Mrs YFG: on cutting my clothing spend by 90%

Mrs YFG here.

This week I walked into a colleague’s office and remarked “nice coat”. Turns out it was £450, and is meant to look as expensive. This gave my colleague the opportunity to let loose. They weren’t happy. She had to drape her coat over the back of her chair. It had no loop to hang the coat on a hook. She wasn’t impressed. For £450 she didn’t even get a coat hook.

My first thought was WTF. Why spend that much money on something which doesn’t return its value, and which you don’t love? Why buy it when you are unhappy with it? And then I remembered that we had different priorities. Different desires. We are different people. And I used to have the same desires…

MrsSpendyYFG

I grew up learning that if you earned money, you earned the right to spend it as you wished. I worked from age 11 (paper round…). That money was mine to do with as I pleased, as long as I saved one-third of it. The harder I worked, the more money I received, the more I could spend. My capacity for acquiring pretty shiny things expanded. Excellent.

This carried on throughout university: my loan was there to be spent. If I had it, I spent it, and if I didn’t, I had my savings. Because I was going to earn it all back as a hotshot lawyer, right?

Lifestyle inflation hit me hard when I started working at The Firm. I went from being a poor student to a trainee on well over than the average UK annual salary. Each month I’d save a quarter of my salary and then proceeded to use the rest for what I felt I deserved. I could afford it, right?

I would think nothing of spending £300 per dress (try The Fold London for such epic beauties). And more commonly about £100-£150 on something fancy from Hobbs. I would buy these items to cheer myself up and try to repair my poor self-worth. I would look more beautiful if I wore expensive clothes: I would be better.

Of course, this is a ridiculous amount of money to spend on things that are not essential and don’t matter. I am fortunate enough to have had that disposable income. It makes me feel stupid for wasting it.

Buying stuff won’t improve your self-worth

Years later (and thousands of pounds poorer) my self-worth is not improved. Dressing top to toe in LK Bennett does not make me a better, happier, or smarter, person. I could do my job in pyjamas (and would very much like to do so). I wish I had put the money into my savings instead: £100 saved is £100 I don’t have to earn.

Just because I can afford something doesn’t mean I need or want it.

Safe Withdrawal Rates: An Inconvenient Truth

Recently I’ve read up a lot on Safe Withdrawal Rates (SWRs). For those that haven’t come across the term, it’s a method used to find how much a retiree can withdraw from their portfolio of assets each year without running out of money before reaching the end of their life. The most famous SWR is the “4% rule”, which, in many respects, is a cornerstone of the FI Community.

A crumbly cornerstone?

Calculating a suitable SWR can be an important part of understanding how an individual can fund their income needs in retirement. Those eagle-eyed may spot that I used the term ‘can be’. At this point, I’ll warn the reader that I’m going to take a jump forward and delve straight into the nuts and bolts of calculating Safe Withdrawal Rates. If you’re new to this subject, I’d recommend reading a little more background on SWRs. I’ve recommended some helpful articles at the end of this post. Going back to ‘can be’, the reason SWRs may not be helpful is because: (i) predicting the future is hard; and (ii) the calculations have strong limitations.

Before I dive in

I want to make it clear that none of this post should be construed as a personal attack on the authors of various Safe Withdrawal Rate studies. It also doesn’t mean I think they are wrong. Most of the authors are far more qualified and far brainier than me. I also haven’t read every book, article or piece of literature on the subject. There is a huge body of work out there, and its not possible to read it all. So it’s entirely possible I’ve missed things (if I have please let me know in the comments). My aim, in sharing the following criticisms is to help readers understand the important limitations in using SWRs and to know when and how to take these calculations with a pinch of salt.

Let’s begin.

How you calculate a Safe Withdrawal Rate

Typically speaking there are two methods of calculating a Safe Withdrawal Rate:

  1. Historical Data approach – in this approach you use real historical data to calculate investment returns and other statistics required to generate a SWR. This is sometimes also called a ‘backtesting approach’.
  2. Monte Carlo approach – in this approach you use a Monte Carlo or other model to simulate a large number of investment return scenarios to test a SWR based on a set of assumptions. This is sometimes also called a ‘simulation approach’.

I strongly favour the Historical Data approach. Whilst I won’t go as far as saying Monte Carlo approaches are useless, for the specific purposes of SWR projections they have a huge fundamental flaw which makes the results from such analysis tenuous. [Note, in general Monte Carlo simulations are a great analysis tool, but for the specific reason I set out below be vary wary when they are used to model investment returns. There is also a third, hybrid, method called “bootstrapping”, which is a combination of a Historical and Monte Carlo approach. I don’t cover it here. But it too has some conceptual problems.]

Why the Monte Carlo approach is fundamentally flawed

To create a Monte Carlo simulation you need to create a set of assumptions. These are used to generate your future scenarios. The biggest flaw in the approach is that you need to make an assumption about future investment returns. The reason this is such an issue is that stock market returns do not follow a normal distribution. If stock market returns don’t follow a normal distribution, what do they follow? The answer is: we don’t know; or: it’s up for debate.

Back in the 1960s Benoit Mandelbrot, a mathematician and polymath, suggested returns follow a Levy Distribution. In 1963, future Nobel Prize winner Eugene Fama, in his first published paper, examined Mandelbrot’s work, and considered that equity returns follow a type of stable distribution. Research in the following 50+ years has concluded that equity returns don’t follow a Levy Distribution, rather they either follow some other Stable Distribution or, as is more commonly thought, some kind of Power Law Distribution. To put that in common parlance, equity returns have “fat tails”.

The most important thing about all these distributions is this: you cannot calculate an average. The reason for this is that under such distributions no value is impossible. You could have returns of 5% per year then BAM! the market drops 23% in one day. These huge outlier values make a calculated average on historical values meaningless – they will massively shift the next time there’s a huge market movement.

Source: Wikipedia, by Autopilot – Own work by uploader; DJIA values from http://www.cs.princeton.edu/introcs/data/DJIA.csv, CC BY-SA 3.0, Link

That’s why Monte Carlo approaches for calculating SWRs are flawed. The approach relies on an imperfect assumption of market returns, using an average and standard deviation that we know are incalculable. What makes it worse is that for calculating a SWR we are looking precisely for the points of failure – the so-called ‘black swans’. These one-offs can be one of the largest determinants in whether a SWR strategy works or not.

So if we’re ruling out using the Monte Carlo approach, that leaves us with the Historical Data approach. Let’s look at some of its limitations.

Limitations of Historical Data based Safe Withdrawal Rates

1. Successful SWRs are ill-defined: The thin line between success and failure

The first limitation is arguably the most abstract but, for me, the most important: How successful decumulation is defined. Success will vary from person to person. For most people, success is having enough income to cover living expenses and support an adequate standard of living level. Failure is the opposite, having insufficient income such that a retiree’s standard of living falls. But we are already adding vague terms into our definition. For example, what is an “adequate standard of living”? is there an “acceptable variation” in standard of living?

Using a proxy

It’s for this reason that SWR calculations typically use a proxy to this definition: success is not running out of money. This is much easier to calculate – you look at the balance in the bank – but it does mean some element of “true” success is lost. It’s possible to have zero or even negative net worth and still have an income. Conversely, it’s possible to be a paper millionaire but be unable to draw any of the wealth as income. But as using an income definition for success is very challenging, we have to fall back on the next-best which is using portfolio value as a gauge of success.

Adjustments to the SWR

Another element to success when calculating SWRs is the rate at which a SWR would not have reduced a portfolio to zero. Some calculations consider 90% (or lower) as an acceptable rate of success. Others would shiver at the thought that 1 in 10 times you’d end up broke. An answer to this is the SAFEMAX (or MSWR, Maximum Sustainable Withdrawal Rate): the highest historical rate that would not have run out of money.

Alternatively, a stricter definition is what the author at Portfolio Charts calls the Perpetual Withdrawal Rate: the rate which preserves the inflation-adjusted principal in the worst decumulation time horizon. However, this definition leaves us with a question: are we happy for our pot to dwindle to zero? or do we want our pot to stay the same (or grow)? (and potentially be passed down through inheritance). The answer of course will depend vary for each person. But neither of these definitions appear attractive. A portfolio inevitably falling to nothing creates a potential risk of running out of money. A portfolio where the principal stays the same (or grows) may seem like a waste, resulting in missed opportunities (FOMO).

In Summary

There are lots of different definitions used to define successful decumulation when calculating SWRs. But none of these will be the ‘true’ definition of success for each retiree. Each has its own limitations which we should be aware of.

2. Inflation: Expect the unexpected

The second limitation comes from the assumptions we have to make about inflation. These pop up in two places: (i) investment returns; and (ii) future expenses.

Investment returns

Dealing with investment returns first. The main reason we invest is to protect against inflation. One of the big issues with some (not all) SWR calculations is that they use nominal returns. That is, they do not account for inflation eroding the value of the principal. Therefore, calculations that use real returns should be favoured. But there is an issue with this, and we’ve already said it: we invest to protect against inflation. By using the returns on investments that people have historically used to best inflation we are baking in an assumption that they may continue to do so in the future.

The trouble is, we can’t do much about it. That’s because most modern economies use Monetarism. This is where the Government controls money supply to try keeping prices stable. An underlying tenant of Monetarism is that it is impossible to know (or expect) inflation in advance. If inflation was predictable then Governments would not be able to affect inflation by controlling the supply of money. So in principle, if we fiddle with our inflation assumptions (from taking the guidance targets of the relevant central bank) we are making ‘bets’ on inflation that are not knowable. That’s fine, but can you predict the impact with any accuracy? We’ve seen with Quantitative Easing (QE) that predicting how inflation and asset prices react to money shocks is very difficult (impossible?) We can also see another issue in the graph below:


Source: tradingeconomics.com

Since the early 1980s most Western Economies adopted Monetarism and have been successful in “controlling” inflation. But most SWR calculations will look at investment returns stretching back 100 (or more years), in periods where Governments did little or nothing to control inflation. How relevant are asset prices and returns from periods that had high inflation (and deflation) compared to our current (and future?) low and stable inflation environment? The answer is I don’t know, and even people far smarter than me don’t really know the answer.

Future expenses

In terms of future expenses, we’ve already touched on one issue with inflation that creeps in here: that is, future inflation is unpredictable. When withdrawals are deducted from the investment portfolio in a SWR model, these are usually done in a lump sum at the start of the year (month). But this implicitly assumes that the retiree was able to accurately predict living expenses in advance (for this reason, I prefer a calculation using monthly figures). For example, living from the 1970s trying to predict daily fuel costs was a nightmare.

 

Source: Wikipedia, by TomTheHandOwn work, CC BY-SA 3.0, Link

EREVN summarises this issue better than I can:

When looking at simulations the difference between 92% success and 96% success (just to make up two numbers) is probably meaningless when there’s a 75% chance you have some unplanned spending shock that the simulation isn’t taking into account.

There’s one final issue with inflation. The calculations typically use aggregate measures of inflation – such as CPI. But these are likely to vary significantly to your own personal inflation and even to that of your cohort. Both EREVN and Karsten at Early Retirement Now have looked into this. But the trouble is, it’s very difficult to change the inflation rate baked into a calculation without making hidden assumptions (what your behaviour would be in certain economic scenarios; what relationship between your personal inflation and asset returns). We can calculate our personal inflation by tracking our expenses – but this is imperfect. We can also try to adjust using different measures of inflation (such as CPIH which includes housing costs. But, to be honest, I feel these are delving into an element of mathematical precision which doesn’t exist.

In Summary

The Historical Data method requires implicit and explicit assumptions on inflation. Within these assumptions we are assuming that some element of inflation is knowable even though this is not the case. Inflation shocks can, and do, happen. We should be wary of false precision due to the unexpected nature of inflation and our imperfect estimates for it.

3. Historical data: An oldie but not a goodie

The third issue is that the Historical Data approach needs to use actual investment returns. The trouble is, we don’t have much of them. In fact, our sample is even smaller than you might think – remember that investment returns day on day, year on year are not independent of one another. As Karsten at Early Retirement Now puts it:

Strictly speaking, there are just under 3 truly independent samples of 50 year return streams: 1871-1920, 1921-1970, and we are charitable with the last one, 1966-2015, by ignoring the little bit of overlap in the first 5 years. So, if someone tells us their strategy has worked 96 out of 96 times, we would be impressed. But if someone tells us their strategy works 3 out of 3 times, we would be suspicious about that 100% certainty claim.

Unfortunately, this isn’t the only issue with historical data. Another issue is patchy data – missing in places – or we have to thread together data sources that aren’t strictly the same to create a continuous data source.

A third issue is that is, old market data is not very good for telling us about returns today. The four most well-known long-term data sources are:

  • Ibbotson SBBI which goes back to 1926 (Ibbotson also ‘created’ some further sets going back to 1815 and 1825)
  • Shiller/Yale which goes back to 1871
  • CRSP (Fama French) which goes back to 1926
  • Dimson, Marsh, Staunton/Credit Suisse/Triumph of the Optimists which goes back to 1900

There are a number of issues with data as we go back in time (lots of these issues are heavily discussed, so I won’t go into too much detail, EREVN has a good primer):

  • There’s very few companies in some of the sets
  • Lots of stocks are missing because not every exchange was counted
  • The composition of industries was wildly different compared to today
  • The data sources get patchy, there weren’t computers, so data was cobbled together from lots of sources
  • Finally, the world was a very different place!

What this means is that the further we go back in time the dodgier the data. As a rule of thumb I get nervous when data is from before 1980 and I avoid data from before 1970 if possible. Unfortunately, this drastically reduces the amount of data we have to work with. As such, we need to give a wide berth to analyses that can tell us historical equity returns to 1 or even 2(!) decimal places. Remember: “there is uncertainty surrounding every estimate from those simulations!

4. Withdrawing: Taking your money and running

There are roughly speaking three types of withdrawing methods:

  1. Fixed – a set rate, or set amount is withdrawn each year, adjusted for inflation.
  2. Variable – withdrawals vary depending on the circumstances.
  3. Valuation-based – withdrawals vary depending on certain valuation parameters.

In my opinion, a Variable withdrawal method should be preferred.

Fixed Withdrawals

Firstly, whilst the most common in various studies its difficult to see how a Fixed method reflects reality. I think most people would struggle to keep spending constant year-on-year if there was market turmoil or a long-bull run.

Secondly, such a method forces a low withdrawal rate to account for the worst possible market scenarios. Not to mention, that it would be irrational for a person to continue to withdraw at fixed rate forcing themselves into destitution. A retiree would, if necessary, lower their withdrawal rate. But the Fixed method takes no account for this.

Finally, in a good case scenario, a Fixed method forces a retiree to stoically stick to a fixed withdrawal and prohibits them from enjoying any upside in investment returns. It feels philosophically wrong for a retiree to not enjoy the fruits of their labour (and arguably is a failure as the retiree ‘enjoys’ a sub-standard level of living).

Valuation-based Withdrawals

Valuation-based methods involve increasing or reducing withdraws based on market valuation metrics. Most commonly CAPE (or CAPE10). I don’t want to write too much on CAPE because it is discussed enormously in the Finance community (and Prof. Shiller’s work is, by any measure exceptional), but there are several significant problems for using CAPE in a SWR calculation (I appreciate I’m very likely to be in minority on this, but bear in mind it’s just my opinion! If you’re aren’t familiar with CAPE ignore my boring bullet points below):

  1. CAPE has poor predictive power – whilst, in the best situations, a higher CAPE value gives a slightly higher probability of lower returns, the predictive power is mixed.
  2. CAPE is not very ‘actionable’ – a CAPE value of “x” tells us little about how much to reallocate between stocks and bonds or the likelihood of a market crash, we have to superimpose our own reallocation rules on top of it to make it actionable and this potentially leads to over-fitting or data mining.
  3. Where CAPE does have predictive power, it is over longer periods of time 10+ years. This is a significant portion of any retirement period, and it would take some brass balls to keep under-withdrawing (in a low valuation bear market) for 10+ years waiting for CAPE to come good.
  4. The data CAPE is based on is patchy data (we’ve talked about dodgy historical data above). To add to that, earnings have changed over the years as accountancy rules have changed. Earnings in 1970 are not the same as in 2018 but for the purposes of CAPE they are.
  5. CAPE is noisy – even where CAPE has predictive powers, the range of potential outcomes is often very wide.

A caveat

For those reasons, I conceptually prefer a Variable Withdrawal method. Being honest, I haven’t reviewed all the methods (there are lots of them), so I can’t (and I don’t think anybody can) say which method is ‘right’ or ‘best’.

5. Death and taxes: There are only two things certain in life

And they’re both missing in SWR calculations! Taking taxes first, SWR calculations almost always exclude taxes – that’s because it is very complicated to model tax charges and these charges are highly dependant on the individual and their circumstances. What this means is that a SWR before tax is likely to represent an upper bound to what your SWR is in practice.

Another big thing missing from most SWR analyses is death. What most analyses do is set a ‘retirement period’ typically of 30+ years, and then run the calculations. But by doing so this makes the assumption that end of retirement (death) is knowable. There are two big risks here: (i) we live longer than the estimated life span; and (ii) we don’t account for the likely changes we might make depending on our ongoing view of mortality.

Taking (i) first, this suggests we should consider using a longer ‘retirement period’; for my money 30 years seems very short, even for those reaching retirement age. Therefore, we should prefer analyses that use longer (such as, 60 year) retirement periods. It also gives credence to considering a Perpetual Withdrawal Rate; this implies an infinite retirement period.

Secondly, it informs us that analyses with shorter periods are more likely to over-estimate a SWR. However, the longer the retirement period the more old data we have to use – causing a trade off. Finally, a very long retirement period or Perpetual Withdrawal Rate can have the counter-intuitive result of giving a higher SWR. This is because over long periods of time the power of compounding rockets up the value of the investment portfolio. But this is no comfort for a retiree who may have to survive 20/30+ on a meagre withdrawal rate before things ‘come good’.

On (ii), we can think about some of the issues that we discussed under point 4 Withdrawing. If we knew we had only a few years to live would we change our behaviour? I think for a lot of people the answer is yes – we’d probably enjoy our money a bit more whilst we are with our loved ones. However, if our life expectancy slowly increased would we slowly reduce our spending to compensate? You might be saying “Yes I would!” But research on the general population generally finds we are poor at self-discipline. What this means is that as the length of our retirement period increases, our ability to support a withdrawing regime becomes fuzzier.

There are two further things that are missing from some SWR calculations and these are: (i) Social Security/Pensions; and (ii) Fees. I comment on these briefly, because these can and should be factored into the calculations. The possibility of state provision in retirement reduces our income needs and therefore reduces the amount we need to withdraw (i.e. increasing our SWR). On the flip-side, investment fees are a drag on portfolio returns and reduce the SWR.

So what can we do about it?

In the main I think we should still use SWRs to prepare for retirement. Now before you go crazy that you’ve read 3,000 words for nothing, let me quote Winston Churchill:

“it has been said that democracy is SWRs are the worst form of Government decumulation planning except for all those other forms that have been tried…”

Even though there are lots of issues with various parts of calculating a SWR that doesn’t mean we should scrap the concept. In fact, the SWR is helpful if we are conscious of the limitations and risks that come along with. In that respect, we should use SWRs in our planning, but not necessarily use them for concrete plans (or as former Dwight Eisenhower put it: “In preparing for battle I have always found that plans are useless, but planning is indispensable.”). So what does that mean in practice?

1. Use various Safe Withdrawal Rate analyses as indicators

Each SWR analysis has its own merits, but is likely to understate or overstate the appropriate rate in a certain direction. For example, calculations using a 30 year retirement period are likely to overstate the SWR. A very long retirement period may understate a SWR. In this way we can triangulate a range of SWRs. We can get a rough idea of what the bookmarks are for an appropriate SWR based on a set of circumstances.

2. Beware false precision

Given all the limitations it’s not mathematically possible to accurately assess a SWR to a high level of precision. Beware analyses that say results such as “our calculated SWR is 4.03%”. This is false precision. The error bars around each spot estimate of a SWR are substantial, so when we are thinking about rates we should be ditching the second decimal point, and arguably even the first. A more suitable result for a SWR analysis could look something like: “3¼ ± 1%”. This means testing your decumulation strategy on a band of rates. The error bars around a spot estimate of SWR can be substantial (depending on the study). So when we are looking at a particular SWR we should consider whether it is possible to estimate that rate to the precision of two decimal places (and for some studies even one decimal place). To that end, it is more prudent for a result of an SWR analysis to give a defined range, something like: “3.25% to 3.5%” or “3.5% +/- 0.5%”. The breadth of that range will depend on the quality of the underlying data, and the statistical noise around the spot estimates. However, you can use the strategy under point 1, to narrow down wider ranges to improve their personal suitability. For example, say the range is 3.5% to 4.0% with 3.5% being commensurate with a 50/50 stock/bond portfolio and 4.0% a 80/20 stock/bond portfolio; but your personal risk tolerance is towards a higher bond allocation. Then aiming for something closer to 3.5% would be prudent. With that in mind, its worthwhile testing your decumulation strategy across a band of rates.

3. Be flexible

Where things are uncertain, we should counter-act this by being more flexible. Our behaviour can and should adapt as information and circumstances change. That doesn’t necessarily mean working a side-hustle in retirement (which can be a bad idea) but a worthwhile attempt might be acquiring skills that never go out of demand or skills that are at their most valuable during periods of economic downturn/low returns. An important enabler of flexibility is insurance. Insurance seems to be less discussed in the FI Community, self-insurance seems very popular. But having the right insurance policies can be an excellent way to protect against life shocks. Finally, whilst some may decry me for being wishy-washy, being flexible in your life outlook can also help add security to your withdrawal method. An example is being open to moving home (aka geo-arbitrage).

In closing

As I mentioned at the start, none of this should be read as a personal criticism. In fact, there has been a huge amount of great work done by lots of very smart people. But its important that we know the limits to the work done so far. All predictions of the future need a big health warning. Its important that you don’t blindly take a SWR from a study as a fact. You should mould a SWR to your own personal circumstances. I want to end with the following quote from Portfolio Charts (which was a very instructive source for this post) that encapsulates this post perfectly:

Just because something did great in the past does not mean it will continue to do so on your own personal time-frame. I believe withdrawal rate research is a wonderful way to help set financial goals and guidelines, but one should never put their life savings in the hands of a single back-tested number. Flexibility, intelligence, and determination will beat mechanical withdrawal rates every time!

Thank you for reading. Please share your thoughts (and criticisms!) with a comment.

All the best,

Young FI Guy

Resources:

Portfolio Charts, an excellent site with explainers on SWRs and various calculators:

Early Retirement Now, probably the number one source in the FI community on SWR research. Kartsen has done some amazing work, most notably his 23(!) part series:

EREVN on Medium, has also done some great analysis on SWRs: https://medium.com/@justusjp

Retirement Investment Today, was one of the main catalysts for me achieving FI and thinking about SWRs from a UK perspective:

Living Off Your Money – Michael McClung – I’ll confess I’ve only read the first three chapters, but on the basis of Monevator’s recommendation I did buy the book at the weekend and plan to read the rest of it.

 

[Note: the post was edited on 02/05/2018 on the “false precision” point following feedback from several readers. I felt that the example I was giving was being unhelpful and suggesting that SWR analyses are noisy to the point of being useless. As I set out in the article, I don’t think that’s the case. SWRs can be a very useful tool if they are tailored to your personal circumstances. But we should be conscious that we can’t boil it down to one exact figure. Using a range, narrowed down through applying your situation to each analysis, is prudent way to get more mileage out of a SWR figure.]

Why We Write

It’s 1942 and Frank Capra is about to embark on his most challenging project to date. By this point Capra, one of the most influential American film directors of all time, had all ready conquered Hollywood. He had already won the Academy award for Best Director three times. And he’d produced, what would become, some of the most influential movies of all time. Amongst them: It Happened One Night, Mr. Deeds Goes to Town and Mr Smith Goes to Washington. But this was his toughest challenge to date. To persuade the American people to fight and die for their country against the growing fascist tide. To explain to them: Why We Fight.

By most reckonings, the Why We Fight films were a success. But hindsight masks what a difficult task this was. Even though the Japanese had just bombed Pearl Harbor, the US had engaged in a decades long non-interventionist policy. That’s not to mention that the country had only just started taking tentative steps out of the Great Depression, would be siding with their antithesis would-be allies the Soviets, and just 20 years ago bloodily tipped the balance in the “War to end all Wars“.

During WWI it was speeches that mainly served to bolster morale. Whilst some speeches would continue to hold such power, it was film, the growing medium at the time, that would spear the fascist propaganda machine. The first of the films, Prelude to War would win the Academy Award for Best Documentary. And the films would have a long-lasting cultural impact on the US. In particular, that the US were the force of good who had a moral duty to fight the forces of evil (the films are available in the public domain, although do bear in mind that, as propaganda films, they contain many untruths and sometimes even outright racism towards other nations).

Why we write

This past week I’ve been reflecting on my experience so far writing this blog. I’ve been following the FI community for a long time, both through many blogs and podcasts. Some of those writers are what encouraged me to reach to FI. When I left my job just over a year ago, I had planned to do some writing. However, I still wasn’t sure whether I would “do the blogging thing”.

For some time, I had reflected on my “word emissions”. Whilst I’ve never been the most talkative of folks, I’d always aimed to say something if it felt important. But I was feeling I was just another emitter of chatter in a world polluted by noise. Over time, I’d been slowly withdrawing away from commenting online and sharing my own thoughts in the Personal Finance community. That’s not to say I didn’t have things to talk about; rather I had felt drowned out in a sea of noise. I questioned what special insight I had over thousands, millions of others.

I’ll confess that it was Mrs YFG who really encouraged me to start blogging. She thought that I should share my thoughts (and rants) with other people. And that those people would find what I had to say both entertaining and enlightening.

Starting the blog

So I started the blog halfheartedly. I wrote a few pieces, but made no attempt to promote them. A turning point came when I felt compelled to leave a comment on the Monevator website. In fact, it was more so the troll response that I got from another commenter. I was frustrated by their (wrong) personal attacks but I was just going to ignore it. But Mrs YFG told me: you’re right, they’re wrong – you know more about this stuff than 99% of people – why don’t you explain. And so I responded.

It was that response that started a trickle to the blog. And that trickle left many positive comments. These comments encouraged me that, opposite to my gut feel, I wasn’t just “adding more noise”. Feeling more confident I wrote some more, and started to go back to my old habit of writing comments on some of the blogs I followed.

The trickle has turned into a daily flow of readers. Now up to 10,000 total visits. And to all those visitors, the commenters and especially the persons who have linked to and shared my posts, I am immensely grateful.

Learning the Internets

An irony in all this is that Mrs YFG and I have another social media account with the best part of 100,000 followers. 10,000 views is a fraction of what each post gets. Not to mention a single post usually gets more comments than this entire blog has to date. But I tell you this, each comment I’ve got on this blog has felt so valuable. Each a small confirmation that I was right to start writing.

Another slice of irony is that, for a millennial, I am incredibly old-fashioned. Most of my posts originate with the simplicity of pen and paper (including this one). I don’t have Facebook, and have no real clue how to promote posts in social media circles (let alone maximising your SEO, whatever that means). I’m on twitter however, mainly due to the insistence of a good friend of mine (I’m still learning how to use it).

That leads me towards the denouement of this piece. The other night, I was reflecting on my blog journey thus far. The thing I’ve found most valuable was being, once again, tapped back into the Personal Finance community.

I’ve enjoyed so much reading the blogs and comments from people I had never seen before. Some of those posts have changed my view on things. But what struck me most was how much excellent content out there and being talked about. In my semi self-imposed absence, the Personal Finance community has grown from being, what used to feel like a couple of strange dudes whispering in the corner of the bar, to being the loud diverse party slap centre in the bar.

The Good Fight

That’s important. Because whilst there’s been a great deal of progress in the Personal Finance space over the past few years there’s still lots of problems. Financial illiteracy is still rife. Much of the Finance industry still engages in opaque practises and deliberate attempts to bamboozle the public, and is being dragged kicking and screaming towards accountability and transparency. And whilst the mainstream media is improving its financial media, much of it falls woefully short and in some cases is downright dangerous to investors.

That’s what conjured up the image of Why We Fight. The fight against fascism replaced by the fight against wage-slavery and poor financial decisions. A collective attempt to unwind the prevailing propaganda in Western society. That spending money will buy you happiness. That a Finance industry that works for its benefit, rather than yours, is fine. That being ignorant of how taxes, pensions and investing works is OK. It’s why we write.

Since starting my blog, I’ve been encouraged, in a way more than ever, that the forces of good in the Personal Finance community will prevail. But I do wonder whether blogs, podcasts and social media is how we will win. What do you think? How can we best bring the fight?

All the best,

Young FI Guy

The State Pension NI Fiasco?

Last week This Is Money ran an article titled: “Officials admit they can’t say if your state pension top-up will work and tell savers to seek expensive financial advice” (link)

This follows several earlier articles on the “State Pension Fiasco”:

  • Couple who lost £7k topping up their state pensions finally win a ‘goodwill’ refund as HMRC stands by its baffling system (link)
  • The state pension top-up fiasco: Savers are paying to boost their incomes only to find payouts don’t rise and they can’t get a refund (link)
  • I’m being deprived of £155 full state pension despite paying NI for 45 years because I was ‘contracted out’ behind my back! Steve Webb replies (link)

The articles are all high on anger but less clear on what the problem is. In part though, that’s because the problem is quite complicated and not easy to explain. The thread that runs through each of these pieces is that the Government has done a very poor job of communicating the 2016 changes to the state pension (the “single-tier” or “new” state pension).

In this piece I’m going to try my best to explain what’s going on with the new state pension, why things are going and what you can do about it. Before all that, let’s take a potted history of the UK State Pension.

6 April 2016: the day the earth stood still…

On 6 April 2016 the Government brought in the New State Pension (NSP). The key distinguishing element of the NSP is that it is single-tier – it has only one element – for 2018/19 it pays £164.35 per week. There are no other payments or anything like that – just one amount. The concept behind it was two-fold: (i) the old pension system was convoluted, a single-tier pension is much simpler; and (ii) the new system paid the same to everyone, the state wasn’t going to pay out extra cash to “rich pensioners”. But to understand the NSP, we need to look at what it replaced.

The Old State Pension (pre-6 April 2016)

If you reached State Pension Age (SPA) before 6 April 2016 (men over 65, women over 63), you get the Old State Pension (OSP). There were two elements to it: (i) the Basic State Pension (BSP); and (ii) the Additional State Pension (ASP). To get the full BSP you needed 30 years of National Insurance Contributions (NICs) or credits. For 2018/19 the full BSP is £125.95. If you had less than 30 years then the amount was scaled down commensurate with the number of years you had accrued. So far so easy. The ASP was where things started to get complicated. First, we need to go back to 1961…

State Graduated Pension Scheme

In 1961 the government introduced the State Graduated Pension Scheme (SGPS). Designed, to reflect that some people had paid additional NICs compared to the self-employed (through the fixed rate Class 2 contribution, note Class 4 doesn’t provide entitlement to any benefits, it’s only Class 2 that counts). However, most occupational schemes contracted out of this – by paying the value of the ‘additional’ NICs out of the occupational scheme instead of paying it to the Government. In effect, very few people accrued under the SGPS.

SERPS

In 1978 something that might be a bit more familiar came along, the State Earnings Related Pension Scheme (SERPS). To cut it short, if you earned above certain limits you accrued an extra pensions entitlement to reflect that you were making more NICs. You would accrue the entitlement at a 25% rate, what’s more only your best (i.e. highest paying) 20 years counted. It sounds too good to be true, and it was. The accrual rate was too generous and in 1988 the accrual rate for those retiring post-2000 was cut to 20% and career average earnings used. Again, many people were contracted out of SERPS.

S2P

As you may have guessed, the Government again changed its mind. In 2002 they replaced SERPS with the State Second Pension (S2P). The aim of the S2P was to widen the scope of people who could get an additional entitlement and to skew benefits away from high-earners to low and medium-earners. In short, the Government created a “three-band system”: increasing accrual rates for lower earners to 40% (between certain limits) and lowering them to 10% for “middle-earners”, with the rate for higher earners, 20%, the same. The Government made a commitment that nobody reaching SPA before 6 April 2009 would be worse-off under the new system compared to SERPS. So those people received an additional accrual top-up (this principle pops up again later and is one of the causes of the current New State Pension issues).

It wasn’t long before the Government realised they once again set accrual rates too high. In 2010, the Government scraped the “three-band” system for a less generous “two-band system”. The middle and upper bands were combined and both accrued at 10%.

This lasted only 2 years until April 2012 when the Government changed the lower band to a fixed rate, and generally speaking, less generous accrual. The Government also stopped contracting out for those with a DC scheme, so only DB members could keep contracting out.

As you can probably surmise, working out your S2P requires a brain the size of two watermelons. Firstly, you split your earnings across the bands and revalue them to the tax year prior to reaching State Pension Age (SPA). You then multiply the earnings by the relevant accrual rate (including any adjustments required for SERPS). You then divide by the number of years in your working life (from age 16 to SPA).

Pension Credit

There was one final element of the Old State Pension. Under the OSP there were also State Pension Credits. In short, these were designed so that people would have a minimum floor for their State Pension (i.e. wouldn’t have a below-poverty level pension). There were two types of credit:

  1. Guarantee Credit – If you have income below £163 (single) or £248.80 (couples) and savings under £10,000 (with a few other conditions) the Government tops you up to £163/£248.80 (2018/19 figures).
  2. Savings Credit – This is a credit for those that built up savings for retirement. In effect if your income is higher than a certain level, the Government tops you up. Because the full-rate New State Pension was set above the maximum Pension + Savings Credit, the Savings Credit became no longer relevant for people reaching SPA after 6 April 2016.

To take-away, there were things in place to make sure you got a certain level of pension income in retirement.

In Summary

If there are two important themes to take away from the OSP it is this:

  • It was very complicated; and
  • Continually chopped and changed, but with a commitment that those under the SERP/old system wouldn’t lose out under the new/S2P system.

Back to the NSP

It wasn’t just the amounts and the simplification that changed on 6 April 2016. Several other rules changed, many of which caused problems:

  1. You need to have at least 10 years NICs to get anything (up from 1 year)
  2. To get the full £164.35 you now need 35 years NICs (up from 30)
  3. From 6 April 2016 you can’t claim a SP based on a spouse’s NIC record.
  4. All NIC classes (employed vs self-employed) accrue at the same rate.
  5. The Government set the principle that you couldn’t have a lower pension than your accrued entitlement to the ASP/SERPS/S2P as at April 2016.
  6. Contracting out for DB schemes ended (it had already ended for DC schemes)

Problem 1: Not all NICs are equal

Numbers 1, 2 and 3 meant that some people suddenly found themselves “short” of the NICs needed to get the new full pension. To help with that, you could make voluntary contributions. However, there are two types of voluntary NICs. Class 3 – which allows you to buy a higher level of the old BSP (and now New State Pension) and Class 3A – which bought old Additional State Pension (until 5 April 2017). These bought different things and it is entirely dependent on your contribution record whether you needed to buy Class 3 or Class 3A or both.

Secondly, and most importantly, Class 3 NICs for years after 6 April 2016 contribute to the NSP, increasing the rate by 1/35th. If you made Class 3 NICs for years before 6 April 2016 these could count towards your old BSP and not towards the NSP, and could therefore be pointless.

Problem 2: You can’t be worse off in the new system than you were under the old system

In a way this is a nice problem to have, but it means that to calculate your entitlement you need to calculate a hypothetical entitlement under the old system. I’m not being facetious here but: THIS CALCULATION IS INCREDIBLY COMPLICATED.

For those under State Pension Age at 6 April 2016, you first calculate what’s called the Starting Amount, a hypothetical based pension which is the higher of:

  1. What you would get under the old State Pension (BSP plus ASP); and
  2. What you would get if the NSP existed from when you started work (age 16).

If this amount is lower than the full NSP you can contribute Class 3 NICs from between 6 April 2016 and SPA to get the full NSP. Voluntary contributions for years pre April 2016 may or may not increase your pension depending on whether the Starting Amount is based on the Old System (1) or the New System (2). If your Starting Amount is based on the Old System and you have 30 NIC years then contributions for years before 6 April 2016 will not increase your pension.

If the amount is higher than the NSP then the difference between this figure and the NSP is called the Protected Payment. The Protected Payment is paid on top of the NSP, it increases by CPI every year and most importantly any further NIC years post 6 April 2016 will not add any more to your State Pension.

If you’ve followed all that, then you’re doing better than the first time I read about all this!

Why things have gone wrong

With all the background out of the way, we can look more carefully at what’s gone wrong. It’s generally a combination of two things:

  1. The calculations are very difficult; and
  2. The Government (DWP) have done a terrible job at communicating what the changes mean for you.

Maybe (a) or (b) on their own would be manageable, but together its caused huge problems for a lot of people. Let’s look at some common questions.

“I was contracted out for most of my working life, I’ve now lost my pension!”

Nobody has “lost their pension”. How to think of this is to imagine two big jars. One labelled private pension, one state pension. If you were not contracted out when you earned money you filled up the private pension jar through your occupational scheme and you filled up the state pension jar via NICs. If you contracted out, you didn’t pay some of the NICs that you would have put into the state pension jar and but instead your employer would give you the value of that extra state pension “you were giving up” when it came to taking your private pension (i.e. by topping your pension up). By contracting out you traded some, or all, of the state pension for a more generous private pension.

“Nobody told me this at the time!”

The contracting out decision was usually done at the workplace, not individual level. That’s because if there were mix-and-match of people with different contributions it would have been a ballache for HR to calculate. So usually all employees at a company contracted out or they all didn’t. As Sir Steve Webb (ex-Pension Minister) says: “you were probably not aware of this at the time – the National Insurance figure was simply deducted at the reduced rate from your paypacket without you realising that it was a lower rate.”

“I made voluntary class 3 contributions and it didn’t increase the state pension I’m due to get”

This can happen for two reasons, both reflect poorly on DWP/HMRC.

The first reason is that you would have made contributions for years before 6 April 2016 and your Starting Amount is based on the Old System. As I mentioned above, if your Starting Amount is based on the Old System, contributions for years before 6 April 2016 may not increase your pension. By topping up for years before 6 April 2016 you may have been topping up an already “maxed out” old Basic State Pension.

Being frank, I think the Government should take a big bit of blame on this (as well as elements of the financial press exhorting people to make Class 3 contributions). They heavily warned people that they might need to make voluntary contributions but they made it less clear on the very important “what years count” rule. This should have been in huge flashing lights for people to make it very clear what contributions earn what entitlements. For most people, the distinction of what year means what isn’t very clear and is arbitrary.

The second reason is that your Starting Amount is higher than the New State Pension. That is, you would have been better off under the old system than the new one so in effect you get paid an amount as if you were on the old system. Making class 3 contributions is therefore irrelevant.

The Government can maybe take a little less bashing on this. But the reason people get confused on this is because it is a very confusing calculation. To do the calculation you need to work out your entitlement to the BSP and ASP and this in turn may require you to calculate your accruals under SERPS. You then also need to calculate the much simpler entitlement under the NSP. So, it’s all well and good bringing in a new, simpler system but the reality is, it’s not simpler for most people, in fact it’s a lot more complicated.

This is not to mentioned other issue, Pension Credits, which may secretly kick in which would top-up your income to a level near-commensurate with NSP and make voluntary contributions not cost-effective.

What you can do about it

If you are reading this and thinking about your pensions entitlement and whether you need to make voluntary contributions then you can get what’s called a State Pension Statement from the Government. You can do so from the following website: https://www.gov.uk/check-state-pension. Alternatively, you can complete what’s called a BR19 form and post it off. You can download the form from this website: https://www.gov.uk/government/publications/application-for-a-state-pension-statement

The statement will give you a headline figure: for a lot of people this will be £164.35 (for 2018/19). This is the full New State Pension. If your figure is more than £164.35 then that means you accrued a higher entitlement under the old system, so you’re state pension is based on that (see about the Starting Amount above). If your figure is less than £164.35 then that means you have yet to earn enough NI years to get the full NSP. This means you need to make further NICs to get the 35 years required for the full NSP. You can do this in a few ways:

If your starting amount is based on the Old State Pension:

  1. If you have more than 30 NIC years then you can’t top up your pension using pre April 2016 contributions. But you can make post April 2016 contributions. Either through working, voluntary Class 3 contributions, or self-employed Class 2 contributions.
  2. If you have less than 30 NIC years then you can top up your pension using pre April 2016 contributions to a maximum of 30 years (thereafter extra pre April 2016 contributions will not add to your pension). If at this point your starting amount is still less than £164.35 you can make post April 2016 contributions to increase your pension.

If your starting amount is based on the New State Pension:

  1. You can work for the additional years required, making Class 1 or Class 2 contributions.
  2. You can make voluntary Class 3 NICs for any incomplete contribution years over the past six years by paying for the relevant missing months.
  3. If you have lots of years left until SPA, it might not be worth making voluntary contributions for gaps, as you might get the required number of NIC years through future contributions.

If your statement shows an amount less than you were expecting, or don’t understand it, then you can call the Future Pension Centre on 0345 3000 168. They will be able to explain how the figures are calculated and send these calculations to you in writing. They can’t give you financial advice however, so don’t expect them to advise you whether to pay any voluntary NICs. From what I’ve read online, the vast majority of people find them very helpful to contact.

Some closing thoughts

If you’ve got this far, thank you for reading. I appreciate this is a potentially very dry and dull topic. Whilst there has been lots written on the subject, I have struggled to find resources that pulls it all together and aren’t 30 pages long! The best resource I have found is a presentation by Royal London from 2017 (link) and on the related website (note: it’s set out for “advisers only” so use at your own risk).

Below is a diagram from the presentation that pretty much puts into pictures what I’ve set out above. Even in diagrammatic-form it’s still quite a chore (note 2016/17 figures are used in the diagram).

[edit 27/05/2018: Royal London updated the above resource for 2017/18, the link should take you to the updated slide deck. The picture above is still for 2015/16]

Some further helpful resources:

Royal London: https://adviser.royallondon.com/technical-central/pensions/general/state-pension-transition/

Pensions Man: http://www.pensionman.co.uk/learning-zone/the-new-state-pension-where-advisors-fear-to-tread/

Age UK: https://www.ageuk.org.uk/globalassets/age-uk/documents/factsheets/fs19_state_pension_fcs.pdf

Whilst I think the intention behind the move to a single-tier pension is noble, it has been poorly executed. HMRC and DWP do not have stellar reputations in being open, transparent and good communicators. Expecting them to communicate such wholesale and complicated changes was never going to be without hiccups. Another issue was trying to do too much in one go; fiddling around with NI years, contracting out changes and the extensive linking to the old State Pension. In addition, there’s stuff I haven’t even talked about, such as changes to the state pension age and bereavement allowances. In that sense it feels like the main purpose of the change, simplification has been lost in trying to achieve other (political?) motives.

Please feel free to share your thoughts. Whilst I’ve tried to ensure I’ve got everything correct, there’s a possibility (probability?) I may have made mistakes or typos in places. As always, conduct your own due diligence and if in doubt speak to an expert.

All the best,

Young FI Guy

Why we don’t buy each other gifts

The YFGs don’t observe the usual gift-giving traditions. We don’t do Valentines, Anniversary, Birthday or Christmas gifts to each other. This invites a mix of hilarity, misunderstanding and respect from our family and friends.

Simply put, we have no reason to give gifts to each other at any particular time of year or spend a certain amount of money on each other because of a specific calendar date. I bought Mrs YFG a coffee machine in October, just because we both wanted one, and I surprised her without her having to make the decision about which one to buy. I buy her flowers just for the hell of it. To her that means much more than me rocking up with some candles and perfume on her birthday. What she really wants on her birthday is a day off work and all my attention.

Let’s be clear – we buy presents for other people, and other people buy presents for us. We just don’t get them between ourselves as husband and wife. Instead we show our affection for each other every day, not through buying some material good on an arbitrary date.

I would prefer not to give or receive gifts at all. I want people to save and invest their money instead. And I typically don’t want anything (if I need it, I’ve usually bought it already!) But nobody else agrees with my miserly ways. They just say I’m a grouch. Mrs YFG ascribes to a milder version of my grumpy anti consumerism: Semi-Frugality.

Semi-Frugality

Mrs YFG likes to think of Semi-Frugality as spending money on stuff that really matters. Buying things that make her life significantly better in the long-term. She does this by only buying stuff when she knows it will provide more value to her in the long-term than its price. When she finds things that are no longer giving her value, she re-sells them on Ebay or gives them to charity. Semi-Frugality comes from the other direction of Frugality. Semi-Frugality means that by spending only when it makes sense, you implicitly end up saving money for your future. Frugality comes from saving first and spending second. I’m definitely in the Frugal camp – it’s how I’ve always been. But that doesn’t work for everyone (and Mrs YFG). We each have to find our own way to make Financial Independence work for us.

On the spectrum

I think a mistake that lots of personal finance blogs (and personalities) make is that there is frugality or not frugality. For those that aren’t naturally frugal, the idea of extreme frugality must be quite off-putting. Clearly, there is a spectrum when it comes to spending, from vaskning through to early retirement extreme. Finding the right balance is important and what can make a focused attempt to heavily save for retirement successful or doomed to fail. For Mrs YFG and I, I am more towards the ERE side of things, but not by much.

Bringing balance to the frugality

One of the most commonly cited “frugality hacks” is to cut out the lattes from Starbucks. And whilst I think for a lot of people, cutting down on the coffee trips is a good way to save some money, there will be some people who enjoy their coffee so much that cutting the habit brings a negative, rather than positive, impact to their life. In that sense, it’s important to find balance – as the Jedi Knights must do in Star Wars. Too much cost cutting, in the wrong places, will feel like a punishment and the dark side will grow.

That’s why I bought the expensive coffee machine last year. Mrs YFG loves a good cappuccino in the morning, but felt guilty every time she stopped at Costa to pick one up. Equally, when she didn’t have her morning cappuccino she’d feel unhappy as she was missing out on something she really enjoyed. Now we can have dozens of cappuccinos for the cost of one at Starbucks. We enjoy trying out different types of coffee (including forking out for Monmouth Coffee).

Some readers are probably wincing at me talking about buying a £50 coffee machine and £10 bags of coffee in the same verse. But in a way, that’s the point. Some people would find our coffee habit ludicrous. But that should be a big red flashing warning light. If they are spending lots of money on it, they should consider it a ripe area to save money. Likewise, if the thought of having delicious and fantastic coffee at home is making you salivate then maybe its a sign of something you truly enjoy but aren’t letting yourself have.

The gift of not gifting

That’s why for us, we can pass on not buying each other gifts. It’s the spontaneity of gift giving to one another that brings us joy. It’s the thought of expressing our love to each other everyday through little things that makes us happy. And going through an annual ritual of present buying seems like a silly way to do it.

 

All the best,

Young FI Guy

Happy New Tax Year!

As you’ve probably already worked out I’m a few shades different from normal. Mrs YFG has got pretty used to that over the years but one thing she still finds funny is how much I enjoy the new tax year. Every 6th of April is like a mini-Christmas to me. Now before you start calling the authorities that there is a madman on the loose – let me explain why. I’m one of those guys who likes a good deal – a bit like Harry Redknapp without the bulldog and bank accounts. And to me there seems few better deals than the annual ISA and pension giveaways that save investors 000s of pounds each year in saved income and gains taxes. Each 6th of April I’m like a squirrel, burying my nuts out of the grubby hands of the taxman.

In this post I wanted to outline what I do each new tax year and why. And then share a few comments on things that have changed this tax year. This is by no means the “warts-and-all” tax guide which I’m sure has been prepared by people much smarter and less lazy than me. But hopefully it’ll give an example of the things I think about.

What I get up to in the new tax year

Firstly, I max my ISA allowance of £20,000. Unfortunately, there was no increase to this year’s allowance, but given we got a hefty £5k increase the year before, I’m not gonna protest too much. In the past this usually involved me dumping the £20,000 I had saved up in my bank account each year. Now I’m a lazy layabout on/off worker, I only manage to save up a little bit of cash to chuck into the ISA pot. The rest of the allowance I make up using something called “Bed & ISA”. This involves selling my investments outside of a tax-wrapper and re-buying them in the ISA. Most brokers, including mine, only charge a single transaction fee (or make it completely free) to do this, making it cheaper that manually doing the transactions. When Bed & ISA-ing there are a few things to think about:

  • Defusing capital gains – by selling investments that have made some gains, I can use up your Annual Exemption of £11,700 (18/19) so that I don’t have potential CGT to pay. Once within the ISA there are no capital gains, so I won’t have to worry about this ever again. The issue is, if I sell too many assets (c.£45k) or make too many gains after losses (£11,700) I would need to file a self-assessment. You can read more about this at the excellent Monevator website.
  • Realising capital losses – on the other token, if its been a rough time for some of my investments I can sell them and claim a capital loss in a self-assessment. This can be used against future capital gains (with a few rules, check out the .gov website for all the gory details). Bear in mind that losses are used first against gains in the same year, so if I’ve also sold assets with a gain, less than the Annual Exemption, I would “lose your losses”.
  • Reducing your income tax bill – the other tax element is my income tax bill. There are two elements: (i) interest income; and (ii) dividend income. Starting with interest income, this results from the distributions of Bond funds and ETFs (to qualify, a fund/ETF must, generally speaking, hold over 60% in fixed income or cash-like assets) and from direct holdings of Gilts and Corporate Bonds (bear in mind that you don’t get charge capital gains tax on Gilts, making the need to protect them in a tax-efficient wrapper much lower). Dividend income arises from distributions from equity funds and direct share holdings. There’s also potentially different rules for REITs and you need to consider the effect of withholding tax, generally reclaimable in a SIPP but not in an ISA. All the above also applies for Reporting Funds if you have non-Reporting Funds, as defined, first give yourself a smack on the bottom and then read this, again from the great Monevator website). Interest and dividends are tax differently. Here’s the break-down:
    • Interest – you get an interest allowance of £1,000 (basic rate payers) or £500 (higher rate payers). So if your interest income from all your un-sheltered investments (remember, including bank interest) is less than these amounts you won’t have tax to pay! This can make interest paying investments less of a priority to shelter. But…
    • Dividends – In dark days gone past dividends would be paid after “deducting” a confusing notional dividend credit. In short, if you were basic rate payer you didn’t have to pay any more tax on your dividends. In 2016/17 the government finally scrapped this mind-bendingly confusing system and gave everyone a dividend allowance of £5,000, now £2,000 (see more on this below) and jacked-up the dividend rates (which are higher than for interest income). If you earn total un-sheltered dividends of less than £2,000 you don’t have tax to pay. This means that if you are likely below the allowance then sheltering dividend paying investments may be less of a priority, but if you are above the allowance then it’s more of a priority.

Back to the real world

So this tax year I’m doing the following:

  • Transferring £4,000 in cash from my savings into my stocks and shares ISA.
  • Bed & ISA-ing £16,000 of an equity ETF and re-buying it in my stocks and shares ISA. This is because this investment has a substantial gain (the total holding has a gain above the Annual Exempt amount), so by selling I’m defusing part of the gain and lowering the likelihood of having to pay CGT in the future. Secondly, I’m over the dividend allowance, so the distributions from the fund are taxable, and at a higher rate than my interest income.

As another example, I’m helping a family member do the following:

  • Bed & ISA-ing £20,000 of a bond ETF re-buying it in their stocks and shares ISA. They don’t have capital gains to worry about at the moment and they are below the dividend allowance, but above the interest allowance. So they don’t pay tax on dividends but do on interest. So moving the bond (rather than equity) investments reduces their tax.

New tax year changes for 2018/19

I wanted to close by writing about some (but not all) of the 2018/19 tax changes.

  • The Dividend Allowance – as mentioned above, this is cut from £5,000 to £2,000. Now, I’m gonna try to be calm, but this change has made me very angry. Firstly, the new allowance lasted only one year before being substantially changed. Now investors should be investing for the long-term, so when a major change to taxes is implemented (which it was, in moving from the old dividend credit system) investors are really punished when these changes last in the months not years. This is a particular bad as the allowance accompanied the pension freedoms. Many quick-thinking people may have cashed in investments from their pensions believing that they would not be stung by taxes on their investments but have easy access to them only to see the allowance slashed. I’ve also seen a number of commentators state that the case for S&S ISAs reduced because of the dividend allowance. Those not using their allowance last year might be ruing their choices. But there’s a double kicker:
  • The Money Purchase Annual Allowance (MPAA) – has been cut from £10,000 to £4,000. Broadly speaking, this is the annual amount you can put into the a pension after en-chasing a money purchase pension. So, you may have taken money out of pension, using the much touted flexibilities, thinking you won’t pay tax on your dividends and you could always put it back in to a pension at a good rate. Unfortunately, the government changed the rules drastically, again after only one year. Even worse, these changes have been enacted retrospectively from April 2017 (so anyone who hoped to stuff their pockets before the change was in legislation may come up short). I understand why these changes were made (limit pensions re-cycling and to raise tax rates on higher payers) but to investors the continually changing rules make it very difficult to plan for the long-term.
  • Auto-enrolment – From April 2018 the automatic (unless you opt-out) rate put into your pension goes up from 1% to 3% (and 1% to 2% employer contribution). There’s been a flood of articles on this in the mainstream media, but given this changes has been on the cards for years its hard to see how this is a shock. Maybe we might see more “shock” when the rate goes up to 5% (3% employer contribution) next year. Hopefully a savvy finance type you are already getting the max contribution from your employer (https://youngfiguy.com/pensions-isas-the-basics).
  • The Annual Exemption for Capital Gains nudged up from £11,300 to £11,700. The Personal Allowance also nudged up from £11,500 to £11,850, the bands for higher rate also nudged up. They didn’t for Additional Rate payers, so if you are one, please feel free to sob into your champagne…
  • The Buy-to-Let Mortgage Offset reduced from being allowed to deduct 75% of your mortgage interest on BTL income down to 50%. Apparently this is less of shock (maybe because the mainstream media went a bit mad when it was first announced). It’s going down to 25% next year, and finally to 0% in 2020/21 (just to prepare you in-case you drop your monocle in your soup when you read about it in the Telegraph next year).
  • Student Loan thresholds are going up. They are nudging up slightly for Plan 1 payers (those before 2012). More importantly, for those post 2012 (with the enormous, higher than commercial rate loans) the threshold is jumping up from £21,000 to £25,000 (as well as the interest thresholds). The threshold had been controversially ‘frozen’ at £21,000 since 2012, and by controversial I mean the Government had made a desirable retrospective money grab, breaking promises given to students. Thankfully, the thresholds are due to increase with average earnings from next year on-wards (well until the Government changes its mind again).
  • Finally, the Lifetime Allowance (LTA) is (finally) increasing from £1,000,000 to, wait for it, £1,030,000, in line with CPI (3%). No accounting for the dramatic earlier cuts or the lack of an increase last year. Finally, a little bit of good news for those who’ve done the responsible thing and built a great nest egg for retirement. Unfortunately, there’s no cast iron guarantees that the Government will keep increasing the LTA in line with inflation. So good luck forecasting 10/20/30/40 years into the future.

I hope you’ve enjoyed the post. I also sincerely hope I haven’t made any mistakes or typos – if I have please let me know! Please remember you should do your own research or speak to an authorised financial advisor or financial planner before making any and every investment decision. If you make an investment or decision on the basis of any of the information above you do it at your own risk.

All the best,

Young FI Guy

That time I locked down the Amazon Prime

In early 2017, I locked my wife out of our Amazon account. Intentionally. Before Mrs YFG was on the wagon, she was a fully fledged impulse purchaser. Need a slow cooker? Reed diffusers? Face electrolysis set? Amazon has it and you can buy it using their ‘patented’ one-click system.

When she had an inkling that she needed something, or wanted something, she’d go straight on and buy it. Why? Because that satisfied her craving at that point for stuff.

Mrs YFG would often splurge on the commute home from work. Usually late at night and tired, you are very vulnerable to the whims of craving for stuff. Some very smart researchers have found loads of empirical evidence about ego depletion. By the end of a long day, making challenging decisions, you find that your willpower and self-discipline has been used up – like a tank of petrol. You find that you mentally replace the not-so-easy question of: “do I really need this?” with: “do I like this?“. Spoiler alert: you probably do like it, otherwise why would you be looking at it; and you probably don’t need it because you’d already have it.

Present day Mrs YFG is selling a lot of this stuff on eBay to get rid of it, or giving it to charity. Much is unused and most didn’t make her happy. She’s also discovered that she can make good money out of selling things that no longer bring her joy.

I have to confess that I myself sometimes fall for the dangers of Amazon Prime. There is something dangerously convenient to be able to buy anything you want at the click of the mouse and have it hand delivered to you the next day. Especially when I’m frustrated if something’s gone wrong or waiting to fix something. Amazon has a seductive lure, promising to make things better. I have to slow myself down and remember the real reason I’m feeling frustrated or down – and that buying stuff won’t fix that.

Our unconventional (and cheap) wedding

We are at the time in our lives when our friends invite us to their (increasingly overpriced) weddings. It is not uncommon to see weddings that are £30,000 or £40,000 – two twenty-somethings without a house but will spend that kind of money. Sometimes, it’s even more than that – like the viral article from the BBC a few weeks ago – “I regret spending £50,000 on my wedding”

When you saying “wedding” the prices mysteriously go up

Mrs YFG and I originally approached our wedding assuming we would have the “traditional wedding”; white dress, ceremony, reception, all that shizz. A couple of weeks into the planning, once we started adding up the costs and getting back the outrageous quotes, we said “balls” – we went back to the drawing board.

As a mathematician/economist (geek) I went back to first principles:

  • Why are you making a decision on something for your wedding? – why are you spending the money? Is it because you genuinely believe that item will make you happier or add to your day, or is it because people expect it?
  • What makes a good wedding? What were the best weddings we had been to?
  • What is most important to you? What is the thing you want to remember about the day?

Thinking these things through with Mrs YFG-to-be we realised we had been putting the (wedding) cart before the horse. We thought we’d have to do all the wedding planning a certain way, forgetting that we don’t live in communist Russia, we could decide exactly how our day and what we wanted.

The things we realised were:

  • Wedding ceremonies are boring for us (and I think 99% people) – there’s only so many times you can hear the same Corinthians bible verse (“Love is patient. Love is…blah blah blah”).
  • The best weddings were where there was great food, free drink and fun (good music, dancing, good crowd).
  • The worst weddings were stuffy, where you’re trapped at a table next to Great Aunt Dorothy talking about her thimbles for 3 hours, and the food sucks.
  • The most important thing for us was that we had fun and enjoyed the day.

Our wedding day(s)

So we did things a bit unconventional. We got married at a registry office, in a beautiful old town-hall, in a beautiful oak panelled room with huge comfy leather chairs. If you want a fancy outfit, spend money on a dress/suit you really like and want to wear again. Mrs YFG refused to wear a white dress. She bought an evening dress from a high street shop and checked it fit, then wore it. She’s worn it since as it’s one of her nicest dresses and has a special meaning to her. Mrs YFG bought me a new work suit, which I continue to wear (occasionally). I refused to wear a tie as I hate ties.

For the ceremony itself, we had no vows – in fact we asked for the shortest ceremony possible (we wanted to go drink and celebrate as soon as possible). We invited only the people who really wanted to be there (close family) – a wedding party of 8. We then went and had a private dinner at one of our favourite venues in Central London – where we had unlimited wine and a beautiful room (I can’t even remember how good the food was though…)

Later that evening, being quite drunk and tired, we then had a house party in the evening where we invited about 30 friends over for a celebration. Mrs YFG wore her pyjamas and drank a lot of wine (her favourite type of evening). We decided to split our wedding day over two – that way we got to have more parties and also not be utterly exhausted after cramming everything into one long day.

Our wedding reception was the next day, so we had time to rest and recover. We booked a restaurant out for the reception in the evening and set up a tab, ordering food and drink on the tab – everyone drank and ate for free. We didn’t pay for set meals which were overpriced and pre-prepared. No hire fees just a minimum spend. We bought a nice pre-made wedding cake from a supermarket and decorated it with some flowers. The flowers we got from a friend of a friend who is an amateur florist, who did this stuff in her spare time. We reused the wedding bouquets as the table centrepieces. We didn’t buy any fancy decorations and other paraphernalia – we picked up half a dozen disposable polaroid cameras for people to take pictures and got those huge sweet shop jars of penny sweets. Mrs YFG got one of her professional DJ friends to do the music and he did a great job for a decent price.

We didn’t go on a honeymoon after – we spent the time together doing up our house. And enjoyed our first Christmas together.

We aren’t cheapskates, I swear!

Don’t get me wrong – we could have spent much more on our wedding. And maybe we might have had a (marginally) “better” time (or maybe not…) But we spent the money we saved on our house, which we get to enjoy every day. The concept of the ‘perfect day’ is particularly troubling – when is anything in life perfect? Demanding perfection is only likely to leave you disappointed. We had a great time – and to be honest, much of it is hazy blur lost in a whirlwind of drink and talking to hundreds of people and being pulled from place to place.

A final tip – wear comfortable shoes.