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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.
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.
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.
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.
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.
A recent pensions report by KPMG calculates that FTSE 100 firms are now paying as much into their schemes to pay off past deficits as they are paying in contributions for current employees.
It gets worse. Rather than the traditional model of spending twice as much on new benefits for existing employees than on pension fund deficits, Mike Smedley, pensions partner at KPMG, predicts that that within five years, £4 out of every £5 being paid in would be to clear past deficits.
I’ve covered all the problems of final salary pensions before, most notably in this blog.
Another thing that I would like to add now is that if you are considering leaving an employer and you are a member of it’s final salary scheme, you would be missing out on an employer contribution of around 20% of your pay (before bridging the deficit) if not more depending on the terms of the final salary scheme. This is especially the case in the public sector where the keep or ditch the final salary pension debate does not seem to take place. In fact, public sector pensions are “unfunded” – that’s pension income paid by today’s tax payer rather than money that has been set aside. So if you do leave this type of employer, make sure you consider how you are going to replace contributions to your retirement.
The crazy world of Premiership football appears capable of seeing through this recession with even more spending (a ’solution’ now synonymous with the government). Millions of pounds have once again been swirled around in the pre-season and now the season is here, the landscape would appear to have changed somewhat.
Traditonally, much of the spending on both transfer fees and wages has been met by the revenue from sponsorship, TV package deals and Champions League football. With this revenue already beginning to dry up regardless of performance on the pitch (R.I.P. AIG, Setanta money), the dependence of this revenue to pay for huge loans new owners have incurred in order to buy/expand clubs has become ever more paramount. Like any business, when revenue drops, overheads still have to be met.
If we are to believe that banks will be repairing balance sheets for years to come, then Champions League football is a must for all clubs with big loans. We’re talking the likes of Manchester United and Liverpool here, heavily debt backed clubs who seem to negotiating with their banks on a regular basis. But there’s only room for up to 4 clubs in Champions League football. Chelsea and Arsenal have been the other regular attendees to the party. They’re not without financial problems too.
In the last couple of seasons more money has come into the Premiership. The likes of Manchester City are backed by hard cash and Aston Villa have sugar daddies too. Suddenly we have more genuine candidates vying for the top four places. The fight for the four places is beginning to turn into less of a monopoly after all. For not all the high spending clubs can get in the top four. Clubs backed by cash or sound strategies are bad news for clubs backed by debt. With budgets dependent on maximum incomes that one day won’t come, a premiership football team will go bust.
Alistair Darling said on BBC1’s Andrew Marr show that “we did not stabilise the banking system out of some charitable act”. Well, as the lender of last resort, the act was charitable as the banking system would otherwise have collapsed. However, the banks are certainly not charitable. They get lost in their own momentum of greed, chasing markets up and down, as do investors.
As Hyman Minksy wrote “from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes, the economic system’s reactions to a movement of the economy amplify the movement – inflation feeds upon inflation and debt deflation feeds upon debt deflation.” (Minsky, Hyman P., “The Financial Instability Hypothesis” (May 1992)).
Minksy advocate Paul McCulley points out “People are momentum investors by nature, not value investors. People naturally take actions that expand the apex and nadir of cycles. ” (“The Shadow Banking System and Hyman Minksy’s Economic Journey”, PIMCO, May 2009). He goes on to say ”One implication for policymakers and regulators is the implementation of counter-cyclical policies, such as contingent capital requirements for banks that increase during boom periods and are reduced during busts.”
However, Angela Knight, chief executive of the British Banker’s Association has blamed the opposite occurring with a lack of capacity in the wholesale market for pushing up bank costs and said the need to “hold twice as much capital as before the recession” was holding back lending (Independent on Sunday, 9th July 2009). Only full nationalisation would be able to counter this. Look at how well Northern Rock is doing.
Having sufficient reserves going into a recession is not just a regulatory requirement, it is also common business sense. It’s just that we’ve had the biggest financial crisis that busted balance sheets preceding it. Now we have a recession to fight. That brings further defaults home to roost and the need for sufficient reserves, on top of the need to repair balance sheets.
Minsky broke the whole process down to the “Hedge Borrower”, “Speculative Borrower” and the true “Ponzi Borrower”. In this recent debt crisis, Paul McCulley referred to these borrowers as capital and interest repayment borrowers, interest only borrowers and finally ponzi borrowers with loans not meeting the repayment and solely reliant on further house price increases. Since the Minksy moment in August 2007, where the ponzi borrowers could no longer rely on house price increases, these three units of debt are pulling back to leave the traditional repayment loan borrower, leaving casualties in it’s wake. And it is these that the reserves are covering.
Alistair Darling’s fighting intervention is just political sound biting. In the private sector, the momentum of the borrowers to reduce debt and for the banker to increase reserves is a natural momentum difficult to reverse without seeing it through from beginning to end. We hear of the successful entrepreneur being refused money and it’s an undeserved slap in the face for some. However, because you’ve been successful in the past, does not mean you will be successful in the future. Many entrepreneurs have made it to be very rich indeed but not without defaulting on their debts in the past. When the majority are de-risking (individuals, businesses and banks), why lend to those taking on risks? Not all will make it, leaving a massive and costly “silent cemetery” as Nassim Nicholas Taleb would call it (The Black Swan, 2007). When banks want to reduce their risk appetite, they let you know loud and clear. When they want you to borrow, they do the same.
Charities always face a tough time with falling revenues in any recession. As purses tighten whilst we busily pay down our debt in this particular balance sheet recession, not a week goes by without reference to a bleak outlook for charities. Even the second richest human on earth Warren Buffett reduced his donation to the Bill & Melinda Gates Foundation by 30%, down from $1.8 billion last year to $1.25 billion this year.
Yet the more difficult times are, the more important donations are. The Bill & Melinda Gates Foundation will see through a recession. Other charities won’t. St Peter’s Hospice in Bristol recently said it was closing. The recession has left the cancer charity about £500,000 short of the £5.5 million annual running costs.
At the very least, it’s therefore worth reminding ourselves of the tax relief available when contributing to a charity so that we can pass on what we can.
If you are a tax payer, always remember to tick the gift aid box. This will ensure that for every £1 you contribute, an additional 28p is added by the government. 25p represents basic rate tax relief of 20% and the additional 3p is a transitional relief available until April 2011. For higher rate tax payers, an additional 20% tax or 23p for every £1 can be reclaimed by completing a tax return (so maybe contribute more if you could?). For the very higher earners caught out by the new pension tax relief rules on those earning over £150,000, consideration should be given to making a contribution that brings earnings down to below £150,000 thereby enabling the tax payer to enjoy 40% tax relief on their pension contributions.
Charity may begin at home, but taking the time out now to make sure the right boxes are ticked can make a big difference all round.
In case you didn’t know, the world of financial services is going through a major change over the next few years as the Retail Distribution Review (RDR) does away with commissions and imposes higher educational standards on advisers. For many IFA’s, the RDR represents yet another bureaucratic headache getting in the way of the everyday business of helping their clients. However, here are three reasons why even the most resistant adviser should welcome the enforced changes to adviser knowledge and commission.
The growth of Financial DIY
Compeer’s March 2009 Financial DIY report suggests that for those resistant to change, the RDR is a blessing in disguise.
Some of Compeer’s findings include:
- 29% of adults believe their knowledge is as good as financial advisers’ – uniformly spread across age and socio-economic groups
- 28% of adults believe advice is just disguised sales of investment products – A&Bs (39%) and 40-49 year olds (34%).
- 26% of adults believe financial advisors add insufficient value to justify their fees (A&Bs 38%)
It’s about time therefore that IFA’s upped their game for their own sake.
They also found that:
- Overall use of IFAs fell in 2008 – 7% fewer respondents regard a commission based IFA as their main financial advisor compared to 12 months earlier.
- 6% of adults cite a fee based IFA as their main financial advisor, up 33% on the previous year.
- A growing proportion of people (67%) taking professional advice now seem to have accepted a fee based model.
And when you take into account the trend from 2003 onwards the picture doesn’t get any better:
- 44% of adults view the internet as an essential source of financial information and advice.
- 42% of A&Bs unadvised in 2008 (26% in 2003) and 44% of C1s (27% in 2003).
- Of those with over £1m of liquid assets, 61% make all or most of their investment decisions with professional advice.
The growth of financial DIY is powerful. Nails are already being hammered into the coffin of the traditional IFA.
Life insurers are going bust
There’s the other small issue that life insurers are going bust. Life insurers often report rosey results on a European Embedded Value basis to satisfy the markets. However, these results include future premium income on policies sold but not yet collected. With less than half of policies in force after five years, the International Financial Reporting Standards measure which does not include future income but includes investment losses have been showing unsustainable losses for some time. Up front commissions funded by the illusion of long term contracts are therefore unsustainable.
The loss of indemnified commissions under the RDR is therefore insignificant. They were already on the way out.
Bear markets badly expose the transactional, commission based adviser
Traditional commission based advisers often sell themselves on their ability to pick funds, find the best product – little more than a personal shopper in some ways. When the focus is on the transaction rather than the long term plan, the indemnified commission based adviser’s credibility and business model tends to sink as fast as their client’s funds. By focusing on working with clients on their plans and charging explicitly for the life enhancing work, advisers’ business models are far more sustainable.
Be thankful for the RDR. For the transactional IFA, it was a wake up call. For those financial planners already prepared, the industry is better for it.
