Cheap money is still blowing bubbles

In my last blog I noted how the investment banks are doing very well. Borrowing at 0.5% and investing in government bonds yielding more.

A similar but far more destabilising transaction is the current US dollar carry trade. Speculators appear to be borrowing in US dollars at 0.5% in their droves and investing in other risk assets such as commodities and emerging markets, driving the dollar down and inflating risk assets. The longer this goes on, the bigger the bubble gets. Question is, when does it stop?

Will interest rates be able to remain this low for as long as the central banks have stipulated? All other things being equal, you can see low interest rates for a long time given there’s so much spare capacity in the economy, but it’s not as simple as that. The speculative money going into risk assets is driving up the costs of raw materials and this is especially hurting those whose currencies are weakening such as the US. It’s especially inflationary, a one way track to stagflation. That’s little or no growth with inflation. Typically, in order to control inflation interest rates are raised to temper demand. This is happening in Australasia for example. But what do you do when there’s little or no growth such as in the US and UK? Rather than tempering domestic demand, interest rates may have to increase just to improve the exchange rate and dampen import inflation.  That would certainly help appease China who are also getting concerned. But this would desperately hurt the real economy, the innocent bystander in all of this.

Higher interest rates will also spell the start of the unwinding of the carry trade. Once the unwind starts, it’ll be like a high speed train – no one wants to be the last one holding risk assets using borrowed dollars. Theory dictates that asset prices will fall dramatically (yes, that includes gold) and the US dollar will rise dramatically.

When will this happen? Ah, if only we knew. Bubbles can last years! But what we do know is to be careful. It’s important to know why asset prices rise and fall, who benefits and what happens in the long run. Timing the markets, the average investor gets it wrong. Buy high, sell low is typical. What you can see is a current case for commodities, growth stocks and gilts in this rally; gilts and the US dollar for when the unwind occurs. These assets pay little or no dividends. Many forget the importance of dividends which are a vitally important aspect of stable returns.

Either play one of the the biggest games of casino ever played or, if you are trying to plan for the long term amongst all the noise, diversify your assets ensuring exposure to dividends.

QE, interest rates and hidden gifts

Last week was quite a week in the money merry go round.

On Monday, we had what the City hopes to be the final bail out of Lloyds and RBS costing £38bn, just a week after the Government robbed the private sector banks of their deposits when it offered it’s market leading, 100% backed, 1 year fix of 3.95% gross. I don’t think RBS is out of the woods just yet.

On Tuesday, Australia put up their interest rates again from 3.25% to 3.50%.The likelihood is that the UK will be among the last to put up rates. Together with the likelihood of on-going Quantitative Easing (QE), that will make less people wanting to hold pounds pushing down sterling.

Thursday saw another £25bn added to the QE programme, that’s the Bank of England buying gilts using money from thin air to increase cash assets at the banks which in turn are meant to be loaned out. Evidence suggests not much is being loaned out, but the low gilts yields and low interest rates have meant that to get a decent return, money has gone into risk assets, creating a boom in share prices and a better climate for new share issues/fund raising for flagging PLCs. For big business to start with, it seems that QE is working. It is especially beneficial for the Government. Low gilt yields mean the cost of servicing Goverment debt is kept low – for now.

Had the Bank of England bought private sector debt then borrowing costs might have lowered in that sector, helping small businesses like policy does in the US. Hmmm.

What we can deduce from last week alone is that the UK’s enormous hangover from the debt bubble is still having to be repaired with the loosest monetary policy seen in our lifetimes whereas the likes of Australasia are looking to put the brakes on. This will keep sterling weak, providing a prolonged break for UK tourism and a boost to international investment returns for UK investors.

Oh, and the investment banks have been doing quite okay from all of this. Huge gilt issuances have been profitable for the banks and George Soros recently asserted that “banks are getting … hidden gifts from the government” because they can “borrow at effectively zero and buy 10-year government bonds at 3.5pc”. Hmmm. What with the QE programme of buying gilts from banks, it sounds like a merry go round of debt in the UK to me, further pushing gilt prices up and gilt yields down until someone or something puts a stop to all of this.

How to invest in a recession

You might as well know upfront that this article will not tell you how to beat the market in a recession. Nor will it deliver illuminating wisdom on future share price movements. The good news is that even though you might not beat the market you can beat most other investors.

That’s a bold claim so we had better back it up before going any further. We have mentioned a research firm called Dalbar before. They are an independent firm that produces research and statistics on investor behaviour, amongst other things. A comparison of two equity fund investors from 1988 to 2007, each investing $10,000 showed that the average investor return was $24,011 while the systematic investor return was $31,036 (Source: Dalbar, ‘Quantitative Analysis of Investor Behaviour 2008’. ).

In other words, just by being disciplined, the systematic investor beat the average investor. They didn’t time the market or pick winners, they just behaved sensibly. You can do this too.

So why do people try to time the market? The allure of incredible riches – and if you could really time the market you would indeed get rich. But even professional fund managers don’t get it right all the time. Some go chasing after big returns and have some amazing years of growth but are often followed by massive losses. There are not many funds that are consistently top performers.

So lesson one on how to invest in a recession is don’t time the market. This leaves a couple of options for investment timing – buy and hold or regular investments to smooth out the ups and downs of the market.

Let’s move on to picking winners. When fund managers choose individual investments to put in their fund you expect them to scrutinise the company, the management, the accounts, the markets in which they operate and so on. And they generally have teams of people to help them. Do you really know better?

A survey of American investors which asked how their own portfolio would do and how the market in general would do showed the following:

	Market	Portfolio
June 1998	13.4%	15.2%
February 2000	15.2%	16.7%
September 2001	6.3%	7.9%

(Source: Kenneth L. Fisher and Meir Statman, “Bubble Expectations,” Journal of Wealth Management, Fall 2002)

In other words, we all think we’re going to do better than average. But of course that is impossible so some of us are unrealistically optimistic about our talents.

So that was lesson two: you might not be as clever or as lucky as you think you are so don’t try to pick winners.

A final note of caution on picking winners and timing the market. Where are you getting information from? Do you really believe what you read in newspapers or see on the television? The ‘news’ does not come from some higher source with access to the future; it is written by fallible humans who need to find something to say that sells papers or attracts viewers. And of course beware of share tipsters – they are obviously making money selling their advice rather than following it themselves!

Recessions can be volatile and uncertain times. We have seen a fantastic rally in the markets so far this year (at the time of writing) despite rising unemployment and difficult economic circumstances. The future is uncertain and there are forces that you cannot predict. The government programme of quantitative easing might well have something to do with that (see below for an article on QE). Government intervention also created wonderful growth in banks that looked bankrupt not so long ago. This distortion of the markets is not predictable.

So what can you do to influence your investments?

First of all make sure that you are not timing the market and instead adopt a disciplined approach to meet your goals.

Second, don’t concentrate all your wealth into a few stocks that you have identified as likely winners. The risk of being wrong is too great to bear for most people. Instead make sure that you have a properly balanced portfolio that reflects the level of risk and return that you need to achieve your goals and are comfortable with.

Third, make sure you talk to your adviser about minimising your taxes. If you want to be philanthropic you could give money to charity where you get to choose what it is spent on.

The final lesson for successful investing in a recession is that it is no different from investing at any other time. Make a plan and stick to it with discipline.

Centenarians – the fastest growing age group

According to the Office for National Statistics centenarians are the fastest growing age group in England and Wales.  They explain it thus:

“The major contributor to the rising number of centenarians is increased survival between the age of 80 and 100 due to improved medical treatment, housing and living standards, and nutrition.” ONS, 2009.

It now seems possible or even likely that living to 100 might become commonplace within our lifetimes.  And I expect that could be more true of those who have sufficient resources to live a healthy lifestyle.

People have often suggested in the past that there must be some sort of natural limit to lifespan – a ceiling if you will – but so far there is no sign of it.  So where will it end?

Dr Aubrey de Grey of the University of Cambridge has made a very bold claim.  “I think the first person to live to 1,000 might be 60 already.”  That’s not a typo.  he really said 1,000.  I sense disbelief amongst some readers.  Well, he might not be correct but he’s certainly not a quack.  He explains it in broad terms like this:

“Ageing is a physical phenomenon happening to our bodies, so at some point in the future, as medicine becomes more and more powerful, we will inevitably be able to address ageing just as effectively as we address many diseases today.”  He’s talking about ongoing scientific trials too, not just vague ideas.

Even leaving aside the idea of living to 1,000 we are still facing the wonderful prospect of living to 100 and beyond.  As long as you remain healthy and solvent, what a privelege to experience so much.

When you review your long-term financial plans with your adviser, make sure you are realistic about how long you might live.  It could well be much longer than you think.  This has an important ramification.

There is a risk that you could run out of money in retirement.  These days with our sophisticated lifetime cash flow modelling this can be simulated quite effectively for multiple scenarios, allowing you to see under what circumstances you might run out of money.  It could mean the wealth creation part of your life has to last longer, spending less or just adjusting your portfolio.

According to the Office for National Statistics centenarians are the fastest growing age group in England and Wales.  They explain it thus:

“The major contributor to the rising number of centenarians is increased survival between the age of 80 and 100 due to improved medical treatment, housing and living standards, and nutrition.”
ONS, 2009.

It now seems possible or even likely that living to 100 might become commonplace within our lifetimes.  And I expect that could be more true of those who have sufficient resources to live a healthy lifestyle.

People have often suggested in the past that there must be some sort of natural limit to lifespan – a ceiling if you will – but so far there is no sign of it.  So where will it end?

Dr Aubrey de Grey of the University of Cambridge has made a very bold claim.  “I think the first person to live to 1,000 might be 60 already.”  That’s not a typo.  He really said 1,000.  I sense disbelief amongst some readers.  Well, he might not be correct but he’s certainly not a quack.  He explains it in broad terms like this:

“Ageing is a physical phenomenon happening to our bodies, so at some point in the future, as medicine becomes more and more powerful, we will inevitably be able to address ageing just as effectively as we address many diseases today.”

He’s talking about ongoing scientific trials too, not just vague ideas.

Even leaving aside the idea of living to 1,000 we are still facing the wonderful prospect of living to 100 and beyond.  As long as you remain healthy and solvent, what a privelege to experience so much.

When you review your long-term financial plans make sure you are realistic about how long you might live.  It could well be much longer than you think.  This has an important ramification.

There is a risk that you could run out of money in retirement.  These days with sophisticated lifetime cash flow modelling this can be simulated quite effectively for multiple scenarios, allowing you to see under what circumstances you might run out of money.  It could mean the wealth creation part of your life has to last longer, spending less or just adjusting your portfolio.

Quantitative Easing – money from thin air

There has been very little noise around the Bank of England’s continuing Quantitative Easing (QE) programme.  For whatever reason it seems a little beneath the media radar.  In this article we’ll attempt to explain what’s actually happening.

Is inflation a good thing?

The government sets an inflation target for the BOE.  This target is 2%.  Why does anybody want inflation? I hear you ask.  Most modern economists agree that modest inflation is required for sustainable economic growth.  A steady erosion of the purchasing power of money encourages us to continue spending it now rather than later.  It encourages continued growth.  It also means that even if interest rates go to zero there is still a cost to hoarding cash – the nominal interest rate is effectively below zero.

The Bank tends to try to control inflation using interest rates.  This is a very difficult thing to do as it involves a lot of guesswork about the future and the changes take many months to work.  If inflation looks set to rise above target, then the Bank raises rates to slow spending and reduce inflation.  Similarly, if inflation looks set to fall below 2%, it reduces Bank Rate to boost spending and inflation.  In late 2008 spending in the UK slowed sharply so the Bank cut Bank Rate substantially to mitigate against the risk of inflation falling well below target further down the line.  This didn’t work.

QE – just another tool?

So here’s where QE comes in.  Bank Rate is already at an all-time low of 0.5%.  The Bank has effectively run out of room to manoeuvre with interest rates and needs another tool to increase inflation.  Now, in order for something to remain valuable it needs to remain scarce.  By creating more money the Bank reduces the value of the money already in existence.

Right now the Bank is creating money and using it to buy government debt and a small amount of corporate debt.  Here’s what they say:

“The sellers of the assets have more money so may go out and spend it. That will help to boost growth. Or they may buy other assets instead, such as shares or company bonds. That will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off. So they may go out and spend more… banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses.”  Bank of England, QE Pamphlet, 2009.

Effects of QE and interest rates

Despite these brave words and the pretty pamphlet the Bank has kindly produced to help explain the situation, banks are repairing balance sheets rather than lending.  Those consumers who can afford to repair their balance sheets are also doing so.  It doesn’t seem like there’s a lot of extra consumption going on.

What we have seen is an enormous rally in risk assets like equities and this seems far removed from the real economy where companies are still suffering and unemployment is rising.  So is the QE money just going into the stock market?

With interest rates at just 0.5% there’s less temptation to keep cash in the bank.  It’s just not earning enough interest.  Further, with the inflationary effects of QE eroding cash savings people are keen to be in hard assets rather than lose more of their buying power.   The pound has been slipping against other major currencies recently too.  Add into this mix a rising market that makes those not participating fear missing out on a bumper year and there’s even more pressure to get into the markets.

This is perhaps part of the reason why stock markets have done so well this year despite the clearly awful market conditions.

QE funds government spending

Paul Tostain of Bullionvault puts it like this “The British Government has no money to fund its massive public spending program and ongoing debt repayments, and so it has made itself the only recipient of all the money which it requires the Bank of England to print, and then lend at rock-bottom rates.”  October 2009.

Under the gold standard, national governments had to regulate the issue of money by the discipline of convertibility into gold.  In other words if you didn’t hold gold to back the money you couldn’t create the money.

And gold can’t just be magicked into existence: “The total amount of gold in the world is 160,000 tonnes and it is worth about $5 trillion. Formed into a cube it would have an edge of 20 metres and would not cover a tennis court. The size of the cube is growing slowly at about 11cm per year, as miners extract more gold from the Earth, and the annual rate of growth in the weight of the cube is 1.5%.” Paul Tostain, Bullionvault, 2009

With the barrier of the gold standard removed long ago there is a great temptation for those who can make money out of thin air to do so.  And they often succumb to that temptation.  But this debases the money the rest of us hold.  They are effectively making more money for themselves at our expense.

Where does money come from?

So where does money normally come from?  Well, without going right back to the origins of trade itself, let’s start with banks.  They used to keep reserves of gold and give a credit note that could be exchanged for that gold.  After a while they realised they didn’t need to hold all the gold since it would be unusual for all the people to want their gold back at once.  So the reserves were reduced to a fraction of the total amount outstanding.  Knwoing this, if customers lose confidence there can be a run on the bank – as we saw several times recently, starting with Northern Rock.

But there’s actually something a little more incredible going on in banks these days.  When you borrow money from a bank you’re not really taking money from the deposits of other customers.  And you’re not borrowing money from the bank either.  The bank actually creates the money you want to borrow out of thin air.  The very fact that you promise to repay the money is what supports its creation.  This is a major reason why credit creation has been so vast in recent years.

I would argue, as many before me have, that bubbles would be much smaller and less damaging if credit were limited in the first place.  Now back to QE…

QE as a form of theft?

The Chinese made a lot of noise about this earlier in the year.  Not that they were particularly concerned about our own QE programme measured in the billions.  Their concern is the US money creation running into the trillions.  The Chinese are holding a lot of dollars and thus are understandably a little peeved that the americans are debasing their currency and eroding their debts.

Alan Greenspan wrote back in 1966 “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”  Gold and Economic Freedom, 1966.

He was saying that creating new money to fund government spending is a sneaky way to take money from citizens.  Taxation would be so much more overt and liable to reduce chances of re-election.

What happens when QE stops?

What happens to this extra money once inflation is on the up again?  Well the Bank of England states that it will “put downward pressure on spending and inflation by raising Bank Rate and removing the extra money by selling the assets it previously purchased.”  Sounds easy but nobody knows how or if it will work.  We just don’t know what market forces will be in operation at the time or how they will interact.  A reminder that economics is not as scientific as some would have you believe.

When QE ends and interest rates rise again this will remove the current stimulus to the stock market.  Some say that the current rally is just another bubble.  But really that’s just how markets operate and the only question is how long they last.  The stock market valuations of companies are guesses about the future value of those companies, guesses about their future earnings.  When they turn out to be wrong we get corrections and afterwards it all looks so very obvious.

None of this should be interpreted as a tip to time the market.  Timing the market is unwise for most people.  Don’t try to jump in and out of the market, rather be strict and disciplined with yourself and ensure that you have a balanced portfolio designed to meet your long-term goals.

When you realise where money comes from, that it is created from nothing, you might well wonder why we don’t just use the leaves on the trees instead.

There has been very little noise around the Bank of England’s continuing Quantitative Easing (QE) programme.  For whatever reason it seems a little beneath the media radar.  In this article we’ll attempt to explain what’s actually happening.

Is inflation a good thing?

The government sets an inflation target for the BOE.  This target is 2%.  Why does anybody want inflation? I hear you ask.  Most modern economists agree that modest inflation is required for sustainable economic growth.  A steady erosion of the purchasing power of money encourages us to continue spending it now rather than later.  It encourages continued growth.  It also means that even if interest rates go to zero there is still a cost to hoarding cash – the nominal interest rate is effectively below zero.

The Bank tends to try to control inflation using interest rates.  This is a very difficult thing to do as it involves a lot of guesswork about the future and the changes take many months to work.  If inflation looks set to rise above target, then the Bank raises rates to slow spending and reduce inflation.  Similarly, if inflation looks set to fall below 2%, it reduces Bank Rate to boost spending and inflation.  In late 2008 spending in the UK slowed sharply so the Bank cut Bank Rate substantially to mitigate against the risk of inflation falling well below target further down the line.  This didn’t work.

QE – just another tool?

So here’s where QE comes in.  Bank Rate is already at an all-time low of 0.5%.  The Bank has effectively run out of room to manoeuvre with interest rates and needs another tool to increase inflation.  Now, in order for something to remain valuable it needs to remain scarce.  By creating more money the Bank reduces the value of the money already in existence.

Right now the Bank is creating money and using it to buy government debt and a small amount of corporate debt.  Here’s what they say:

“The sellers of the assets have more money so may go out and spend it. That will help to boost growth. Or they may buy other assets instead, such as shares or company bonds. That will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off. So they may go out and spend more… banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses.”

Bank of England, QE Pamphlet, 2009.

Effects of QE and interest rates

Despite these brave words and the pretty pamphlet the Bank has kindly produced to help explain the situation, banks are repairing balance sheets rather than lending.  Those consumers who can afford to repair their balance sheets are also doing so.  It doesn’t seem like there’s a lot of extra consumption going on.

What we have seen is an enormous rally in risk assets like equities and this seems far removed from the real economy where companies are still suffering and unemployment is rising.  So is the QE money just going into the stock market?

With interest rates at just 0.5% there’s less temptation to keep cash in the bank.  It’s just not earning enough interest.  Further, with the inflationary effects of QE eroding cash savings people are keen to be in hard assets rather than lose more of their buying power.   The pound has been slipping against other major currencies recently too.  Add into this mix a rising market that makes those not participating fear missing out on a bumper year and there’s even more pressure to get into the markets.

This is perhaps part of the reason why stock markets have done so well this year despite the clearly awful market conditions.

QE funds government spending

Paul Tostain of Bullionvault puts it like this “The British Government has no money to fund its massive public spending program and ongoing debt repayments, and so it has made itself the only recipient of all the money which it requires the Bank of England to print, and then lend at rock-bottom rates.”  October 2009.

Under the gold standard, national governments had to regulate the issue of money by the discipline of convertibility into gold.  In other words if you didn’t hold gold to back the money you couldn’t create the money.

And gold can’t just be magicked into existence:

“The total amount of gold in the world is 160,000 tonnes and it is worth about $5 trillion. Formed into a cube it would have an edge of 20 metres and would not cover a tennis court. The size of the cube is growing slowly at about 11cm per year, as miners extract more gold from the Earth, and the annual rate of growth in the weight of the cube is 1.5%.”

Paul Tostain, Bullionvault, 2009

With the barrier of the gold standard removed long ago there is a great temptation for those who can make money out of thin air to do so.  And they often succumb to that temptation.  But this debases the money the rest of us hold.  They are effectively making more money for themselves at our expense.

Where does money come from?

So where does money normally come from?  Well, without going right back to the origins of trade itself, let’s start with banks.  They used to keep reserves of gold and give a credit note that could be exchanged for that gold.  After a while they realised they didn’t need to hold all the gold since it would be unusual for all the people to want their gold back at once.  So the reserves were reduced to a fraction of the total amount outstanding.  Knwoing this, if customers lose confidence there can be a run on the bank – as we saw several times recently, starting with Northern Rock.

But there’s actually something a little more incredible going on in banks these days.  When you borrow money from a bank you’re not really taking money from the deposits of other customers.  And you’re not borrowing money from the bank either.  The bank actually creates the money you want to borrow out of thin air.  The very fact that you promise to repay the money is what supports its creation.  This is a major reason why credit creation has been so vast in recent years.

I would argue, as many before me have, that bubbles would be much smaller and less damaging if credit were limited in the first place.  Now back to QE…

QE as a form of theft?

The Chinese made a lot of noise about this earlier in the year.  Not that they were particularly concerned about our own QE programme measured in the billions.  Their concern is the US money creation running into the trillions.  The Chinese are holding a lot of dollars and thus are understandably a little peeved that the americans are debasing their currency and eroding their debts.

Alan Greenspan wrote back in 1966:

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”

Gold and Economic Freedom, 1966.

He was saying that creating new money to fund government spending is a sneaky way to take money from citizens. Taxation would be so much more overt and liable to reduce chances of re-election.

What happens when QE stops?

What happens to this extra money once inflation is on the up again?  Well the Bank of England states that it will “put downward pressure on spending and inflation by raising Bank Rate and removing the extra money by selling the assets it previously purchased.”  Sounds easy but nobody knows how or if it will work.  We just don’t know what market forces will be in operation at the time or how they will interact.  A reminder that economics is not as scientific as some would have you believe.

When QE ends and interest rates rise again this will remove the current stimulus to the stock market.  Some say that the current rally is just another bubble.  But really that’s just how markets operate and the only question is how long they last.  The stock market valuations of companies are guesses about the future value of those companies, guesses about their future earnings.  When they turn out to be wrong we get corrections and afterwards it all looks so very obvious.

None of this should be interpreted as a tip to time the market.  Timing the market is unwise for most people.  Don’t try to jump in and out of the market, rather be strict and disciplined with yourself and ensure that you have a balanced portfolio designed to meet your long-term goals.

Spending cuts are coming

I don’t think it’s controversial to say that spending cuts are on the way. In mid-September the Institute of Fiscal Studies (IFS) issued a press release regarding leaked spending cut plans. They stated “This would be the tightest squeeze in spending on public services since the UK was negotiating its spending plans with the International Monetary Fund in the late 1970s. The Treasury has said that the second half of the tightening could come either from further tax increases or from further spending cuts.”

Does it matter who’s in charge?

And it won’t matter which political party is in power at the time. “They’re not wrong to be planning cuts, they’re wrong to try to cover up their plans for cuts,” said Mr Cameron.

Will it stunt the recovery?

The worry is that fiscal tightening reduces the amount of money in people’s pockets, potentially increases unemployment and thus reduces consumption and worsens the recession. This would be compounded if other nations, in better fiscal health than ours, continue to stimulate their economies.

Borrowing costs

The issue is complicated by the fact that if UK plc starts to look like a bad credit risk then, just like everybody else, it will have to pay more to borrow money. Even a small increase in borrowing costs can have a huge effect on the total debt accrued.

So it’s a balancing act between being seen to borrow responsibly and not starving the economy at the worst possible time.

The winter of our discontent?

Are you, like me, old enough to remember the winter of discontent? At the time I was eating lunch from a Star Wars lunch box so I didn’t feel quite the same impact it had on adults. But still, I remember the closed down shops, drab peeling paint and strikes just as vividly as the water shortages and sunshine in the summer of ‘76.

Political hot potato

No political party wants to preside over such a state of affairs and it appears Labour want to paper over the cracks for as long as possible. If the Conservatives got in it might make sense for them to get it over with as quickly as possible while still in a position to blame it on the previous government. They have been making some of the right noises but predictably they are light on the details.

In the meantime, those of us who remember the 70s will be making sure that they take precautions to guard against the coming cuts and increased taxes. One precaution is not taking on debt you can’t afford to service and there’s evidence that, for whatever reason, debt is reducing.

This July, personal borrowing fell by £600m, taking the total owed by individuals down to £1.457 trillion. This is the first time the total amount of personal debt in the UK has fallen since records began in 1993. This dip is not just because of reduced mortgage activity but also includes other forms of debt such as bank loans.

The Bank of England stated “Weak consumer credit is consistent with the decline in household consumption this year, and trends seen in the previous recession.” Trends in Lending, September 2009. So we’re spending less but are we saving more? According to the Building Societies Association balances held in savings accounts at building societies fell £202 million in August 2009. That’ll be a ‘no’ then.

Potential tax increases

If government wanted to raise more money rather than just cut spending it might decide to make a few changes to existing taxes:

“By way of illustration, increasing i) the standard rate of VAT, ii) the basic rate of income tax or iii) the main rates of National Insurance Contributions for employees and the self-employed by 1p would each raise roughly £4½ billion or 0.3% of national income in 2011–12. Increasing the higher 40p income tax rate by 1p would raise roughly £1.4 billion. Freezing the income tax personal allowance in cash terms in 2011–12, 2012–13 and 2013–14 would raise roughly £3.7 billion if retail price inflation evolves as the Treasury has assumed in its Budget 2009 forecasts.” IFA Briefing Note BN87, 2009.

All the indications are that both spending cuts and tax increases are coming our way. It is crucial that we make proper preparations for these difficult economic circumstances.

I don’t think it’s controversial to say that spending cuts are on the way. In mid-September the Institute of Fiscal Studies (IFS) issued a press release regarding leaked spending cut plans. They stated:

“This would be the tightest squeeze in spending on public services since the UK was negotiating its spending plans with the International Monetary Fund in the late 1970s. The Treasury has said that the second half of the tightening could come either from further tax increases or from further spending cuts.”

Where will the cuts be? Housing and transport look like softer targets than the NHS...

Does it matter who’s in charge?

And it won’t matter which political party is in power at the time. “They’re not wrong to be planning cuts, they’re wrong to try to cover up their plans for cuts,” said Mr Cameron.

Will it stunt the recovery?

The worry is that fiscal tightening reduces the amount of money in people’s pockets, potentially increases unemployment and thus reduces consumption and worsens the recession. This would be compounded if other nations, in better fiscal health than ours, continue to stimulate their economies.

Borrowing costs

The issue is complicated by the fact that if UK plc starts to look like a bad credit risk then, just like everybody else, it will have to pay more to borrow money. Even a small increase in borrowing costs can have a huge effect on the total debt accrued.

So it’s a balancing act between being seen to borrow responsibly and not starving the economy at the worst possible time.

The winter of our discontent?

Are you, like me, old enough to remember the winter of discontent? At the time I was eating lunch from a Star Wars lunch box so I didn’t feel quite the same impact it had on adults. But still, I remember the closed down shops, drab peeling paint and strikes just as vividly as the water shortages and sunshine in the summer of ‘76.

Political hot potato

No political party wants to preside over such a state of affairs and it appears Labour want to paper over the cracks for as long as possible. If the Conservatives got in it might make sense for them to get it over with as quickly as possible while still in a position to blame it on the previous government.  They have been making the right noises but predictably they are light on the details.

In the meantime, those of us who remember the 70s will be making sure that they take precautions to guard against the coming cuts and increased taxes. One precaution is not taking on debt you can’t afford to service and there’s evidence that, for whatever reason, debt is reducing.

This July, personal borrowing fell by £600m, taking the total owed by individuals down to £1.457 trillion. This is the first time the total amount of personal debt in the UK has fallen since records began in 1993. This dip is not just because of reduced mortgage activity but also includes other forms of debt such as bank loans.

The Bank of England stated “Weak consumer credit is consistent with the decline in household consumption this year, and trends seen in the previous recession.” Trends in Lending, September 2009. So we’re spending less but are we saving more? According to the Building Societies Association balances held in savings accounts at building societies fell £202 million in August 2009. That’ll be a ‘no’ then.

Potential tax increases

If government wanted to raise more money rather than just cut spending it might decide to make a few changes to existing taxes:

“By way of illustration, increasing i) the standard rate of VAT, ii) the basic rate of income tax or iii) the main rates of National Insurance Contributions for employees and the self-employed by 1p would each raise roughly £4½ billion or 0.3% of national income in 2011–12. Increasing the higher 40p income tax rate by 1p would raise roughly £1.4 billion. Freezing the income tax personal allowance in cash terms in 2011–12, 2012–13 and 2013–14 would raise roughly £3.7 billion if retail price inflation evolves as the Treasury has assumed in its Budget 2009 forecasts.”

IFS Briefing Note BN87, 2009.

All the indications are that both spending cuts and tax increases are coming our way. It is crucial that we make proper preparations for these difficult economic circumstances.

Minimum pension age increasing to 55 in April 2010

This is more of a quick reminder than a post but it is important to mention it.  A minimum pension age of 55 will apply by 6 April 2010. Until then it is age 50. Quite a jump. If you are 50 now but don’t take your pension until after April 2010 then you will have to wait until you are 55 to do so.

Many contribute nothing to their pension

PwC recently stated that the private sector needs to contribute a massive 37% of pay to match the pension of a long-serving career civil servant.

They took expected defined benefit Civil Service pension payouts as the starting point and took into account expected movements in asset prices that would influence the eventual pension paid by a defined contribution scheme.

Now we can moan all we like about the unfairness of public sector pensions that the rest of us private sector tax payers subsidise, and I’ve certainly done my fair share, but that gets us nowhere.  What we defined contribution payers must also reflect upon is how much really needs to be set aside for our future if we want to secure a reasonable standard of living in our golden years.

Some are currently contributing nothing for their future.  In a recent survey the BBC found that half of Britons aged 20 to 60 are not putting any savings into a pension.  For many, the personal disaster of poverty during old age is slowly creeping up on them.

So how would it feel to go from contributing 0% to say, 25% of income ? How does that feel? Probably not that great.

Or how’s going from 0% to 5% to 10% to 15% to 20% to 25% ? More palatable this time?

The key is, you have got to start somewhere and reassess, reassess, reassess.

Ideally, identify what a good retirement looks like, how much it costs and work backwards to see how much you need to save. Then reassess, reassess, reassess.

Dangerous lack of knowledge on annuities

In my last post I stated that just 6% of annuities taken out are protected against inflation, or escalating, leaving the remaining 94% as level (figures for 2007, Just Retirement).  I want to compare this with recent figures from the BT Pension Scheme, a final salary pension scheme.

The BT Pension Scheme has offered the option of exchanging inflation linked guarantees for an initially higher level paying pension since April 2009. In a recent report, the scheme confirmed that a quarter of all new retirees forego inflation-linked benefits in exchange for a higher initial but level pension.

That’s only 25% of retiring BT members going for the level pension compared to the 94% of those with personal pensions going for a level pension.

Opt out is a powerful tool

Why such a difference between the stats above? Better the devil you know? Education? Inertia?

Probably a little bit of all three, but most probably inertia. It’s a big step to “opt-out” of the default.

That’s why “Personal Accounts” due in 2012 have gone down the opt-out route.

That’s why campaigners have asked for the “open market option” rather than securing an annuity with the existing provider to be the default option.

And that’s why I think an inflation-linked annuity from personal pension retirement funds should be one of the default options (it isn’t at the moment), as this is more likely to inform and educate those at retirment on inflation risks that lie ahead. For the last 10 years, inflation hasn’t been a problem. How about the last 20 years? The last 30 or 40 years? How about the next 10 or 20 years?

Opt

For sure, to “live now” or “live later” is a big conundrum but perhaps another part of the problem lies with the unqualified adviser. The Annuity Clearing House, a retirement income specialist, recently revealed a potentially terrible lack of knowledge of “at retirement” issues in a study of 275 leading IFAs. Less than half of the IFAs questioned had a thorough knowledge of the annuity market. Just one in three had good knowledge of the increasingly important impaired annuity sector, while just one in eight feel they know enough about investment annuities.

Make sure you’re dealing with someone well qualified to go through all the options.

In my last post I stated that just 6% of annuities taken out are protected against inflation, or escalating, leaving the remaining 94% as level (figures for 2007, Just Retirement).  I want to compare this with recent figures from the BT Pension Scheme, a final salary pension scheme.

The BT Pension Scheme has offered the option of exchanging inflation linked guarantees for an initially higher level paying pension since April 2009. In a recent report, the scheme confirmed that a quarter of all new retirees forego inflation-linked benefits in exchange for a higher initial but level pension.

That’s only 25% of retiring BT members going for the level pension compared to the 94% of those with personal pensions going for a level pension.

Inflation linked annuities ought to be one of the opt out default options

Why such a difference between the stats above? Better the devil you know? Education? Inertia?

Probably a little bit of all three, but most probably inertia. It’s a big step to “opt-out” of the default.

That’s why “Personal Accounts” due in 2012 have gone down the opt-out route.

That’s why campaigners have asked for the “open market option” rather than securing an annuity with the existing provider to be the default option.

And that’s why I think an inflation-linked annuity from personal pension retirement funds should be one of the default options (it isn’t at the moment), as this is more likely to inform and educate those at retirement on inflation risks that lie ahead. For the last 10 years, inflation hasn’t been a problem. How about the last 20 years? The last 30 or 40 years? How about the next 10 or 20 years?

Not all IFAs know their annuities from their elbow

For sure, to “live now” or “live later” is a big conundrum but perhaps another part of the problem lies with the unqualified adviser. The Annuity Clearing House, a retirement income specialist, recently revealed a potentially terrible lack of knowledge of “at retirement” issues in a study of 275 leading IFAs. Less than half of the IFAs questioned had a thorough knowledge of the annuity market. Just one in three had good knowledge of the increasingly important impaired annuity sector, while just one in eight feel they know enough about investment annuities.

Those of you who have an adviser should ensure their suitability.  When it comes to making decisions over how to take your pension, possibly a one-off event, ask the adviser you are dealing with how qualified they are to deal with your situation. A good adviser, who is not a specialist in options at retirement, will often be able to call on the assistance of a specialist colleague.

Gambling with your pension

I love the BBC. It provides free advertising for the work I do. Not a week goes by without some reference to people not setting aside enough to their pension. It’s a welcome reminder for all and it makes my job easier.

But less time is devoted to the complex area of how to take your accumulated pension pot. It’s a big decision to make on how to maximise or make best out of the pot you’ve got. It’s a critical, possibly one off decision that will affect the rest of your life in a big way, yet the decision has to be made when perhaps you are not feeling your sharpest.

Put simply, you can have an annuity, income drawdown or a scheme pension.

Each have their own attributes and can be tailored to an individuals needs. I’ve already covered impaired annuities here. Lets look at another interesting problem in annuities.

You can either have a level annuity or an escalating annuity, that’s one that goes up with say, inflation. For the last 10 years, inflation hasn’t been a problem. How about the last 20 years? The last 30 or 40 years? How about the next 10 or 20 years? OK, I suspect your thoughts on inflation are changing. Maybe they didn’t need changing.

However, just 6% of annuities taken out are escalating. That means 94% of annuities are vulnerable to inflation (source: Just Retirement).

The problem people face is that a 65 year old male with a pension pot of £100,000 could secure a level pension of £7,200 per annum starting from NOW. If the type of pension selected were to escalate with RPI, the starting income would be a seemingly meagre £4,500 per annum. At lower levels of inflation, it can take many, many years for an escalating pension to break even with a level pension but, should inflation suddenly hit 10% and stay there, it would only take 5 years for annual income to surpass the level pension and a further 5 years for cumulative income to be greater than cumulative income from a level pension.

Life’s questions still remain though. Live now or live later? Will I be alive later? The question deeper than this is can I afford to be alive later?

Suddenly the annuity game becomes a bet.

To hedge your bets however, depending on your situation, you could at the very least consider splitting your pension fund, securing a level annuity with half your fund and an escalating pension with the other. That way, the bets are off and you can grow old slower.