I wrote this blog hours before the budget which abolished annuities. For some reason I decided this morning, to write about investment as if annuities didn't exist. From 2015, for new pensioners- they will no longer be the default, indeed they are unlikely to figure much in most people's thinking. Either this was a bizarre coincidence or I am a genius. I suspect the former.
My thanks to Alan Higham for lifting some scales from my eyes (and not for the first time). At a TPNW event last week he spoke in his new guise as at retirement guru for Fidelity about funds. He made a simple but very effective point. Smoothing the investment return is important for funded pensions but not while you are building up pension savings, it’s good when you’re drawing them down.
I’ll try and explain.
When you are saving for retirement you can’t draw on those savings, the Government won’t let you – the money’s for your later life. So while the money is building up , it can be going up and down with the markets and you can let your pension provider take the strain. Plus you are feeding in money every pay period which evens things out (some months you buy expensive markets, some months cheap- it’s called pounds cost averaging and it’s another reason not to worry about rises and falls in stocks and shares.
Don’t worry about the ups and downs of the market when you’re saving
But when you are drawing your retirement income (aka pension) it works the other way round, you drawdown cash when the market’s low and you really hurt your finances, they may not recover with the next rise- you may have done irredeemable damage.
Now I suppose that Alan has got some relative up north about whom he can illustrate this better, but the image that comes to my mind is one of those TV chefs you watch when hung-over on a Saturday morning- James Martin and his gang. When they’re making sauces they always get you to stir in the ingredients gradually so the sauce is smooth and properly mixed. What you don’t want to do is lob in half a pound of butter or the whole packet of flour at one go- everything goes lumpy and you’re in food hell.
So with pension saving, steadily pouring in the money works best, wanging in a big wedge from time to time doesn’t.
Steady pouring over time makes for good sauces and good pensions
My comparison works too when it comes to consumption, the consumption phase of a pension is of course when you spend the money. Completely different conditions apply with money as they do in the kitchen. You’re not going to want to eat your hollandaise sauce out of the mixing bowl , piping hot and with those whizzy steal beaters in your face, you want the dish served up regular and predictably.
The same with money, you want predictable income in retirement with no nasty surprises. Which doesn’t mean being served a cold KFC and a can of flat coke (which is my culinary analogy for an annuity), you do want some decent nosh at the end of it all, which is why most sane (rich) people go for a drawdown of their money.
You may have noticed the Morecambe and Wise-ish, reference in the title of this blog and be wondering when I’m coming on to the Andre Previn bit. Well here I’m back to Alan’s point, modern fund theory , new technology and access to new asset classes means that the common man (or woman) can now access a properly diversified fund which provides “equity type returns without the volatility” or to return to food- night after night of reasonably priced suppers.
You need diversity for regular income and regularly good suppers!
These diversified funds work because they depend for their return on a range of differing types of investment which can be organised so that even when some markets are bad, the fund can be supported by returns for the markets that are good. This is know as the principle of uncorrelated returns and it delivers something like a “free lunch” as in “diversification is the only free lunch”.
Now I know that most people are suspicious of free lunches and trust in the maxim “if it looks too good to be true- it probably is” but there really is something in this diversification business – it really does produce smoothed growth and though you lose some of that growth because you have to pay a lot to the fund managers, it’s still a good deal – when you’re in the consumption phase.
You don’t need to pay through the nose for regular income (or suppers)
But, and this is where the Andre Previn bit finally arrives, paying for this smoothed approach when you are building up money is a waste of time #WOT! It suits fund managers for you to pay them to smooth your returns but the costs of the smoothing are substantial and you don’t need it! Which is why I don’t support the use of expensive DGFs in the savings phase of a pension plan.
If however, you can get diversification and the extra cost is insignificant and the returns are not diminished by investing in rubbish then I am happy with what you could call “diversification-lite” which is what you get from many of the workplace pension providers these days ~(think L&G, Aviva, Standard Life, NEST, NOW). But that doesn’t mean that the more volatile approach of investing purely in equities is a bad thing- (what happens in the defaults of many other workplace pensions). Where I draw the line is when the fund costs for diversification are five or six times the costs for non-diversification which is like using Chateau Petrus in your Bouef Bourgignon.
But don’t waste Chateau Petrus on the Beef Stew
These diversified growth fund (DGF) are all the right funds- but they are being used in the wrong order. Fund managers should be using them to help people draw down and avoid using annuities. If you have £100k + in your DC pot, you can probably use a DGF and enjoy regular quality meals in retirement without ending up eating gruel in the poor-house. The same should go for those who have £75k and 350k and even £25k – but that means smarter products that use economies of scale- and that’s a subject for another day.
This post first appeared in www.pensionplaypen.com