To read the full article click here (you may need to register for ft.com). I summarise the arguments below.

Target date funds are the basis of the default fund in the government-sponsored NEST auto-enrolled pension scheme, which is an important boost to their credibility. The next step in putting them on the retail investment map will be product launches from private providers. We expect Vanguard, a target date fund market leader in the US, to be amongst the first. This will allow anyone with a personal pension to match their capital and contributions to a specific retirement date or, if they plan to draw down in retirement, to a sequence of dates.

Target date funds make the risks taken by an investor and the expected payoffs specific to age, stage and the manner in which they expect to take pension benefits, whether as an annuity (with or without inflation protection) or drawdown. It can also make risk-taking activity specific to ‘utility’ or the way in which they value different attributes of the payoffs from risk taking. In personal retirement planning, utility or welfare is significantly defined by the adequacy of real purchasing-power outcomes at distant horizons and the consequences for spending of shortfalls in adequacy. Volatility does not explain utility well in pensions saving. Correctly defining utility, and allocating capital to maximise expected utility at the right time, represent important gains relative to the failed ‘balanced management’ paradigm that dominates investment management today.

In the article I examine whether these benefits can be delivered without the time-intensive personal financial planning or segregation of portfolios that we can achieve, working with very wealthy clients.  I believe this is exactly what is enabled by our adoption of the technique or ‘portfolio separation’: the separation of portfolios into a risky segment and a risk-free segment – risk free in terms of the nature of the outcome (real or nominal) and its date (or duration) supports. It will require, as it does for us, very high orders of systematic  decision processes. It is scalable to the mass market and target date funds supply the basic chassis if not the engine.

Pension rules were devised with the paternalistic objectives of encouraging savings and then ensuring stable and sustainable incomes throughout retirement. The wealthy can exploit these rules differently from people largely or entirely dependent on pension schemes to deliver their retirement ‘income’.  Within the constraints of the rules, they have choices about how much to save in pensions and how much to draw from pensions that are driven entirely by externalities like tax efficiency or by a combination of personal objectives and tax. If they made themselves heavily dependent on payments from pension plans to fund their retirement spending, it was because they were either advised by someone who did not know how to game the rules successfully (accountants often got this wrong) or were not advised at all. We approach the latest round of pension changes, still in draft form in the 2011 Finance Bill, in this spirit.

The idea that financial decisions subject to rules might be made easier by applying strategies honed in competitive games ought not to be unfamiliar to wealthy investors. Even if it is unfamiliar it ought not to be counter-intuitive.

Winning in this context is about maximising the after-tax cash flows from personal pension funds but doing so as part of a holistic plan that maximises personal welfare, or benefit, from all forms of wealth and in terms of all different personal goals, of which securing lifetime spending is just one, albeit perhaps the highest, priority. This is how we develop wealth strategies collaboratively with our clients.

The Coalition Government’s contribution to the pensions regime that was last overhauled in 2006 is a series of changes to the rules, some of which reduce flexibility and some increase it. It is flexibility that determines the scope to game the rules.

Seeking advice

We highlight below the changes and the possible implications for winning strategies. If you think this applies to you, it is likely you will need to take professional advice.

• The typical scale of the difference between optimal and suboptimal decisions in this area makes paying for good advice entirely logical.
• You should not assume that because you have an adviser in place or that you took advice at A Day that you do not need to check whether your strategy is now or ever was optimal.
• You should not assume that this is just about searching for information and tips on the internet and managing your own retirement plan. Optimal decision making in conditions of uncertainty about capital markets and inflation, when subject to complex tax and other rules as well as uncertainty about future changes in those rules, is a massive challenge for professional advisers let alone self-directed investors.

At NMB, retirement planning is an important part of ensuring ‘capital efficiency’ across the whole of a family balance sheet. In wealthy  households, where there are resources available to meet multiple goals that deliver very different forms of benefit or favour different beneficiaries, capital efficiency as a conceptual approach to managing finances integrates each of

• maximisation of goal-based welfare
• effective risk management
• minimisation of tax
• avoidance of unnecessary costs.

Given its obvious importance in your life, you should ask yourself why financial management ought not to be one of your largest budget items and why you would not give it the attention it deserves. 

Changes in the next Finance Bill

Contributions

• 5th April 2011 is the last chance for individuals not caught by ‘regular contribution’ rules to make large contributions in their final year before ‘retiring’ (ie crystallising benefits) and gain tax relief at their marginal rate on up to £255,000 of UK relevant earnings.
• From 6th April, those caught by the regular contribution rules will be able to make up the difference between Labour’s cap on tax relief of £20,000 pa and the new cap of £50,000, reaching back up to three  years.

Should you make further contributions? You will want to consider the following.

1. Anyone making contributions should avoid the mistake of assuming that the after-tax cash flow values are higher in a pension wrapper than out. Recommendations usually focus on the tax relief going in and tax free ‘rollup’ and ignore the tax treatment of the money coming out, which effectively includes a charge on the apparently tax-free rollup. Increased marginal tax rates, if these survive through much of a retirement phase, affect this comparison significantly. At higher marginal rates in retirement than when saving, the net present values of a stream of lifetime cash flows generated from a pension fund is likely to be less than the value of a flow generated outside pensions. Ironically, the comparative values also depend critically on assumptions about death and IHT treatment. Finally, they are also sensitive to what investments you would hold.
2. Contributions also need to tie in with the Lifetime Allowance and any protection you have or could have in place.
3. Think about whether your retirement spending will be too heavily dependent on externally-imposed drawdown rules. There has to be a balance between capital in and out of pension pots because the drawdown rules conflict with the typical spending profiles in affluent households that are front-loaded and with typical plans to fund later stages with property sales. Pensions may not provide the spending power when you need it.

Drawdown

• If the Finance Bill passes, the drawdown regime will be the same before and after age 75 and will be referred to as Capped Drawdown. This was presented as an end to compulsory annuities at age 75 but in fact wealthy people could have avoided the penal drawdown rules after 75 by moving to a plan written under ‘scheme rules’. So there is no real gain in flexibility.
• Contrast this with the fact that everyone planning to take benefits before age 75 by drawdown is affected by a reduction in the maximum draw. If the Finance Bill passes, between 0% and 100% (currently 120%) of the Government Actuary Department (GAD) rate (derived from a gilt yield and age) can be taken as drawdown instead of buying an annuity. This is a significant loss of flexibility and increases the risk of excessive past contributions causing timing problems for spending.
• Flexibility is also lost because the resulting drawdown rate is based on a capital value at intervals of three years, down from five years, if the Bill passes. A fall in markets can therefore trigger a fall in maximum draw, if the fall in triennial valuation exceeds the upward drift of the GAD rate with age. Longer periods offer greater flexibility to manage the profile of the draw.
• There is still a slim chance an individual already in drawdown can request a new valuation basis before 5th April but HMRC only allow this on the anniversary of a previous valuation.
• These rules are also impacted by transfers from one provider to another.

These constitute prima facie reasons for bringing forward the crystallisation of benefits and start of draw before 5th April 2011 – but subject to the personal relevance of the next two sections.

Death benefits and IHT

• Up until such time as the tax free cash is drawn from the pension, the whole fund can be passed, on death, to your chosen beneficiary(s) as a lump sum without any income or inheritance tax (IHT) consequences. Once the fund has been crystallised, or you reach age 75, this option is lost. Though not a change, it is inconsistent with the principle espoused by the Treasury that tax relief already given should be recovered either by income tax on benefits taken as income or as a Tax Recovery Charge set at 55%. Death before 75 remains an exception to this rule, unless Parliament questions it.

Should you therefore opt for phased crystallisation? Under existing rules for drawdown, tax free cash can be spread across a number of years by crystallising part of the plan each year (the plan normally being divided into ‘segments’). The drawdown options are then applied to each ‘opened’ segment. Because each crystallisation produces both a tax free sum and a stream of payments, manufacturing an even stream across time means all the plan segments will be opened in the first decade of draw rather than spread across the plan. Phasing crystallisation therefore competes significantly with the tax-efficient disposition of death benefits on unopened segments.

How you make this trade off depends critically on the strength of any bequest motive competing with lifetime spending or gifting. The mathematical impact of the probability of death before 75, combined with a bequest motive, also influences whether to take advantage of the main change in drawdown affecting the wealthy: flexible drawdown.

Flexible drawdown

• The Finance Bill proposes to give complete flexibility on drawdown provided an individual can satisfy a Minimum Income Requirement (MIR) of £20,000 pa in the form of pension annuities or defined benefit scheme benefits (including State pension). It prevents a member who expunges their fund from falling back on State benefits. This test only has to be met once.
• The decision approach will vary if an individual can satisfy the MIR from final salary scheme benefits and the State pension. Otherwise, the price of meeting the MIR is an annuity purchase from the personal pension pot which potentially conflicts with the objective of the increased flexibility.

Compared with phased Capped Drawdown, the option provides more scope to control a changing rate of draw, such as to minimise personal income tax, potentially leaving more of the fund open to the impact of death before 75. Individuals may have opportunities to exploit brief windows of low personal taxation due to their personal circumstances – although this aspect of the draft legislation may attract attention in debate.

Lifetime Allowance

• The Finance Bill also alters the Lifetime Allowance of pension benefits (by capital value equivalent) from £1.8m to £1.5m. Any breach will be tested cumulatively with each crystallisation event, including occupational scheme benefits. Any excess will be subject to a tax charge of 25% (as currently).
• The Lifetime Allowance will be tested again at age 75 (as currently) to ensure that people who defer drawing and have then exceeded the allowance pay the 25% charge, as a disincentive to using deferral as a strategy for mitigating IHT. Flexible drawdown could help in managing the combined chance of death before 75 and a 25% charge at 75.
• To protect people who had already planned on a limit of £1.8m (and did not have any form of protection under the original ‘A Day’ regime) from inadvertent breach, as a result of the impact of unknowable investment growth on contributions already made, it will be possible to apply for Fixed Protection to ensure that their personal limit is £1.8m not £1.5m.
• As a condition of Fixed Protection, a member would have to make no further contributions so anyone planning this might want to consider making a final contribution before 5th April 2012.
• Deferred and active members of a defined benefit scheme are also affected (differently) by rules on the accrual of benefits and therefore risk a breach of their Fixed Protection.

Though not a change, the management of the risk of breach is highly sensitive to assumptions about nominal investment returns and future government policy about moving the Lifetime Allowance up if inflation turns out to be driving returns above protected levels. Planning is therefore a hostage to political fortune as well as to the uncertainty of real, post-inflation investment returns.

Managing the second risk assumes skills in modelling real investment returns probabilistically. It is not enough to rely, as most advisers do, on deterministic nominal return projections. In most cases, the same projection rates are used as the FSA prescribes for pension providers yet financial planners are under no obligation to use these non-probabilistic (and over-simplistic) assumptions. Good risk management is obviously about stress testing, not relying on assumptions that have only a 50% or so chance of being reached.

Continuous reprojection of probable outcomes, in real terms that correspond to spending,  is a key part of the financial management you should be paying for in retirement. If your financial adviser or investment manager cannot do this, you should talk to us.

Tuesday 28th September 2010

Olswang Offices, 90 High Holborn, London, WC1V 6XX

From our experience working with lawyers across a number of city firms we have identified characteristics that appear to persist.

1. The investment approaches that have been adopted bear little relevance to the outcome the individual or family is trying to achieve. More often than not, risk has been shunned in favour of hope-for  lower volatility, using standardised portfolios that will result in lower outcomes, such as less spending in retirement.
2. Despite overwhelming evidence that it consistently fails to deliver better returns for retail investors, most solicitors are still paying a high price for active fund management and almost all believed  they were paying less to the financial services industry than they actually were, or needed to be.
3. Most solicitors had a lack of clarity about the relative attraction of property versus financial assets, particular when considering leverage in the form of a mortgage.
4. Confidence and trust in advisers was low, with many of your peers refraining from action, taking advice from multiple sources and some reluctantly driven to a self-directed approach.

We have been invited to speak to the Olswang partners for a second time because a group of existing partners valued highly the work that we completed for them and believe others should be offered an opportunity to learn a little more about how we work with clients.

In this workshop, Stuart and Joe will describe an approach that focuses on your goals and not those of the industry, including:

• The benefits that come about from goal-based financial planning, including a hierarchical framework that makes financial decisions easier and more consistent;
• How best to implement a simple low-cost structure suited to those in the early stages of high savings; and
• How we design and manage a portfolio of investments to deliver specific, duration-matched, quantified outcomes as defined by the client during the planning stage.

(Please note this is only open to delegates of the 2010 Clinical Radiology Annual Meeting )

By attending this short seminar attendees will gain a greater understanding of the NHS Pension Schemes, enabling them to;

• Understand the primary differences between the 1995 and 2008 NHS pension schemes
• Determine which one of the two schemes is likely to be most appropriate for them
• Calculate the deemed value of their NHS pension
• ‘Game’ the pension rules in order to maximise the level of pension benefit
• Determine whether they are on course to breach the Lifetime allowance and what it means if they do

For those with privately funded pensions supplementing the NHS Scheme, Joe will go on to;

• Set out why the investment approach should differ between ‘accumulators’ and ‘decumulators’
• Help you to understand which aspects of planning will have the greatest impact on retirement outcomes
• Discuss practical measures that allow you to keep control of costs
• Highlight practices that are to be avoided at all costs

And with the Coalition government setting out its pension objectives in two recent consultations, Joe will also cover the areas that are most likely to impact the seminar attendees, and so covering;

• The impact of likely changes to the pensions annual allowance
• Improved pension flexibility that is likely to come about with the introduction of a ‘Minimum Income Requirement’

The Budget announced a change from RPI to CPI as the basis of future inflation adjustment to certain benefits, including the state pension. Subsequently the DWP announced that it would use CPI, not RPI as currently, as the basis of Limited Price Indexation for private pensions and of indexation of public-sector pension benefits. 

The Government’s message is consistent, based on the context of the index use and therefore the components of the index. If benefit claimants do not own their own home, mortgage costs and housing depreciation are not relevant but rent is. If recipients of public sector pension do not have a mortgage, mortgage costs are not relevant. By emphasising the home ownership components, it has (possibly unintentionally) led people into thinking the inclusion of home ownership costs explains the past higher trend increase in the RPI than the CPI and is the basis of a systematic and sustainable bias.  

Media reporting has picked up on this implication and reported it without question. But it misses an important point. The reason why, other things being equal, we should expect RPI to lead to higher levels (and so increase the cost to the taxpayer of providing indexed benefits) is that it uses arithmetic means whereas the CPI uses geometric means. The NSO has quantified the effect since the CPI was introduced in 1997 as an average downward bias of 0.5% pa. This is almost exactly the actual difference in the indices that has been widely attributed in the media to the housing component.

House prices affect both the mortgage interest payments and the housing depreciation components of the RPI. They affect mortgage costs because the NSO attempts to capture the changing national average mortgage level as the base for multiplying by a current interest rate, as distinct from the unchanged mortgage of the same typical household. Similar tricky concepts influence the differences in competing house price indices. House prices affect the depreciation component (whose presence I will not try to explain) similarly although the effect ought to be less because it separates the building element from the plot. Both mortgage interest payments and depreciation have a weight of about 5% in the RPI. Rents have a similar weight but are common to both indices.

Over the long term, it is reasonable to expect house prices to rise faster than general costs, because of the links to earnings, via credit. A realistic long-term trend in relative prices is about 2% pa. I suspect it would be less (it was zero in the US until the late 1990s) if development land were more freely available. Building costs ought not to have a trend different from general prices. With a mean interest rate change of zero, this translates into a bias between 0.1 and 2% pa, mainly depending on the dodgy depreciation component. Clearly, the component difference between the two indices is smaller than the computational difference and also overwhelms the debate about which index is right according to the context.  

For pensioners in particular, who either rent or own homes but do not typically have mortgages, including or excluding a 5% weight for mortgage interest payments, however logical,  is trivial relative to the computational bias.

There is a debate to be had about the most appropriate index based on its computation as well as its components, so that we can be clear that the change is fair to both beneficiaries and taxpayers.

Generally, we might expect statisticians to prefer to compute a series with a mean change different from zero using geometric means. In the specific case of the CPI, it also applies a concept that consumption patterns change with shifts in relative prices, which seems intuitively more accurate and would not arise if aggregating arithmetic means.  I can see why a fair-minded, disinterested decision maker (a politician?) might opt for the CPI.

Understanding the concepts behind the Government’s change is important if reacting to clients’ questions and suspicions. Clients are not helped by comments such from Buck Consultants in the Sunday Times last weekend that ‘the change had effectively wiped £67,000 off the total value of the pension pot’ for someone earning £100,000 with 30 years service. For a start they assumed 0.75% pa difference in trend (where does that come from?) and in any case why assume this is their right?

Understanding the concepts is also important for assessing the impact on the ILG market. Here we need to separate the impact on investors betting against the implied inflation rate or breakeven rate of inflation from the impact on investors hedging the inflation risk implicit in their liabilities or goal outcomes.

The first ought to affect yields almost immediately, as a once off change. It would reflect the expected difference in RPI and CPI not as a long-term trend but over the term of their bet. This impact may now be complete.

The second poses a technical problem, until the market creates CPI as well as RPI swaps. But the impact on risk preferences is neutral. ILGs, whatever the index used, still represent a tight hedge for inflation compared with the very loose match provided by real assets like equities and property. The separation of risky bets and risk free hedges will still look to many clients like a better way to manage risks than relying on diversification effects from using more and more building blocks with less and less certainty about the correlations.