an imaginary strategy

I wrote previously that I think that the best way to choose a pension is to decide on a strategy and work out the cheapest way to buy it. I'm going to have a go with my imaginary friend Clive. Clive has decided that his asset allocation strategy for his pension portfolio is as follows:

• 60% in a UK Index Tracker fund
• 10% in a US Index Tracker fund
• 10% in a European Index Tracker fund
• 5% in an emerging markets fund
• 15% in UK gilt fund

Since Clive is imaginary, please do not think that this is a good strategy for any real person. This post is about how to get a strategy cheaply, not what strategy you should pursue.

Clive can contribute £80 per month (before tax) to this pension. Lets look at three different providers, Hargreaves Landsdown and their SIPP, Standard Life and their Personal Pension and Friends Provident and their Stakeholder Pension. In each case, I couldn't find any set up or administration charges associated with the pension, so the only charges appear to be the fund management charges. Each of the pensions has a minimum payment with the highest being £50 per month after tax.

The table above gives the weighted charges, assuming that all funds grow equally. You can see that for this strategy, the Hargreaves Landsdown pension is the cheapest.

pensions are actually invested in equities

I've just been reading a Wealth Check in the Independent. Its one of those things where they take someone's current financial position and three or four experts offer their advice.

I'm so annoyed at the final piece of advice that they've given the woman, on her retirement and pensions. All the experts quite rightly say that this 23 year old should start saving for her retirement immediately. They correctly say that she should see if her employer offers a scheme and if not, to consider a stakeholder scheme. All well and good. However the final piece of advice given by Danny Cox of Hargreaves Landsdown is:

To boost her retirement fund and increase her chances of earning more money than expected, she should consider investing in equity-based funds. Although there is risk entailed, Cox advises that Katherine will benefit in the long run if there is a downturn in the market, if she has her money in equity rather than stakeholder savings.

This is a completely misleading statement.

It implies that in general payments into a stakeholder will be into a sort of savings account. This is pretty much never the case. The value of a stakeholder pension may go down as well as up, but over the 40 years this woman has, it is pretty sure to be up. Basically, the money in a stakeholder pension is normally held in equities (at least in part) and in particular, it often held in an equity-based fund.

I think what the expert was actually trying to suggest was that she hold some of her money in actively managed equity funds that hedge against a stockmarket fall. I have issues with whether or not that is good advice, but in this article, that isn't what is stated anyway.

The reader is left with the impression that money in a stakeholder pension is not in equities and that it is in "savings" (with the guarantee that implies). This is so not true of stakeholder pensions in general, its ridiculous and the suggestion that there is a reasonable likelihood that over the next 40 years the stockmarket will be lower than it is now is not even being given the short shrift it deserves :(

pensions allsorts

In the UK, there are several different types of pensions, split into two groups:

occupational pensions

• defined benefit = final salary
• defined contribution = money purchase

private pensions

• personal pensions
• stakeholder pensions
• self-invested personal pensions

Occupational pensions are run on behalf of the employer, often by an insurance company such as Standard Life. You can generally contribute via salary sacrifice and often the employer contributes too. If your employer has more than a certain number of employees, they must either offer access to an occupational pension scheme, group personal pension scheme or to a stakeholder scheme, although they do not have to contribute. The two types of occupational pension available are defined benefit and defined contribution.

A defined benefit or final salary scheme is one in which the pension (benefit) is defined in advance as a percentage of the final salary. The percentage you can get will depend on how long you have been working at the company and is roughly positioned so that if you worked at the same company for your entire career you would receive a pension of approximately two-thirds of your final salary. This pension is paid for by investing your contributions sacrificed from your salary and generally the employer contributes also. With this type of scheme, the trustees of the scheme will choose how to invest the money they have so that there will be enough to pay out all the retirement benefits of the scheme to all members. The biggest risk that you face is that the scheme will be wound down or the company go bankrupt (potentially due to pension liabilities). Defined benefit schemes have become much rarer of late.

All other pension schemes work similarly. You contribute an amount of money every month which is then invested. In return for investing before income tax, you agree not to take the money out until retirement (due to rise to 55), there are further rules about how you may withdraw the money at that point. You are responsible for choosing the investments so that you will have a sufficiently large pot of money to live off once you are retired. These underlying investments are the important part of the pension and the bit that generates the money, everything else is just a set of rules.

Occupational defined contribution or money purchase schemes have the added benefits that often the employer will contribute to your pension pot in addition to your own contributions. Also as all the employees in the company are invested through the same scheme, discounts can often be negotiated on the investment fees. The main drawback is the limited number of different types of investment that the money can be placed into.

Personal pensions work in exactly the same way as money purchase pensions do in terms of risk. The main advantage of a personal pension is that it is not linked to any one employer and can be taken out by anyone. The disadvantages are that the charges can be high as an individual pension pot is not usually large enough for discounts to be negotiated, there are also often restrictions on the minimum amount of money that may be invested each month and the variety of investments available varies considerably depending upon the provider.

Stakeholder pensions are like personal pensions with the added benefits that the fees are capped at 1% per annum, the lowest payment that must be made monthly is £20. The drawbacks are that range of investments available is generally small and that the fees are usually set at the maximum 1% despite the underlying investments being available with much lower fees (often 0.1% to 0.5%).

Self-invested personal pensions or SIPPs are like personal pensions, but with the added benefit of having a very much wider range of investments available. In particular it is possible to invest in almost any unit trust, exchange traded fund, investment company, bonds, individual shares and cash*. They may have higher fees especially if they allow investment in the more esoteric options, but that is not always the case, many SIPPs are run by discount funds supermarkets have very reasonable fees similar to those found in stakeholders, although they usually have stricter rules on the amounts of money that may be transferred into the pension.

I think that the best way of investing through pensions is to determine what your overall investment strategy is, taking into account the amount of risk you are comfortable with and the length of time you have until retirement, and then working out the cheapest way of getting there, taking into account all your own circumstances.

*It is almost always a poor idea to invest a pension fund in cash.

misunderstanding pensions

I’m an avid reader of money makeovers and discussions individual personal finances and I’m struck by how often people say that they don’t trust pensions. I realise that this is affected strongly by the private pensions mis-selling scandal and the collapse of Equitable Life. And it’s certainly true that lots of pension funds have been adversely affected by the bursting of the dot-com bubble. But, I’m starting to think that lots of British people don’t realise what pensions are.

As far as I can see, pensions are just a tax wrapper. The wrapper is just a set of rules that allow you to get tax breaks. The underlying investment is what you should be relying on to make you money. It wouldn’t surprise me if many of the people who had money-purchase pensions in 2000, didn’t realise that some or all of their money had been invested in the stock market. And if they didn’t realise where their money was, they probably wouldn’t connect the bubble bursting with their loss of pension funds.

A pension isn’t something to be mistrusted; it’s just a set of rules. Your best weapon in preventing mis-selling is to educate yourself. If you want to mistrust something, then it should be the underlying investment. If you truly believe that shares are on average going to do worse than savings accounts in the next twenty to thirty years, then you can put a pension wrapper on a cash savings account.

switching from stakeholder pension to sipp

As I wrote earlier, I have been considering transferring my stakeholder pension to a self-invested personal pension (SIPP).

My basic investing philosophy at the moment is to put all my equity investments in index tracking funds, so currently I have a stakeholder pension invested entirely in a fund tracking the FTSE All Share index. The whole thing has a management charge of 1%, in common with most stakeholder pensions. The minimum regular payment is £1 per month and the minimum lump sum investment is £100.

The SIPP I am considering switching to is offered by Hargreaves Landsdown. Here I would invest in a different fund tracking the FTSE All Share index. This fund has a management charge of 0.25%, the SIPP itself has no fees associated with it and is touted by money saving expert as the cheapest SIPP on the market (unsurprisingly, as its basically free). The minimum regular payment is £50 per month and the minimum lump sum investment is £1000.

After a little discussion and thought, I decided that there wasn’t a good reason to stick with my stakeholder pension so I sent off for the application form. However, on reading the small print, it would appear that to transfer my stakeholder pension into the new SIPP it needs to have a balance of £5,000. I estimate that it currently has a balance of £3,800.

This leaves me with two choices.

1. Continue paying into stakeholder and transfer when it reaches a balance of £5,000
2. Start the new SIPP, leave the stakeholder where it is and transfer when the stakeholder grows to £5000

To decide which is the better option I got out my trusty spreadsheet tool and did some calculations. I know the amount that I am able to contribute each month to a pension so I used that together with an annual rate of return to calculate which would give me the better result. I assumed that the rate of return would be constant for simplicity and used the following formula to (iteratively) estimate the monthly balance of the pensions.

=(prev month balance + payment)*(1+growth)^(1/12)*(1-charge)^(1/12)

This showed that initially, I would be better off if I started the SIPP straight away. However, continuing with the stakeholder and switching once it reaches £5,000 would make me better off within a couple of months of reaching £5,000 and the difference increased as time went on.

I tried varying the rate of return rate and found that if I set the rate of return higher, there was less of a difference, but with a negative rate of return, the difference was exacerbated (and obviously it would take forever to get enough in the stakeholder to tranfer it).

Taking a leaf out of JLP’s blog to act on the maths, I’ve decided to stick with the stakeholder pension until it reaches £5,000 and then switch. Fortunately if the stock market grows overall, that should take me less than a year and even if there is a net decline, I’ll still be over the £5,000 barrier within two years.