Insuring Against Sequence of Returns Risk with the State Pension

Anybody who is intending to retire (particularly those taking early retirement) without a healthy Defined Benefit Pension or without knowledge of a guaranteed healthy inheritance should be wary of and maybe even have a healthy fear of sequence of returns risk.  It is the risk of receiving a series of investment returns that are negative (or lower) during a period when you are in portfolio/wealth drawdown which then never allows your wealth to recover even when investment returns normalise.

Blackrock have a couple of charts which demonstrate the phenomena nicely.  Firstly, let’s look at Sequence of Returns during the Wealth Accrual Phase (ie before Retirement).  The chart below shows 3 investors who each make an initial investment of $1,000,000 at age 40 and then never invest again.  Each has an average annual return of 7% but each experiences a different sequence of returns.  25 years later each has the same portfolio value even though valuations varied along the way.

Click to enlarge, Sequence of Returns during Wealth Accrual Phase

Now let’s look at Sequence of Returns during the Wealth Drawdown phase.  Again we have our 3 investors making the same initial $1,000,000 investment, the same average annual return of 7% with annual returns following the same sequences as during the Wealth Accrual Phase.  25 years later each have very different portfolio values with Mr White now forced to beg for food under a bridge.

Valuing the UK Equities Market (FTSE 100) - May 2015

My investment strategy requires me to moderate my equity holdings based upon my view of current equity market values.  I run this valuation monthly for the Australian (currently targeting 15.5% of total portfolio value at current valuation vs 17% at fair value), US (as a proxy for my international equities and currently targeting 10.4% vs 15%) and UK (currently targeting 19.0% vs 20%) Equity markets.  Let’s look at the UK Equity market in more detail.

Firstly nominal values.  Between yesterday and the 1st April 2015 (“month on month”) prices are up 3.3% and since the 1st May 2014 (“year on year”) prices are also up 3.3%.

Chart of the FTSE 100 Price, Click to enlarge

Regular readers will know I’m not a fan of this type of chart as:

• the unit of measure, £’s, is being constantly devalued through inflation (although in the current market one wonders for how much longer); plus
• Pricing should be plotted on a logarithmic scale as opposed to a linear one as by using this scale percentage changes in Price appear the same.  

So let’s correct the chart for the devaluation of the £ through inflation (I use the Consumer Price Index (CPI) here) and convert to a log chart.  This normalised chart shows that Friday’s FTSE 100 Price of 7,031 is actually still 25% below the Real high of 9,331 seen in October 2000.  We’re also still 14% below the last Real cycle high of 8,164 seen in June 2007.

Chart of the Real FTSE100 Price, Click to enlarge

Life’s Great Saving Hard and Investing Wisely for Early Retirement

This week as I was thumping up and down the motorway on my lengthy daily commutes I couldn’t help but take some glimpses of the current and potential future life that this journey to Early Financial Independence is providing.  There are of course negatives but the positives really did override my thoughts.  Let me share a few random musings.

Saving Hard

In a post back in March I shared a little about my personal life which included my ‘9 to 5’.  Today is my 397th post on Retirement Investing Today and that post is right up there when it came to Comments at 51 to date.  Some of them pointed to a punishing work life which prompted me to look around at my colleagues and I do agree that I work much harder than most but this is a little by design as I always want to stay in the top 10% of my peer group.  The rub is that what seems a negative to some is now just normal and on autopilot to me plus on the whole my health and wellbeing is as good as it has ever been.  The positive though is that this approach allows things like earnings increases of 44% in a year and I can already see a door potentially opening that may allow another step change in earnings.  So while I admit to being tired come Friday night I also think my colleagues probably are as well.  The difference is that I have an extra chunk of cash which I can save to power me towards Financial Independence Retire Early (FIRE) which means I’ll be done in the not too distant future and they’ll retire when the government lets them.

On the spending front I've also realised that Living Well Below My Means is now just an autopilot activity.  I no longer crave stuff and get zero satisfaction from consumerism.  I do still track spending religiously just in case I need to correct course but I no longer have any sort of budget and certainly don’t have a £0 one.

These two mind sets currently allow me to save 54% of gross earnings.  Sure it’s not at my target of 55% but do you know what – I really am starting to not care anymore.

Click to enlarge, Gross Savings Rate

Investing Wisely

My investment portfolio which is largely just a set of diversified tracker funds is running pretty close to plan through nothing more than passive portfolio rebalancing and to the end of April 2015 has grown by a Real (after inflation) Compound Annual Growth Rate after expenses of 4% since inception.  It’s also now pretty close to being an autopilot activity.

Click to enlarge, Performance of £10,000 within RIT Portfolio and Benchmark vs Inflation

One active element with my investment portfolio is of course my High Yield Portfolio (HYP).  Trailing dividend yield is a healthy 5.0% when compared to the FTSE100 at 3.5%.  Capital Gain since inception is also a healthy 38% vs 31% for the FTSE100.  Over the shorter term it’s not so rosy with Capital Gain year to date at 3.5% vs 6.0% for the FTSE100.  So this non passive piece is not quite on autopilot but the strategy is well defined and I'm still happy with the results.  The question I'm starting to ask myself though is can I really be bothered with it.  I'm going to watch it for a year or two more but if results do start to converge toward the index I may just go passive.

Valuing the Housing of England and Wales at County Level – Year 3

Every year in May I like to spend a few hours of my life that I’ll never get back preparing a house Valuation metric that goes beyond that generally presented by the mainstream media by getting more granular and trying to Value housing at County level.  This should then for example help us to understand if there really is a north south divide when it comes to housing.  Last year’s efforts can be seen here.

My definition of Value is simply how many years of gross earnings (median and average) are required to buy an average house.  This is a simple average Price to Earnings Ratio (P/E) and is not unlike how some might value a company share.  Importantly I am not interested in Affordability which is one’s ability to service debt at current interest rates and is what I think actually drives the UK housing market.  This is because I believe that the average punter doesn’t ask is this house good Value but instead asks how much can I borrow and then spends to that limit.

For House Prices I am using average house prices as published by the Land Registry. This is calculated by using:

• The Land Registry House Price Index (HPI) dataset.  This index uses repeat sales regression (RSR) on houses which have been sold more than once to calculate an increase or decrease.  As it analyses each house and compares the latest buying price to the previous buying price it is by definition mix adjusting its data also.  It uses all residential property transactions made in England and Wales since January 1995 so covers buyers using both cash and mortgages.
• Average prices are then calculated by taking Geometric Mean Prices (as opposed to an arithmetic mean), to reduce the influence of individual values, from April 2000 and adjusting these prices in accordance with the Index changes.  They are seasonally adjusted. I am using the latest published data which comes from March 2015.  

The Valuation analysis is arranged according to the Regions and County’s defined by the Land Registry and is shown in the Table below.  Unlike the mainstream media I am calling high house prices bad (unsurprisingly the County with the highest house price is London at £462,799 and is shown in dark red) and low house prices good (the County with the lowest house price is Middlesbrough at £62,546 and is dark green) with all other prices shaded between red and green depending on house price.

For Earnings I am using the 2014 Annual Survey of Hours and Earnings (ASHE) which provides information about the levels, distribution and make-up of earnings and hours paid for employees within industries, occupations and regions in the UK.  To ensure that our Earners and Homes are located within the same County I’m using the Earnings by Place of Residence by Local Authority.  This dataset presents weekly Earnings at both median (the middle point from each distribution) and mean (the average) levels which we have arranged into each Land Registry Region and County in the Table below.  I then multiply the data by 52 weeks to convert it to an annual salary.  I am calling low earnings bad (the lowest average earnings are £17,638 in Blackpool and are dark red) and high earnings good (the highest average earnings are £36,982 in Windsor and Maidenhead and are dark green) with all other earnings shaded between red and green depending on earnings.

Transferring my Company Pension into a SIPP – Part 2

On Saturday the SIPP of choice for my Company Pension transfer was heading towards Interactive Investor and their annual costs of £176.  Valued reader comments plus some more DYOR has instead led me to Hargreaves Lansdown.  Before you Comment that they are an expensive percentage fee broker/platform with annual charges of 0.45% let’s run through my thinking.

Firstly, dearieme highlighted that provided you stick with Shares, investment trusts, ETFs,
gilts & bonds and don’t add any funds Hargreaves Lansdown become a percentage fee broker/platform but with a capped maximum annual expense of £200.  I can work within that no fund criteria.  So now once your pension is greater than £44,444 that 0.45% starts to reduce.  Transfer £100,000 and it’s down to 0.2%.  On top of that John and Cerridwen also raised some red flags against Interactive Investor.

Secondly, even though the SIPP is now capped I hear you saying that it’s still £24 a year more expensive than Interactive Investor and sweating the small stuff matters.  This is where it gets interesting.  Hargreaves Lansdown currently have a promotion running until the 12 May 2015 that provides a cash back incentive for transfers of Stocks & Shares ISA’s, Cash ISA’s, Junior ISAs/Child Trust Funds (CTFs), Funds, Shares and Pensions.  They also advise that “if you need more time to decide please let us know and we will extend this deadline for you (up to three months for ISA, fund and share transfers, and six months for pensions).”  Transfer big sums and it’s a significant amount.  Between £100,000 and £124,999 and its £250 cash back which means you’re now ahead of Interactive Investor’s current annual charges for 10 years.  Transfer £125,000 or more and its £500 which puts you ahead for 20 years.  Dealing costs for me are going to also be £1.95 more expensive than Interactive Investor but I think I can set the SIPP up with 9 trades which would take a bit under 1 year off that benefit.

I highlighted in Saturday’s post that the reason for not just using my current YouInvest SIPP was the all eggs in one basket risk.  I currently have some of my HYP in a Hargreaves Lansdown Vantage Fund & Share Account and so adding a Hargreaves Lansdown SIPP will increase my exposure with this provider from 6% to 21%.  I’m ok with that level of risk.

So by switching from Interactive Investor to Hargreaves Lansdown I can save some money while also moving to a wrapper that I know and am happy with while keeping provider risk to acceptable levels.

Transferring my Company Pension into a SIPP

About half of my current monthly savings are salary sacrificed into my employers Defined Contribution Pension plan.  I do this over adding directly to my own personal SIPP for a few reasons:

• My employer matches contributions up to a certain level;
• My employer adds the majority of the employers National Insurance that they save into the pension; and
• The 2% employee National Insurance that I would have paid is also able to be added into the pension

Wealth Warning: Before I proceed it’s worth reinforcing that my employer pension plan is a Defined Contribution Pension and not a Defined Benefit Pension.  It also provides absolutely zero additional benefits.  If it was or did either of those things what I describe below may not be the right approach.

These benefits definitely outweigh the high 0.6% to 0.76% expenses I'm then paying for trackers and the lowest cost active funds (where a tracker is not available) within the Pension.  That said if I could find a way to get the money in through salary sacrifice as I do today but then transfer at regular intervals into my SIPP I’d get all the salary sacrifice benefits of the company pension as well as all the low cost benefits of a DIY SIPP.  This effect would be noticeable as I've been with my current employer for a large portion of my Financial Independence Retire Early (FIRE) journey meaning some 15% of my total wealth is now held within the company pension.  I estimate it would reduce my total wealth annual expenses from 0.31% per annum to about 0.25%.  0.06% doesn't sound like much until you run the numbers and realise its £60 per annum if your wealth is £100,000 and £600 per annum on £1 million.

Regular readers will know I've been trying to find a way to do this for some time.  I've tried two different angles:

• Get my employer to open me a new Pension policy with them salary sacrificing into that new account.  The old account would then be dormant allowing a trivial SIPP transfer by simply filling out the short transfer form that is available from any SIPP provider.  Unfortunately my employer wouldn't budge here as it was just too much “admin”.
• Ascertain from the insurance company who provides the Defined Contribution pension if and how this can be done.  They obviously have a vested interest in being as slow and obstructive here as possible.

I am however pleased to announce that many emails, phone calls and a lot of time later I have achieved success.  In case any readers are trying to do something similar the form I needed is what is called a Declaration of Claim Discharge which is a simple 2 page form which importantly includes a section called a Partial Transfer Request which enables me to check a box entitled “If you wish to move the ‘maximum amount’, please tick the box opposite”.  All I have to do is complete this form and then attach it to the SIPP transfer form from my chosen SIPP provider and I'm away.