income you are likely to simply increase the amount you save. The habit takes over. The Apps which encourage people to save loose change are very positive in this respect. It is also surprising how much you can accumulate by relatively painless but consistent saving. It is the power of compound interest. It would be more helpful if the financial press focused on how easy it is to accumulate large sums from regular small savings than on headlines figuring the impossibly large sums.
How much you accumulate depends upon return. If you save £100 per month at 6% for 40 years reinvesting interest you will end up with around £200k. More important, 3/4 of this will be interest. Is 6% a meaningful number in today’s environment? If you invest in a low-cost index tracking equity fund with dividends reinvested it is most certainly meaningful. One of the most interesting observations is that you can can invest £240 per month over 40 years at 6% and end up with ££603k. Witchcraft? No, tax relief. Even non-taxpayers can invest £300 a month in a pension and get 20% tax relief (hence £240 pm net cost). The shocking headline figure that people need at retirement over and above the state pension is usually £240k. This can be achieved saving £100 pm net (£120 pm with the tax relief). If you get an employer contribution as well it is net even less. Really it is all very doable.
Of course I am assuming 6% return on average over 40 years with dividends reinvested. Is this reasonable? History says it is reasonable though this is not much help. The point is you can always save a bit more as your circumstances allow. If you start by saving £100 pm in a tax efficient way then you are on course to achieve a good sum at retirement. It is a good base from which to work as your circumstances change. And it is less challenging seen as £100 pm. What about stock market volatility? What about it? You are investing monthly over 40 years. You averaging in and will not be liquidating until 40 years (maybe not even then). Stock markets tend to go up although they do so through strange and wonderful paths. Volatility is of no interest to you so why does anyone even mention it?
What about when you get to retirement? Now you have to generate an income from capital. You can buy an annuity which disappears when you (and your spouse if relevant) die. If is a risk sharing exercise with those that live longer than expected being subsidised by those that die early. Or you can go into income drawdown. You invest the capital and live off the income (and capital if you wish) but anything left can be left to anyone you want if you die (tax-free if you die before 75). The annuity pays out as long as you live but drawdown can run out if you overspend. Not difficult to see why the state prefers you to buy an annuity.
Much is made of stock market volatility once again and once again it is not wholly relevant. If you determine to live off natural income from your fund (dividends, coupons interest) then you will not be liquidating so why does volatility matter? The only thing that matters is the volatility of dividends etc. They tend to rise but there may be cuts in some years. You need to keep a cash buffer if you are running on a tight budget or have room to tighten your belt. Neither are that challenging to organise. Can you match an indexed annuity with dividend income. I have already demonstrated that you can in a previous blog.
There are 3 big implications from this light-hearted blog. First, get people saving by showing how little net they need to save to accumulate a pot for retirement. Second, market volatility is not relevant to individuals saving consistently for retirement. Third, market volatility is not relevant to individuals generating income in retirement though dividend volatility is very relevant. One wonders therefore why the FCA is so obsessed with identifying risk preference.