In Focus: Winter 2020

Hello and welcome to the last In Focus of 2020 – and my first one!

In Focus

Your quarterly financial planning newsletter • Winter 2020

Welcome

Find out what's in this issue

Welcome

Hello and welcome to the last In Focus of 2020 – and my first one!

I’ve joined the Punter Southall Aspire team as the next step in a career dedicated to making sure financial planning really gets to the heart of what you need.

To help you shape your priorities, our winter edition features research and tips, such as running the rule over your pension as the year comes to a close (a good time to do it).

“Pound-cost averaging” isn’t a phrase that trips off the tongue but is the official term for what is essentially: don’t put all your eggs in one basket. Here, we offer some helpful points on what it means in practice.

We also include a guide on how to avoid dysfunctional financial planning, together with a clear explanation of something you may have heard about – the four per cent pension rule – but not necessarily looked at too closely. Do spare a few minutes, if you can.

I hope you have a peaceful, restful break and that next year gives everyone much to look forward to.

Bryan Parkinson

Managing Director, Financial Planning
b.parkinson@psaspire.com

The essential pensions end of year guide
Pound cost averaging to avoid short-term volatility
How to avoid a disjointed financial plan
Is it time to update the 4% rule?

The essential pensions end of year guide

As we head into 2021, it's the opportune time to consider your investments for the year ahead

The essential pensions end of year guide

Key tips for reviewing your pension investments for 2021

The end of the tax year arrives every April. Many people use this time as a nudge to review their finances (see our previous issue for more info).

Yet the end of the calendar year can also be another helpful time in which to take stock and review your pension strategy, ensuring that you’re on track towards your goals.

The quieter moments over the Christmas break are often an opportune time to consider the year ahead and give your pension investments a stronger chance of performing well, whilst mitigating unnecessary fees and taxes.

We'll cover:

Reviewing allowances
Reviewing fees & taxes
Reviewing performance

Reviewing allowances

Over recent past decades the rules surrounding how much you can put into your pension have become more complicated.

First of all, the lifetime allowance in 2020-21 is £1,073,100 - which represents the maximum you can save into your pension pot(s). As such, one crucial aspect of your pension strategy to review is whether your nest egg is set to exceed this limit - or remain comfortably within it. If you withdraw any amount from your pension over this threshold as an income, you are set to attract a 25% tax charge - or 55% if taken as a lump sum.

This problem is still faced in 2020 by many professions such as senior doctors, so it helps to review regularly ahead of your retirement to make sure you don’t fall into costly traps later with your pension.

Secondly, your annual allowance gives you the right to save up to £40,000 per year into your pension(s) - or up to 100% of your earnings (whichever is lower). The opportunity this presents cannot be overstated due to the tax relief on offer for pension contributions. In 2020-21, this stands at 20% relief for Basic Rate taxpayers and 40% for those on the Higher Rate. As an example, imagine you earn £60,000 per year and decide to put £8,000 into your pension in the 2020-21 tax year.

Instead of 40% going to the government as income tax (i.e. £3,200), this goes straight towards your future - providing a welcome boost to your retirement fund. Another way to look at this is a 40% return on investment, which hugely surpasses most stock and bond assets.

Bear in mind, however, that unused allowances can only be claimed up to the past three tax years. After that, the opportunity is gone to make use of it for your future. As such, consider taking a moment over Christmas to ask yourself whether you have made full use of this great allowance currently on offer to you.

The lifetime allowance in 2020-21 is £1,073,100 - the maximum you can save into your pension pot(s)

Reviewing fees & taxes

Your pension is not taxed as you save into it.

Once you start using it for income, however, it’s subject to income tax (e.g. 20% on income between £12,501 and £50,000). Here, if you want to keep taxes low in retirement, then naturally you will pay less if you choose to keep your income lower. Yet it’s important to have enough coming in each month to live comfortably. One area where you might be able to exert more control now over pension costs eating into your returns is the management fee on your investments.

It costs money to invest your cash, since this typically goes into funds (e.g. of stocks and/or bonds) which are managed by companies. Yet the amount you pay for each fund does vary depending on the particular fund, whether it is actively managed and the company in question. Here, it might be possible to improve your returns by avoiding funds which charge a high fee - but don’t show value by offering better performance.

If you are contributing to a workplace pension, then your options might be more limited since the scheme likely has “preset” portfolios where the funds are picked for you. However, you can still choose which of the funds within these portfolios you are invested into to try and increase your returns and offset the charges (depending on your appetite for risk).

It should also be noted that there might be better opportunities elsewhere - perhaps through a private pension where you have even more control over your selection of investments.*

Again, Christmas can be an opportune time to do a bit of research into the fees you’re paying so you can speak with your financial adviser in the New Year.

Reviewing performance

As mentioned previously, it’s not only important to review the costs you pay on your pension but also how the investments are performing

Of course, here you need to be careful. Due to the pandemic in 2020, many stock market indices and tracker funds have taken a hit and are slowly recovering. It’s important not to simply discard a fund from your portfolio because it has had a “bad year”. Yet, equally, be wary of assuming that any fund with a strong record in recent years is destined to do well in 2021. Remember, past performance is no guarantee of future returns.

This is where a financial adviser can be very helpful. Rather than focusing solely on different funds’ past performance, for instance, s/he can look more carefully at their fundamentals in light of current macroeconomic trends. For instance, perhaps after looking at your portfolio the adviser recommends a slight rebalancing so that unnecessary risks are mitigated, and other opportunities are tapped into. A common example here is the “home bias” of many UK pension funds, which are often excessively invested in UK equities despite the UK only making up 5.1% of global market capitalisation.

Perhaps by diversifying into other markets - such as the USA, which holds 54.5% of the global share - your pension’s portfolio could benefit from gaining access to new sectors, industries and opportunities from which it was previously underexposed (although it should be noted that this would not guarantee better performance and the value of your assets could still fall).

*Please note this is not intended as individual advice as circumstances will vary. You should always seek professional advice. The value of your investment can go down as well as up, and you can get back less than you originally invested.

Pound cost averaging to avoid short term volatility

How to mitigate risk whilst still engaging with higher potential returns

Pound cost averaging to avoid short term volatility

Mitigate risk whilst still engaging with higher potential returns

In an ideal world, an investor would be able to commit money to a very “safe” asset (e.g. cash) and see annual, near-guaranteed returns of 8% or more.

Sadly, that world does not exist and so investors are faced with a trade-off between risk and return.

To try and attain more of the latter, one must take on a greater likelihood of his or her investment falling.

Yet to stay in the sheltered harbour of lower risk means missing out on opportunities from which you might otherwise have gained. In worst-case scenarios, investing in a low-risk asset might even lead to making a loss after fees and inflation if you’re not careful.

Fortunately, there are at least two ways for investors to mitigate risk whilst engaging with higher potential returns.

Two options

Firstly, you can diversify; spreading your capital both within and across asset types to avoid a disproportionate loss should any of them underperform or even fail.

Secondly, you can consider spreading out the timing of your investments. This approach is known in the UK as “pound cost averaging”.

Here, we take a closer look at whether this approach is, indeed, a good way to mitigate short term market volatility, or if it hinders the long-term growth of your portfolio.

The big question - when to invest?

After the 2008-09 Financial Crisis, global stock markets witnessed a near 11-year “bull market” where indices such as the FTSE 100, S&P 500 and NASDAQ moved upwards in value (despite short term dips). Of course, with the onset of COVID-19 at the beginning of the year, 2020 saw these markets decline rapidly in a huge “crash” - bringing many investor portfolios down in value with them.

Yet within this 11-year period, many investors faced a conundrum: Should I invest as the market seems to be rising? What if I invest at the peak and suddenly there is a huge crash? Or, what if I delay my investment and miss out on growth opportunity in the meantime?

This agonising decision is brought into particular focus when you’re lucky enough to receive a large windfall - perhaps from a surge in your business’s profits, or unexpected inheritance. For instance, suppose you suddenly happen across £50,000. Should you invest it as a single lump sum into the markets? Is now the best time to invest, or would it be better to wait in an attempt to try and “time the markets” (i.e. invest when they are low and just about to rise again)?

Imagine you invested all of this money into the aforementioned three indices in January 2020 - just before the “COVID crash”. Had you then pulled all £50,000 out of the markets just two months later - when the FTSE 100, for example, had plunged 25% since the start of the year - then you might conceivably have crystallised a loss of £12,500.

However, suppose instead that you had invested all of the money in March and kept it invested until the time of writing (20th November 2020). Your £50,000 might now have risen by as much as 20% - i.e. £10,000 - as the index rose from 4,993.89 to 6,351.

The problem, of course, is that nobody could have predicted the market events that took place in 2020 in relation to COVID-19. As such, how could you know when to commit a lump sum like this? After all, even the best investors do not have a crystal ball.

How pound cost averaging helps

Fortunately, there is a way to mitigate this investment risk.

Pound cost averaging involves “drip feeding” your capital into the markets over time, buying shares and other assets at whatever price they stand at the time of the investment.. This is a natural way to invest for those with no lump sum to commit, but it can also be a powerful approach for those with such a sum. It likely means that your gains will be slower or perhaps more modest, but the risks or angst involved with lump sum investing are typically greatly lowered.

Let’s consider the £50,000 example once more. Instead of investing it all in one go, you choose to instead commit £3,000 each month over 2020 and into 2021. In this scenario, by the time March comes along and the markets crash, only £6,000 has been invested and thus exposed to the volatility. The rest is safely held elsewhere (e.g. in cash). In March and April, however, you also invest £3,000 each time - buying stocks “on the cheap”. As the markets steadily climb back up during the following months, the losses on your first £6,000 investment start to recover. At the same time, the investments you made during the rally rise in value - growing the value of your portfolio.

At the same time, the investments you made during the rally rise in value - growing the value of your portfolio. Of course, pound cost averaging is not without its critics. Perhaps the most powerful is that it presents an “opportunity loss”, since the investor is holding capital in cash (which holds out poor returns) until he /she drip feeds more of it into the markets. For long term investors, this could hold back your returns when considered through a 20, 30 or 40-year window. Here, however, it is important to bear a number of factors in mind. First of all, can you afford to lose any of your lump sum?

Although you don’t strictly “lose” your stock market investments until you sell them at a lower price compared to the initial purchase, you should consider not moving capital out of cash if you have good reason to possibly require it urgently at any point (e.g. for an emergency expense). Secondly, think honestly about your appetite for investment risk. It may be true that in certain circumstances a lump sum could outperform pound cost averaging in the long term. Yet many people will be uncomfortable with investing large sums of money all at once into riskier assets.

Please note this is not intended as individual advice as circumstances will vary. You should always seek professional advice. The value of your investment can go down as well as up, and you can get back less than you originally invested.

How to avoid a disjointed financial plan

The benefits of a holistic strategy

How to avoid a disjointed financial plan

When your finances are aligned under one holistic plan, you benefit from a more strategic overview which also incorporates key life events

Many people might come to a financial adviser to solve a specific financial problem, but don’t take the extra step of integrating the solution into a wider financial plan.

For instance, perhaps you approach a professional for help with life insurance after taking out a mortgage.

Or you might seek financial advice following the birth of your first child. However, the matter of your pension, investments and estate plan are set to the side for now.

After all, those all feel far away into the future...

Exploring the benefits of a holistic financial plan

A holistic financial plan knits together the various strands of your wealth and finances
It aligns your different priorities under one common goal
It avoids the pitfalls that come with addressing financial issues reactively, or in isolation from one another

...yet there are great benefits to creating a “holistic” financial plan.

It brings together all of the various strands of your wealth and finances to pursue a common goal - avoiding the waste that comes from disjointedness.

A lifetime plan

A “holistic” financial plan is a process that maps out all the aspects of your likely financial future - outlining important milestones and life events such as getting married, having children, paying off your mortgage, retiring and more.

Rather than addressing each issue reactively, as they come (by which point a lot of saving potential might be lost), a holistic approach allows you to lay out a road map which unites each one towards your financial goals - both short and long term.

Of course, no one can predict the future and it’s possible that many of these “milestones” may not happen to you (e.g. owning your own home or getting married).

Yet a lifetime plan still holds great value by also enabling you to pursue viable, desirable “backup plans” if your original plan doesn’t happen.

For instance, perhaps you hope to have children one day, so, in your 20s and 30s, you start building a separate savings pot for this (e.g. to help with future university fees or a house deposit when they are older).

However, if you never end up having children, then the plan wasn’t a waste. You still have a pot of investments to commit to something else you care about, such as setting up your own business or retraining for a new field of work.

"Single-tasking"

The danger of not engaging in this kind of long-term, holistic financial planning is that it can lead you into problems later. After all, focusing on financial decisions one at a time, in isolation, can lead to a failure to consider how each decision might affect the others.

An example

For instance, suppose you are now in your 40s and one of your goals is to retire at 55 (or 57, from 2028) and travel the world with your significant other. What if you are currently in a final salary pension scheme which could make this difficult to achieve?

One option might be to build up a separate private pension pot (e.g a SIPP) with more flexibility. But how might this affect your other hopes and goals - such as your ability to make overpayments on your mortgage (in order to pay it off early). Or, if you’re looking at things from the other side, how might your goal to repay your mortgage early affect your retirement plans?

Disjointed financial planning & waste

You also need to think about the tax planning implications of these decisions - both short and longer term.

An example

For instance, in 2020-21 the Higher Rate on income tax in England is 40% on earnings between £50,001 to £150,000 (assuming you have the full £12,500 personal allowance).*

So, suppose your salary is £90,000 and you have two goals - repaying your mortgage early and retiring one day at 55 (or 57, as noted above). How do you decide how much to commit towards each goal? Without considering how taxes feature in the matter, you potentially stand to waste money which may otherwise have moved you closer towards your goals.

Bear in mind the current rules about tax relief on pension contributions: at the time of writing, Higher Rate taxpayers receive 40% relief. So, suppose you could afford to contribute £30,000 out of your £90,000 salary towards your pension each year. 40% relief on this amount adds up to £12,000 which goes into your nest egg.

Had you otherwise put all of this towards overpaying your mortgage, the £12,000 would have gone to the taxman instead.

*Please be aware that you will lose your personal allowance on a 2 for 1 basis on earnings over £100,000.

Of course, this doesn’t mean that it always makes sense - from a tax perspective - to increase pension contributions rather than overpay your mortgage. Yet it does illustrate the importance of not simply considering financial issues in isolation (e.g. retiring at 55/57 or overpaying a mortgage early), but rather crafting a holistic plan that avoids disjointedness.

Mitigating inheritance tax

Perhaps one of the major benefits of this approach is that, ultimately, it could help you pass on more wealth to your loved ones or chosen beneficiaries in the future as an inheritance.

In 2020-21, for instance, the inheritance tax (IHT) threshold is 40% on the value of your estate over £325,000 but certain assets are excluded from this under current rules (e.g. your defined contribution pensions), and also strategies exist to mitigate unnecessary IHT on others - such as making annual gifts or setting up an appropriate trust.

Nil rate bands can be passed between spouses on first death and therefore the basic tax-free threshold available when a wife, husband or civil partner dies can be as much as £650,000 if none of the £325,000 threshold was used when the first of the couple died.

You also need to take into account the residence nil rate band (£175,000 each for 2020/21) which applies when a main residence is passed on death to direct descendants, such as a child or grandchild. There will be a tapered withdrawal of the additional residence nil-rate band for estates with a net value of more than £2m. This will be at a withdrawal rate of £1 for every £2 over this threshold.

Quite often, to craft a holistic financial plan it makes sense to start at the end - e.g. your estate plan - and work backwards to your most immediate financial goals (e.g. establishing an emergency fund). After all, having a clear idea of what you want out of the whole of life can help you make wiser decisions about how to deal with your wealth and finances in the here and now.

Please note that this is based on current tax allowances which can change.

The article is for information purposes only and should not be construed as advice.

Is it time to update the 4% pension rule?

Why a bespoke plan could be considered instead

Is it time to update the 4% pension rule?

The problems with the 4% rule - and why a bespoke plan could be considered instead

The “4% Rule” within financial planning circles usually refers to the idea that you can safely take 4% out of your pension each year to live comfortably and sustainably. It has been popular since at least the 1990s when it was conceived, but has gained more attention in recent years due to rising young YouTube stars in the modern FIRE movement (i.e. financial independence; retire early).

Certainly, one of the attractions of the 4% is that it refines a complex problem - i.e. how to ensure you have enough money in retirement - down to a simple rule which is easy for people to understand.

However, as financial planners our role is to bring working solutions to our clients, not just those which are easy to grasp. Whilst the 4% Rule holds certain strengths and might still be suitable for specific situations and financial goals, this article highlights why it presents large problems in many cases which should lead individuals to consider crafting their own bespoke retirement plan rather than relying on a universal rule.

The 4% Rule: the power of an idea

Human beings seem to naturally be attracted to simple-sounding solutions to difficult issues. Politics is rife with examples. One might arguably point to the right, - such as President Trump’s policy to “build a wall” to solve illegal immigration from Mexico - or to the left - such as Labour’s proposal to re-nationalise certain industries in the 2019 general election (although admittedly proponents would argue such solutions were unfeasible).

Similarly, people can be quickly drawn to quick, easy-sounding solutions to difficult financial problems which later land them in trouble. Indeed, this is arguably why many people fall for pension scams - such as promises by a cold caller that he/she can help you access your pot before the age of 55.

The 4% is certainly not maliciously intended, and it gains further power due to its academic underpinning. In 1994, US financial planner William Bengen put forth the idea in a paper using historical simulations. Taking stock and bond data in the US over a 5-year period, Bengen concluded that a “Safe Withdrawal Rate” from a typical retirement portfolio was 4% and that this should enable most people to live on their retirement savings and investments for a 30-year period. The idea was neat, attractive and quickly caught attention - living on to this day in 2020.

Bursting the bubble with further study

As is often the case in history, popular ideas can be shown to be lacking when individuals have the boldness to challenge their central claims. For the 4% Rule, this happened when Wade Pfau tried to apply Bengen’s research to a wider context to see if the Safe Withdrawal Rate applied in other countries and markets. He collated 109 years of financial market data (1900-2008) and looked at 17 developed market economies using domestic currencies and asset classes. The results were interesting. Pfau concluded that, in the UK, even with the best foresight and “perfect blend” of bonds and equities, a maximum Safe Withdrawal Rate could be placed at 3.77%. Only if the client accepted a 10% likelihood of “failure” (i.e. running out of money in retirement) did the percentage rise to 4.17%. The failure rate then skyrocketed to 27.5% when the withdrawal rate was raised to 5%.

The picture becomes even more bleak when you consider that Pfau’s study didn’t factor in the impact of fees or fund charges which anyone looking to take an income from their pension savings will have to consider.

"The study didn’t factor in the impact of fees or fund charges which anyone looking to take an income from their pension savings will have to consider"

An alternative approach?

If people can’t rely on the 4% Rule, then is there another rule which might suit better - maybe at a lower Safe Withdrawal Rate?

Certainly, the Financial Conduct Authority sees value in offering such “rules of thumb” to assist UK consumers in their decision-making - setting up the Financial Advice Working Group in 2019 for this very purpose. Taking this into account along with the reality that each client’s situation and goals are unique, here is one alternative to consider for those looking to retire early:

Higher equity weights within a retirement portfolio (i.e. a more aggressive stock allocation) might allow for more sustainable income over a 30+ year retirement period. However, such individuals looking at a longer retirement horizon should seek professional financial advice to ensure they understand the higher risks involved with a 60%, 70% or higher equity weight.

One of the central issues to consider here is the fact that people are living longer. Bengen’s 4% was developed in the 1990s when life expectancy for men and women was lower, and also the period of study (i.e. 1900-2008) concerned lower expectancy still. In 2020, an individual might be facing a 40+ year retirement or longer, rather than the 30 years covered in his study where a 50-50 split between stocks and bonds was used in the portfolios for the simulation.

What does all of this amount to?

In short, we can probably safely say that:

The 4% Rule can be useful for certain people, although its utility has decreased as average life expectancy has risen.
The 4% Rule becomes less relevant for those looking to retire early.
Increasing stock weight within a portfolio might support a lower Safe Withdrawal Rate (e.g. 3%-3.5%) based on certain historical data.
However, you should consider discussing your case with a financial adviser before making any big decisions.
Remember, past performance does not guarantee future results and you may get back less than you originally invested.