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.

This is rarely the way ILGs are actually used in private client portfolios, even when managed by highly-qualified professionals. This is a testimony to the ubiquitous hold of money illusion but also to the intellectual arrogance of most professional money managers in the face of investment uncertainty. Arrogance is a form of behaviour conducive to higher fee generation when clients believe market risks can be successfully exploited for gain by skilled agents. But humility is more likely to be conducive to higher return generation when market risk is not easily exploitable or costs of trying are high. Both money illusion and skill illusion explain why so little use is made of ILGs as unique ‘power assets’, as distinct from just another asset class to throw into the diversification pot.  

Risk free or just another bet?

This debate, which rarely reaches the wide audience it deserves, burst into the open in the columns of the FT this month. The American finance professor Jeremy Siegel is well known as the author of ‘Stocks for the Long Run’, a book (now in its 4th edition) which has helped establish in both professionals’ and the public’s mind the essential characteristics of different asset classes that make them useful for investment objectives. Professor Siegel wrote a guest column for the FT titled ‘Inflation-linked bonds face a headwind of many risks’ in which he nodded towards the special benefit of ILGs, particularly in pension plans, but also listed reasons why they were over-priced (both in the UK and their equivalents in the USA) with real yields of barely 1% (’levels that would have been unimaginable just a few years ago’). He concluded by warning of large losses on the horizon for holders of such bonds as economic activity and inflation both picked up. Equities, he felt, offered ‘much better long term protection against inflation than today’s low-yielding inflation-linked bonds’.

Outrage from the ‘power asset’ camp! It provoked a  letter signed by another American finance professor, Zvi Bodie, three frequently-published consulting actuaries familiar to UK pension funds and ex-corporate finance head turned pension consultant, John Ralfe. They argued: ‘The conservative pension saver, especially those with little or no other capital, should avoid the worst outcomes in retirement by holding inflation-protected bonds, even if it means giving up the possibility of the best outcomes by holding equities.’

They also argued that the risk of equities is typically misrepresented by the investment industry, which (either out of mischief or ignorance) understates the risks and overstates the likely payoffs when investing in equities.

Much as I welcome the argument, as it helps to banish popular illusions about risk and the management of risk, I have to say there are fallacies on both sides of this debate, as well represented in these two FT pieces. The faults lie partly in the assumptions that lie behind the maths and partly in a disconnect with personal risk preferences in the real world.  In this Insight we will try to find the firm ground between these two camps and show how it can be used as a foundation for individual portfolio choices.

I am not particularly concerned with a less meaningful aspect of the debate which is that there will always be arbitrageurs in the market and investors with a particular opinion about future inflation who will trade between ILGs and conventional gilts as if both were risky assets. On a short term view, when the position taken is not matched to or defined by the maturity of the bond or the duration of the investor’s objective, they clearly both are bets, not hedges. If this is largely what Professor Siegel was referring to, he is right.

Assuming a non-random equity ’system’

The sort of historical evidence in support of equity investing made famous by Professor Siegel is broadly supportive of the view that equity returns are a fairly intuitive output of adaptive capitalist systems. They do broadly what you would expect as an economist, if you only knew that stock markets recorded the performance of publicly-traded companies in some form of ‘market economy’. However, it is important to distinguish between nominal returns, which are distorted by each country’s and each period’s inflation experience, and real returns, deflated by a national retail price index. Inflation is one of the externalities we expect market systems to adapt to, more or less well.

Interpreting behaviour from real returns, without separating between income and capital, it makes surprisingly little difference if the market economy is Anglo-Saxon, Swedish or Japanese. There is in fact (yet) no theory of why millions of individual decisions by real investors based on idiosyncratic views of personal welfare leads to either similar trends in equity ‘total’ returns (both income and capital) or why the very large deviations from trends that emerge in all the data histories are both bounded and also similar between countries, regions, different stages of economic development and different periods of history. There are many sources of differences, including how they behave together, at the same time, but these may contain less useful information (or none at all) compared with the similarities.

The absence of a theoretical explanation of sustainable trends and of reversion to the trend is a concern for many and a particular concern for academics. But even if there was a theoretical explanation, it would rely on the same data as the only practical basis of experiment. If you have little choice but to participate in the system, you might as well leave proof to others and work out for yourself what view of the world and the system you are willing to hang your hat on. I decided a long time ago that, with respect to real total returns from equities over long periods, it was not a random world.

If the system were random

This preamble is important because many of the critics of the representation of equity risk believe it is in fact a random world. These letter writers, for instance, argue that ‘the proper measure of equity risk is the cost of buying insurance against underperformance versus the risk-free return – a “put option” on a stock market index. If risk reduces over time the cost of equity put options against any shortfall should reduce. But the cost increases the longer the option period, reflecting increasing not decreasing risk. The theoretical price, based on a standard option pricing model and actual prices charged by banks, is about 25 per cent for 10 years and 30 per cent for 20 years.’

The mathematical truth in this statement, that risk expands, not shrinks, with time conceals an assumption that it expands at the rate of a random time series (the square root of time) rather than at the slower rate of a mean-reverting series. The ‘theoretical price’ of the risk derived from option markets is not a proff of anything because it extrapolates from short-period nominal return behaviour which is (probably) random. There is no market in 25 year equity options and, if there were, arbitrage from the physical equity market would cause it to reflect the same assumptions of mean reversion widely made by participants in that market.

ILGs and mean-reverting equity returns

Hanging your hat on a sustainable but uncertain trend in long-term real returns also means that you will assume that the mean expected equity return will rise faster than any risk free rate, such as the 1% real yield of ILGs. The insight that risk rises with time means the band of probable outcomes around the trend increases slightly for every year the investment is expected to be held. (This will still translate into a declining standard deviation of short-period returns the longer the expected holding period, which was the source of the widespread error that risk falls with time, as it does not compound each single-period standard deviation over the relevant length of time.)

The concept of a rising and expanding range of possible real wealth outcomes around a known risk free rate with a lower slope is expressed in the diagram below. The principle to which the letter refers, of both lifting the floor or worst-case outcome but at the cost of a lower slope for wealth generation, is illustrated here by substituting half the equity portfolio by a risk free ILG. Depending on the values assumed, there is a point at which the distribution of outcomes lies entirely above the risk free rate. At any point, you can adjust the level of substitution of equity risk by ILGs to achieve a tolerable worst-case outcome. You would find the same general principles explained in Professor Bodie’s widely-used text book ‘Investments’.

Choosing between risk free and equity bets

The FT letter writers express the opinion that ‘conservative’ investors, worried about the consequences for living standards of a bad outcome, should not make an equity bet at all but accept the certain but very low real return and outcome of ILGs. This is a massive over-simplification. If it has a paternalistic purpose, it is thoroughly misguided.

The question investors at any level of wealth, whatever their instincts about risk, need to ask is ’how much risk should I take, given the consequences of bad outcomes and the floor below which these become personally intolerable, and what will that cost me in resources?’

If, like other reluctant participants in the capitalist system, I want a certain standard of living but do not want to bear much risk to obtain it, I think I would like to know whether I could in fact afford to avoid risk. If the implications of building more certainty into my life was a mediocre living standard, either by making spending sacrifices whist still earning or in retirement (or even both), I might accept a bit of a capitalist gamble to lift most of my probable outcomes above the mediocre.

If, on the other hand, I were extremely wealthy and had no children, and was not hard-wired to keep creating wealth (as many enthusiastic participants in the capitalist system are), I can imagine I might decide to stop taking risk, or would only take enough to secure improvements in my spending power that I was likely to value. I have no need to gamble and no satisfaction from gambling. I can leave the table and live on gilt coupons (index linked, of course).

These practical examples of risk taking preferences, in a real-world context with particular personal consequences, illustrate an important role of ILGs in both financial planning and investment management as the market benchmark of the cost of avoiding risk, in both resources and outcomes.

Choices at retirement

The benchmark for avoiding all risk at retirement is the income provided by an index linked annuity, as this deals with longevity risk as well as capital market and inflation risks. Using a retirement plan as an example:

• On the basis of current real yields, a capital sum of £1,000,000 will produce an annuity income before tax (for a 60 year old male with two-thirds spouse benefit) of £25,250pa. This illustration ignores the practicality that, if it were in a pension plan, you would apply the tax free cash to a purchased life annuity which unfortunately does not come with full indexation. Being an annuity the real payments will be level each year, even though you might prefer higher spending targets early in retirement and less later, but with equivalent real outcome certainty.
• With controlled risk taking, in current equity market conditions, the same sum might generate a profile of preferred spending starting with a gross equivalent draw of  of £40,000 pa at the start of retirement. Depending on the payoffs from risk taking and how quickly or slowly they emerge, the starting rate might increase to a mean expected rate of £90,000 pa in real terms, sustainable to age 95. On worst-case real investment returns, the rate of draw might taper, in line with the time preferences, from age 75 to about £26,000, so never less than the level real annuity.   
• At retirement, it would be illogical to hold ILGs and draw down from them instead of buying an inflation-indexed annuity. More of the resource would need to be assigned to funding the extra years of life beyond the actuarial expectancy of the pool of lives in the annuity fund – the illustrations above assume 35 years instead of about 27 years.  To match the same worst-case gross draw as above holding only maturity-matched ILGs would require £400,000 more capital and to match the median draw would require a further £600,000.

No free lunch

An important insight of the FT letter writers is that equity investing is typically presented as a free lunch. They say: ‘The higher expected return of equities over inflation-protected bonds is simply a reward for the risk of holding equities; it is not a “free lunch” or a “loyalty bonus” for long-term investors.’

Provided the trade off between resources, certainty of outcome and risk taking is properly explained and quantified, there is no illusion involved in making a case for equity investing. On the contrary, it avoids the illusion that avoiding risk is cost free and affordable. In the example above, the actual rate of sustainable draw is consistent with 99% confidence of not breaching the floor, there is no spending of payoffs from risk taking before they have been earned and the cost of avoiding different forms of risk is explicit.

ILGs perform an invaluable and indispensible role both in communicating the principles and quantifying the trade offs. They should feature in every financial plan and every portfolio review. But they should also be the main method of risk control in the portfolio itself.

The peculiar feature of packaged products created at the low end of the risk spectrum is that the downside risk relative to cash is actually much harder to estimate accurately than in equity funds, yet has far greater impact. However ‘cautious’, there is an unavoidable quantum change between cash and low-risk product structures. That is a big issue when cash returns are really unsatisfactory, as now, but customers’ composure when taking risk is low. 

Managing the quantum change safely, so that advisers can be sure customers will have sufficient composure to weather disappointments relative to risk free savings, may require even more education and explanation than the same discussions about location on the risk spectrum higher up, where it is all about different levels of exposure to equity risks. 

Banks have proved particularly unable to manage this process but the problem is not confined to banks. A pattern over the past two years reported by Cofunds is that advisers have dramatically increased their allocations to Cautious Managed funds, particularly multi-manager funds, to the point where they account for almost a third of net flows on the platform. Some of this is at the expense of Absolute Return funds, which had posed problems for risk assessment even before the FSA expressed reservations about this label, and they typically hold less in equities. 

Measuring the distribution of past returns within the Cautious Managed category (using Lipper data), and trimming the top and bottom deciles to try to avoid capturing atypical and miscategorised funds, we find a fairly stable range from top and bottom of about 7% per annum, both before 2008 and after 2009. Relative to cash, this is actually inconveniently wide. But it is perfectly natural once you move from cash to a wide range of instruments by duration and credit risk and a wide range of (albeit small) equity exposures. 

At this end of the risk spectrum many of the incremental return sources take on the nature of insurance, gathering premium income for bearing the risk of occasional losses. So there will always be some exposure to a low probability but high impact event such as the explosion of the distribution in cautious managed fund returns from 7% to 20% in 2008, after the banking crisis. 

For most investors, the answer is to split exposures between genuine risk free assets and equities: bets on or off the table but nothing in between. If inflation is an issue for their risk free assets, they will normally be able to protect against both capital market and inflation risks by holding index linked National Savings certificates or index linked gilts. Both are also more tax-efficient than low-risk packaged products. 

The industry discourages this ‘portfolio separation’ because it finds it difficult to attach a fee to the risk free portion. There is therefore a strong financial incentive for manufacturers to keep creating ‘low-risk’ products and advisers (whether taking commission or, after RDR, charging asset-based fees) to keep allocating to them. I do not believe the FSA has quite grasped the nature of this problem.

This piece was also published by Money Marketing.

Because of the element of soft compulsion and its likely eventual size, NEST can be viewed either as an opportunity to lead and educate the behaviour of savers or as an obligation to do so. Looking for clues in what little Nest Corporation have said about the default strategy, we felt it was pandering to poorly-informed investor behaviour rather then emulating the current best practice in the area of pension  funding. The main risk we could see was that inflation risk was not going to be well managed. Inflation is the cuckoo in the NEST.

We sent out a press release highlighting this risk and challenging Nest Corporation to be more forthcoming about how they planned to manage the default fund so that the ‘purchasing power’ nature of the liabilities, not just their duration, was well matched. Otherwise, the risk reducing strategies used in the target date funds for different retirement dates would not reduce risk, merely swap inflation risk for equity risk. The idea has been picked up in the specialist journals and online industry forums, as these links show.

IFA Online- Warning inflation wreck nest default fund

Citywire – Nest will fail its members by pandering rather than educating

FT Adviser - Director warns Nest on strategy to tackle inflation

Pensions Age – NEST target date fund not so sound

Money Marketing – NEST could leave savers at the mercy of inflation

Investment Week - Warning inflation may wreck NEST default fund

No Monkey Business has been a bit of a lone voice in private wealth management, arguing that diversification is not a risk management tool and that if you want to control risk you have to take risky bets off the table. Risk is about total risky exposures more than about the makeup of those exposures.  Over in the institutional space, however, a radical new approach to portfolio management, known as Liability Driven Investment, has been steadily gaining traction, helped by changes in accounting rules that made pension funds much more sensitive to the impact of diversification falling short. The key difference is that risk is managed largely by ‘hedging’ some or all of the liabilities.  Bets off the table. 

Amongst the leading academics behind this movement is  Edhec Business School. Monday’s edition of FTfm included an article written by Lionel Martellini, Professor of Finance at Edhec, titled A better approach to risk management. In it he says:  

“For a long-term investor facing consumption/liability objectives, risk management should not be understood in an absolute sense, but instead in relative terms with respect to the liabilities: this is the essence of the liability driven investing paradigm that has become the norm in institutional money management. Risk factors impacting pension liability values, notably interest rate and inflation risk, should be hedged away, not diversified away.”

Professor Martellini also says “investment management is essentially about finding optimal ways to spend risk budgets that investors are reluctantly willing to set, with a focus on allowing access to the highest possible performance potential while respecting such risk budgets.”

Do both statements read across to private wealth? Yes. Private clients’ risk budgets are more likely to be about long-term real spending power than short-term volatility, because the liability is usually future consumption, so it is inflation and equity risk that need to be partially hedged in order to squeeze into the risk budget. Step forward, index linked gilts: the private client’s natural hedge.

The article is available on the FT website (you will have to log in to view). It is timed to coincide with Professor Martellini’s new paper on LDI. This can be viewed on the EDHEC website. Not surprisingly, it is highly technical.