The Lifetime Allowance

When I started this blog I didn’t have a set target in mind about what I wanted to write. The result is that I’ve written about all sorts of subjects from why Mrs YFG and I don’t want kids through to the technicalities in Safe Withdrawal Rates.

I enjoy writing about FI and various tangential subjects. But I’ve also really enjoyed writing about personal finance subjects. I like to learn about something, try to understand it and then have a go as explaining it in (hopefully) a concise and easy to understand way.

The most popular post on the blog so far has been on the State Pension and NI-top. Like a moth to flame, I’m continually attracted to writing about pensions. I think that’s because Pensions can be inherently complicated and finding good material on the subject is challenging. It’s also because there are some misconceptions and I want to challenge those.

Today’s subject, the Lifetime Allowance, seems to tick all three boxes. Lets start with a quick introduction.

What the Lifetime Allowance is and why it exists

The Lifetime Allowance (LTA) for 2018/19 is £1.03 million. Basically what happens is if your total pensions are greater than £1.03 million, you will get a 55% tax charge on any lump sums you take or 25% on any pension income you take (more on all that in a bit).

When you put money into a pension the Government provides tax-relief. For example, if you earn £80,000 a year you will be a 40% tax-rate payer. If you put £600 into your pension out of taxed income the government will put in £400 (40% of the total contribution) to bring you up to £1,000.

The underlying principle under the pension tax-relief system is that you defer taxes. Whilst pensions can be used to avoid taxation, generally speaking, what happens is that paying tax “going in” you pay tax later on when you draw on your pension.

It’s this principle which the lifetime allowance is balanced on. In effect, the Government is saying it isn’t in the business of giving rich people unlimited tax deferral benefits. So they created the LTA, a limit to the amount of tax deferral the Government is willing to give you.

History of the Lifetime Allowance

The Lifetime Allowance came into existence on 6 April 2006, known to those in the pensions industry as A Day. A Day is the Pension expert’s equivalent to the birth of Christ – things are either pre-A Day or post-A Day.

Essentially what happened on A Day was that a huge raft of disparate measures and rules were scrapped with new simplified rules coming into force. More than 8 different regimes were boiled down into two: the Lifetime Allowance and the Annual Allowance (more on that another time).

The starting LTA was £1.5 million. It crept up to £1.8m in 2010/11 before being drastically cut down.The 2018 budget provided some light relief, the LTA was increased by CPI (3%). However, the Government has no written commitment to continue increasing the LTA by CPI.

Protection mechanisms were introduced at each reduction in the LTA (including introduction): in 2006, 2012, 2014 and 2016. More on that in a bit.

When is the Lifetime Allowance assessed

The most important thing to remember about the LTA is that it is not assessed when you have a pension pot above £1.03 million. Rather, the LTA is assessed at specific points when you interact with your pension. These are called Benefit Crystallisation Events. There are 12 of them in total. But I’m going to focus on the 6 main ones (and Pre-A day interaction).

A few comments on the table above:

  • You can see a disconnect between how DB and DC schemes are measured. DB (BCE2) at 20 x annual pension; DC at the Annuity purchase price (BCE4) or Drawdown value (BCE1). With annuity rates at very low rates, its possible that were somebody to transfer from a DB to DC scheme that they could end up the wrong side of the LTA and incur a tax charge they may not have done if they’d stayed in their DB scheme (more on that later).
  • A similar situation exists for the QROPS transfer (BCE8) which is measured at Transfer Value. Bear in mind that since 9/03/2017 (retrospectively) QROPS transfers outside the EU incur a 25% tax charge.
  • Pre-A day pots are measured at 25 times pension or max capped drawdown. This is to account for tax-free cash taken. Pre-A day pots are measured when the 1st post A-day BCE occurs (such as, reaching 75 (BCE 5a) with a drawdown pot post A-day).

How the charge is assessed

In effect the charge is assessed by adding up all your pensions and “filling up” the LTA like a bucket. You only get a charge if the bucket starts overflowing.

You can partly dictate the order in which you fill the bucket. By taking some pensions earlier/later you can reduce your LTA charge. For example, as DB schemes are more ‘generously’ assessed compared to a lifetime annuity, it might make sense to take lifetime annuities first if possible. A lot will depend on what an individual’s scheme rules will allow.

Another thing to note is that Drawdown pensions (except Pre-A Day pots) are tested against the LTA twice. The first test is BCE 1 when the funds are first designated and then again on either:

  • Scheme pension (BCE 2), or
  • Annuity Purchase (BCE 4), or
  • reaching age 75 (BCE 5A), or
  • on transfer to a QROPS (BCE 8).

To ensure there no double counting only the increase in funds crystallised under BCE 1 are tested at the second designation.

How the charge is applied

As mentioned above there are two tax-rates: 55% and 25%.  These are commonly called the “lump-sum” and “income” rates. Its perhaps easier to think about these instead as whether the money “leaves” or “stays” inside the pension tax reigme. For example, if you take a lump-sum on drawdown, it leaves the tax regime. The excess above the LTA is charged at 55%.  If you instead take an annuity income, you take a 25% tax charge on the excess above the LTA plus any income tax (note: QROPS transfers count as a 25% LTA charge).

You might think that 25% is lower than 55% so taking income is always better. But it depends on what income tax rate you’ll be at. As an example:

  • Take £100 lump-sum over LTA: £100 x (100% – 55%) = £45 after tax
  • Take £100 income over LTA:
    • 45% tax-rate: £100 x (100% – 25%) x (100% – 45%) = £41.25 after tax
    • 40% tax-rate: £100 x (100% – 25%) x (100% – 40%) = £45 after tax
    • 20% tax-rate: £100 x (100% – 25%) x (100% – 20%) = £60 after tax

As those being hit by the LTA are likely to be high earners (40% or even 45% tax rate), there’s probably little different in overall tax rate between lump-sum and income.

In terms of how it’s charged, usually the pension scheme will pay the charge: called a “Scheme Pays” arrangement. This is because schemes are joint and severally liable for the tax, so they like to make sure the tax is paid instead of HMRC being on their back.

Protection – always use protection?

As I mentioned earlier, HRMC provided “Protections” against the reductions in the LTA. They each work a little differently. And whether, and what, protection is right for you will depend on your circumstances.

2006 Primary

  • Brought in on A Day
  • Aimed at individuals who wanted to keep accruing or saving into pension and were over the LTA
  • Eligible if Pensions > £1.5m on A Day
  • Your LTA is enhanced by a Lifetime Allowance Enhancement Factor (LAEF) to get a ‘personal’ LTA (rounded up to 2 decimal places)
  • Can keep accruing/saving into pension
  • Underpinned by an LTA of £1.8m

Example calculation:

Pensions worth £1.8m.

LAEF = (£1.8m – £1.5m) / £1.5m = 0.2 LAEF

Personal LTA = £1.8m + 0.2 x £1.8m = £2.16 million

2006 Enhanced

  • Brought in on A Day
  • Aimed at individuals who had exceeded the 2006/2007 lifetime allowance of £1.5 million, or believed they might exceed the standard lifetime allowance in the future, and were willing to cease all future contributions or limit future accruals
  • Eligible at any pension value on A Day
  • “Unlimited” LTA
  • But no more accruing (above certain limits, roughly speaking no more than higher of 5% or RPI) or making further contributions into pension
  • Had to surrender “excess rights”

Fixed Protection at 2012, 2014 and 2016 (FP 2012 / FP 2014 / FP 2016)

  • Eligible for anyone without Primary, Enhanced or other Fixed Protection
  • Eligible at any pension value
  • Fixed LTA at:
    • £1.8 million – FP 2012 – must have applied by April 2012
    • £1.5 million – FP 2014 – must have applied by April 2014
    • £1.25 million – FP 2016 – still open for application
  • But no more accruing (above certain limits, roughly speaking no more than higher of 5% or RPI) or making further contributions into pension

Individual Protection 2014 and 2016 (IP 2014 / IP 2016)

  • Eligible if:
    • Pensions > £1.25 million on 5 April 2014 (IP 2014) – must have applied by April 2017
    • Pensions > £1 million on 5 April 2016 (IP 2016) – still open for application
    • Anyone who doesn’t already have Primary Protection
  • Receive a capped and fixed Personal LTA equal to pensions value at 5 April 2014 /2016 up to:
    • Maximum of £1.5 million – IP 2014
    • Maximum of £1.25 million – IP 2016
  • Can keep saving into pensions or accruing

Valuing the benefits

To get the Pensions value for Individual Protection (and Primary Protection) you had to value each pension depending on its type:

  1. Unvested Schemes (i.e. not yet paying):
    1. Money Purchase – at market value of funds
    2. Defined Benefit – at 20 x pension plus any cash by addition
    3. Cash Balance – amount available for provision
  2. Vested Schemes (i.e. already in payment):
    1. Pre-A Day pensions – 25 x pension / Max GAD for capped drawdown at the first post-A Day BCE [*]
    2. Flexi Drawdown – 25 x Max GAD when Flexi Drawdown entered [*]
    3. Post A day vestings – value at BCE

[*] This is a bit complicated see Pru Adviser for more information: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/individual-protection-2014-2016/?advsr=4&advtsr=11&q=individual-protection

Losing Protections

Unfortunately it’s possible to lose protections after you’ve successfully applied for them. In some cases, it can be completely unintentional.

The good news is that Primary Protection and Individual Protections are almost impossible to lose. The only situation where an individual can lose the protection is if they were divorced and the pension was shared. In effect this reduces the level of protection on the pension. Under IP 2016 there is an offset mechanism which reduces the level of loss.

The bad news is that the rules are much more strict for Enhanced Protection and Fixed Protection.

An individual loses Enhanced Protection if they:

  • accrued a benefit which exceeds the permitted limit defined as the “relevant benefit accrual”;
  • contributed to a DC scheme (with some exceptions);
  • had a new arrangement (except in the case of certain transfers); or
  • made some transfers (HMRC has set of permissible and impermissible transfers).

The relevant benefit accrual depends on the scheme rules, statutory rates and the level of CPI each September. Generally speaking, it is very difficult to not exceed the limit if you an active scheme member.

An individual loses Fixed Protection if they:

  • increased their benefits in DB scheme above a certain level;
  • contributed to a DC scheme;
  • start a new arrangement under a registered pension scheme other than to accept a transfer of existing pension rights; or
  • transferred to an unregistered pension scheme (i.e. not a QROPS), from a DC to DB scheme (depending on circumstances) or from one DB scheme to another (again depending on circumstances).

An individual doesn’t lose Fixed Protection if they are subject to a pension debit (divorce). However, they will not be able to rebuild any pension fund without revoking their Fixed Protection.

DB to DC transfers – a word of warning

Generally speaking, DB to DC transfers are allowed under Enhanced and Fixed Protection. But the rights in the new scheme must be actuarially equivalent to the rights being transferred. As a word of warning for those with Enhanced or Fixed Protection, some schemes have been reported to offer transfer values out of DB schemes far in excess of their CETV (Cash Equivalent Transfer Value). Such transfers could result in the individual losing their protections. This is where seeking independent financial advice is very important.

LTA Planning – where paying more tax isn’t always a bad thing

If there’s one thing to take away from LTA planning it’s that:

Paying tax is only bad if it the net benefit isn’t worth it

To give an example, say Jane earns £50,000 and is a member of an employment scheme and the employer will contribute 10% to her scheme unless she opt-out. Here’s the maths:

Amount added to pension fund: £5,000

Lump sum after 55% tax: £2,250

Net cost as a 40% tax payer: £0

In this case, she’s getting £2,250 for free. Clearly a good deal!

 

Now say Jane’s employer will match 10% to 10%. The maths can still be good:

Amount added to pension fund: £10,000

Lump sum after 55% tax: £4,500

Net cost as a 40% tax payer: £3,000

So for £3,000 after tax she can get £4,500 in your pension. An immediate 50% return.

Now whether that will be the right call for her will depend on a few things. If she’s close to retiring, that 50% boost is difficult to beat. On the other hand, if there are ISAs or her spouses pension available then it might be less enticing. Likewise if accessing that money is a long way away. She’ll also want to consider whether she wants to pass on an inheritance to her children; in that respect, the recent inheritance tax changes to pensions can make it a very appealing option.

To round up, I quote Pru Adviser (which was a helpful source for this post):

The key point that clients need to remember is that tax is only bad if the net benefit is not deemed “worth it”. Opting out to save a tax charge, even if the net benefit is better, would be a bit like a client asking their employer to stop paying their salary because there is a tax charge.

In closing – key points

  • The underlying principle under the pension tax-relief system is that you defer taxes.
  • The LTA regime is a claw-back of this the tax deferral
  • The LTA is assessed at certain interactions with your pensions, called Benefit Crystallisation Events (BCEs)
  • How your total pension pot is valued depends on what type of pension it is
  • There are a number of protections to increase or fix your LTA, but you can lose them if you aren’t careful
  • Paying an LTA tax charge is only bad if the net benefit isn’t “worth it”

Please let me know your thoughts. Have you done any Lifetime Allowance Planning? Has the Lifetime Allowance changed what you do with your pensions?

Disclaimer: Please note, I’m not an FCA authorised financial adviser. The site provides information, comment and opinion for information purposes only and should not be considered financial advice. The site may contain incorrect information or mistakes. 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 information you do it at your own risk.

 

All the best,

Young FI Guy

Is private school worth it?

Right now students up and down the country are studying away and taking their final A-Level exams. Mrs YFG and I have carefully observed the mortal panic of colleagues and friends as their kids sit their exams. Good results and the fruits of all the schooling will have paid off. Bad results and it will be back to the drawing board for their future university and career plans.

The stakes are high. Not only because these results will determine what universities and jobs these children will be able to get. But also because Mums & Dads all over the country have spent hundreds of thousands of pounds putting their children through private education. Will it all be worth it?

Giving your children the best possible start

Almost all parents want to give their children the best possible start in life. They want to see their children succeed in the world and enjoy happy lives. For many people, private school is a way of ‘ensuring’ that their children have the best possible chance to succeed.

Both Mrs YFG and I went to pretty dodgy comprehensive schools. Going through state education didn’t hold either of us back. We both got good grades, went to a top Uni and nabbed high paying jobs. Likewise, we know people who went to the best and most expensive private schools only to tumble out with little to show for the huge sums of money spent on their education.

So giving your child an expensive private education is no guarantee of success. Not having a private education is not a guarantee of a life of mediocrity.

It’s all about the money

Unfortunately for Jessie J, when it comes to private schooling it very much comes down to the price-tag.

In doing some research for the article I came across a few estimates for the cost of private schooling your children from nursery through to college.

According to Killik & Co, an investment advisor company, the cost to put a child through private school between 2002 and 2015 was £174,000 to £236,000. They estimate that the cost has ballooned and from 2015-2028 the cost will be £286,000 to £468,000.

I also did some calculations using data from the Independent Schools Council and it could cost between £160,000 and £350,000 to put a child through private schooling from 2004 to 2018 (more on this in a bit).

These are, without being Cpt. Obvious, huge sums of money! Many of Mrs YFG’s colleagues still live pay-check to pay-check despite earning 6-figure salaries. In part, because they are forking out massive sums to keep Tarquin and Octavia in private schooling.

Is it worth it?

One of the biggest factors in me reaching FI was that age 16 my father passed away and I inherited a small 6-figure sum. Rather than blowing it all away, I invested it, with aim of retiring early (having seen how fleeting life is) by saving over 50% of my salary I was able to quickly multiply my stash to the point that working is now optional. In that respect, I was massively lucky (even if that fortune arose through tragic circumstances).

Having money behind me at a young age has given me an enormous advantage in life (along with many other leg ups). This got me thinking. Instead of spending that money on a private education, what if you invested it? Surely a huge stash of money at a young age is as big of an advantage as you could ever hope for in life?

*WARNING MATHS AHEAD*

Without further ado, I am proud to present Young FI Guy’s Super Private Un-education Numerical Kalculator.

I ran some numbers based on the following scenario:

  • Tarquin Jr. was born in 2000.
  • Since 2004 (nursery) he’s been put through private education (through to Sixth Form).
  • Now it’s 2018, he’s about to finish his A-Levels and his schooling.

The questions are:

  • How much would it have cost to put Tarquin through his schooling? and
  • If instead of private schooling you invested that money instead what lump-sum could you have given him today?

Here is the summary:

The cost

I came up with 7 different cost scenarios, these are:

  1. You could fill up your stocks and shares ISA each year from 2000 to 2018. The limit in 2000 was £7,000 up to £20,000 this year. This has a total cost of about £190,000.
  2. If you are a high-roller you could fill up two(!) stocks and shares ISAs, for a total of c.£370,000.
  3. I took the high and low estimates from the Killik & Co research (these refer to an education cycle of 14 years from 2002 to 2015, so pretty close to Tarquin’s 2004 to 2018) and divided them evenly across 14 school years (Reception to Upper Sixth). The cost for these is c.£170,000 to £240,000.
  4. I also went through the annual ISC survey data adding up the costs for each year according to the survey. Tarquin was in Junior school from 2004 to 2011, Senior school from 2012 to 2016 and Sixth Form from 2017 to 2018 for a total of 15 years of schooling. There are three estimates: Boarding School (the highest cost), Day-Fee at a Boarding School (the middle) and Day-only School (the lowest). The costs totalled between £160,000 and £350,000.

In summary, the total cost of the various options ranged from £160,000 to £370,000 with the ISA subscriptions matching the costs pretty nicely. Both in total and by stepping up over time, commensurate with school fees increasing.

Investing

The next thing I did was to say that instead of spending that money on the school fees what if on each January 1st you put that money into an index fund tracking one of three indices: FTSE-All Share Total Return; S&P500 Total Return; or MSCI All Country World Index Gross. I then deducted 0.5% fee lump sum per annum at year-end to roughly simulate investment costs.

The figures are staggering and speak for themselves. In the “lowest-case” scenarios Tarquin Jr. would have over £250,000 to spend on cocaine and strippers his future. With the “best-case” scenarios he’d have over three-quarters of a million!

Investing in the FTSE-All Share, you would have increased your money by only 60-70%. However, investing in the S&P500 or the MSCI ACWI you would have roughly doubled your money.

What’s most impressive

There are two things particularly impressive about these figures:

  1. This was one of the worst times to have invested: you hit both the dot-com bubble and the financial recession, yet your stash still increased enormously.
  2. These returns are back-loaded as the costs of schooling are highest in most recent years (and the ISA limits are highest in the most recent years). You made stacks of cash on your investment despite putting most of your money in relatively late.

If you want to play around with the numbers, you can! I’ve uploaded the spreadsheet which you can access here!

It’s not a fully fledged model (as it’s fixed to cover 2000 to 2018) but I’ve left space to change the cost assumptions, fee assumptions and you can tinker with the market returns.

[p.s. I can’t guarantee it’s fully accurate or doesn’t have any mistakes, if you spot an error let me know!]

Over to you…

I’m pretty against private schooling, but I think that even the most fervent supporters of private schooling might think twice if they could give their child a £780,000 leg-up.

If you had the decision to make, would you rather your child had a private education or a lump of between £260,000 to £780,000 on their 18th birthday?

 

All the best,

Young FI Guy

[p.s. I’ve stuck purely to numbers here without taking in to account the non-numerical aspects. I’m not a crazy numbers-sociopath (or am I?) It’s hard for me to talk about some of the qualitative aspects of parental education choices as I’m not a parent! Many parents will strongly (and perhaps rightly?) argue that private schooling confers many non-educational benefits such as developing discipline, ethos etc. Likewise, none of this takes into account that the most important thing (in my view) is spending time with your children!]

How to budget like a Wall Street banker

Budgeting can be the most important step in successful financial planning. But the way we’re told to budget is usually counter-productive. The reason most budgets fail is that they are doomed from the start. They don’t work. People think about a typical month. Massively underestimating what they actually spend.

The way I like to think about budgets is how Wall Street bankers value companies (and how I valued companies in my previous job).

The mind of a banker

There are two ways to value a company:

  1. forecast all the future profits of a business and add them up; or
  2. find similar companies to the one you’re valuing and use these as a benchmark to value your company

When budgeting is usually explained to people, it’s done so using Method 1. You estimate all your expenses in advance and guess how much you’ll be spending on any given item in the foreseeable future. But this method is much more difficult than Method 2!

The issue is that it’s very difficult to forecast reliably into the future. It’s even more challenging when starting from scratch. It’s daunting and it puts a lot of people off.

For example, how are you supposed to know how much groceries are going to cost you in any given month? Most budgets also look at a typical month and will miss out things like contingencies, emergencies, and unplanned life events.

In my opinion, the better way to start budgeting is using Method 2. Here’s the step by the step guide of how to budget like a Wall Street banker.

Step 1 – Dragging up the past

The first step is to gather your own historical spending data. When a Wall Street banker is valuing a company they need to make sure that they’ve got their own accurate track record for the company they are valuing. You do the same with your finances. There are 3 common ways people gather this data:

  • pen and paper – each time you spend something you write it down (or use an app for this, such as Wally or Monefy)
  • download your transaction data from your bank – almost all banks now make it possible to download your transaction history (this is what I and Mrs YFG do every month: we get a glass of wine and “do the expenses”. Aren’t we cool!)
  • Use an app or software – there are lots of really cool apps that will download the data from your bank account automatically and categorise the data for you. For example, to name a few, there’s Mint, Money Dashboard, Spendee. (We don’t do this because we are reluctant to give a third-party access to our bank accounts!)

The underlying principle behind this tracking is the need to be comprehensive. Every single item is accounted for. Every penny you spend is recorded. It won’t necessarily catch cash transactions unless you manually input them. But it will catch you taking the cash out of your bank account and so will record it that way. There’s nowhere for your expenditure to hide!

Believe me, this process makes you a lot more aware of what you spend. A lot of the time, we are on autopilot and completely forget what we bought and why we bought it (Mrs YFG is bad at this). By doing this data-gathering exercise, you’re actively reminding yourself what you spend each month and you see the figures add up. It can be surprising at the end of the month when we’ve spent a couple of hundred pounds just on lunches!

Step 2 – Reading the entrails

After gathering the data, the Wall Street banker will categorise and summarise it into tables and spreadsheets. Calculating averages and aggregates of the key numbers on an annual, quarterly or monthly basis. So what we need to do is to take our historical data and calculate how much we spend each month and in what categories:

  • Housing (rent, mortgage, home repairs)
  • Utilities (gas, water, electric, mobile phone, internet, TV)
  • Groceries
  • Entertainment and eating out
  • Clothing and beauty products

Here are the categories we use:

House Cash Games
Gifts Council Tax Cosmetics
Food Energy Insurance
Lunch Broadband Eating Out
Coffee Mortgage Holiday
Pigs Water Amazon
Salary Shop Clothes
Interest Health Media
Dividends Investment Charity
Travel Mobile TV
Transfer Books Website

You can create whatever categories work for you. Likewise, you can use those from a website or an app you may use (such as, these are the categories on Mint). If you use an app that gathers the data automatically, then categorising and aggregating is trivially easy.

We personally have our own spreadsheet where we download the data export from our bank accounts. We select a category for each item from a drop down and all the sums and adding up is done and summarised.

Whatever method you use (app, your own spreadsheet or somebody else’s spreadsheet) once you’ve inputted the data, you’re left with a monthly run-down of how much you spend and how much you’ve spent it on.

Step 3 – Keeping up with the Joneses

Before the Wall Street banker can value his company they need to gather the comparable data for his similar companies. To make our budget comparisons we need to find out what people similar to ourselves spend. We can start with finding out what an average household, or a household similar to ours, spend on things.

For example, in the UK, you can get this information easily from the Office for National Statistics (which creates does an annual cost of living survey) or the Money Advice Service (which has a budget planner that compares your data to the UK average). In the US you can get this information from the Bureau of Labor Statistics (which produces a consumer expenditure survey).

We use these average figures to get a rough idea of what a similar household to ours spends and in what proportions. This gives you a very easy baseline budget that you can use.

One of the key benefits of doing this is that we find out what Mr Average spends. This is important. If you spend/save the average, you will get an average result (i.e. not FI and working for the man!). The idea of FI is you spend less than the average and save more than average. This baseline gives you a target to beat, so to speak.

Step 4 – What to compare when you’re comparing

The Wall Street banker has their data. He now needs to start doing the comparisons. The first comparison is very simple: will this company go out of business or not?

For us, the comparison is: am I spending more money than I earn? We compare money made to money spent in the same period (i.e. monthly salary vs. monthly spending, annual salary vs. annual spending). News flash: if you’re spending more than you earn, you will eventually go out of business. Beauty is in the eye of the beholder, but the banker will value you at $0.

The banker will then compare the profit margins, revenue growth and various other metrics of their company compared to the metrics for the average companies in the market. For us, this means comparing our current expenditure to the averages you acquired in Step 3.

There are two benefits to this: (1) if we’re spending more than the average person that implies there is room to cut down, (2) we can find out which areas we spend more on than others (i.e. clothes, cars etc) and this can highlight the areas where we can start to save money.

Equally, it gives a sign of the areas or pursuits that mean a lot to us: for example, a person might spend a lot on Motoring because they enjoy jumping on their motorbike and going for a ride. This process can help us reflect on the passions in life that bring us happiness. These are the things to focus on, the spending on the less important things can be reduced.

Congratulations, you have a working budget

Having done the comparisons and set up our budget, we can now start building up our detailed financial history. Once we have enough data we won’t need to compare to the average, we have our own average.

We can compare our current spending to previous spending and start to recognise patterns or trends. It’s now possible the “true” one-offs, the unexpected expenditure or when we are starting to fall to the siren calls of Amazon.

At this stage, the Method 1 we talked out before is a lot easier to do. That’s because you actually have the detailed data to forecast correctly. We’re not starting from scratch and have something concrete to build from. The Wall Street Banker will use both Method 1 and 2 to cross-check one another. That’s something we can do by using our last year’s expenses as a forecast and seeing whether we end up spending more or less and why.

From time to time we can compare our spending to the average. For example, are we paying too much for certain utilities or can we get a better deal? Our housing costs too high, is there somewhere cheaper we can live?

What do you do?

I hope you enjoyed the post. Thank you for reading. I’d really like to know whether you budget, and if so, how do you budget? Do you have any tips or tricks for creating a successful budget? Are there any tools, apps or spreadsheets you would recommend?

 

All the best,

Young FI Guy

Mrs YFG’s FI philosophy

Mrs YFG here. It’s been a mixed bag for me working towards FI. I have a few years left.

I was brought up with the idea that you always saved one-third of your money. The rest you could spend as you pleased. I did this until about the age of 16.

After working nearly a decade to pursue a career I thought I would follow for the rest of my life, I became mentally and physically tired of it. I thought that being able to say I was a solicitor would miraculously make me happy and all the things I ever wanted would fall from the sky. It didn’t. Bugger.

Mr YFG was on his path to FI and I saw what he expected of life and I wanted that too. I wanted to find a job which was less than 60-70 hours a week and just absorbed all my energy. In fact, how about getting to a point where I don’t have a job?

Hmmmm.

Work doesn’t give you the skills for life

But then I sat down and thought of what I could change in my life – what else could I do with my time? I am qualified to be a solicitor. I can’t build stuff or do DIY, I’m no artist. There was no backup plan. I had no idea what else I could do, or wanted to do, with my life. I had never considered the possibility of choosing to live life without work, or without the trappings of what society expects from me.

Trapped by the guilt and shame of feeling that I was being ungrateful for the privileges I enjoyed, I struggled for years to just get on with it. I had been dealt a good hand in life, I would say to myself “stop being so precious“. I read articles online desperately trying to find other people who felt the same: to know my concerns were valid.

Finding my way

Mr YFG has always gone his own way and often I need to learn or realise something for myself before I agree with him. I was convinced FI wasn’t for me. I ridiculed his spreadsheets at first and resented handing over my credit card and debit card bills so he could assess our expenses. I later realised how I was essentially spending my freedom.

That was before my first nervous breakdown from stress at work. After losing my mind and skipping through months of drugged reality, I reassessed. I left Firm #1 at that point and took some time off to see what I wanted out of life and to consider what other jobs I wanted.

Over four months in 2014, I struggled to be away from work – a job, a routine – and couldn’t find fulfilment without some kind of paid work. I struggled with the prospect of relying on Mr YFG for income (he was working at that time). I knew I didn’t want to not work (if that makes sense). So I went back to work, to Firm #2 where I am now.

Coming back to work with a new view on life still didn’t stop my mental health deteriorating. In late 2016/early 2017, I suffered another relapse caused by work, and I thought “f**k this sh*t” and sat down with Mr YFG to figure out my own FI path.

Discovering my FI Philosophy

While I was online, I discovered people who rejected the idea of a traditional working career altogether. They wanted to enjoy life without the trappings of consumerism, and save money to be able to decide what they do, when they do it. Mrs Frugalwoods, Mr Money Mustache, Retirement Investing Today and the ilk hooked me in.

Skip forward a few years and, inspired by the FIRE community, me and my husband are on the path to financial independence. This blog serves as both a motivation for me and, hopefully, maybe as a method of opening the mind of some poor lawyer trainee sat under a pile of documents at 3 am wondering what the hell they are doing with their life.

The beach where I decided to write this blog. I don’t want to retire and lie on a beach, that would be ridiculous. I just want to use my life for more than it is used for now. Preferably with more beaches involved.

Time to reform inheritance tax? A view from a Chartered Accountant

There’s no tax quite like it. Inheritance Tax (IHT) feels like the most controversial of all UK taxes and the most talked about. But it makes up less than one percent of tax receipts. Fewer than one in twenty deaths result in a tax charge. Over the next few years, couples will be able to gift up to £1m without paying any IHT.

It doesn’t raise much revenue for HMRC. It affects only a few wealthy individuals. What’s the big deal?

In this post, I’m going to share some of my views on Inheritance Tax. The great news for you readers is that the Office for Tax Simplification is looking for your views too. In a rather new, and I think excellent step, they have set up a short online survey which you can (and should) fill out, sharing your views on IHT (this is the link: https://www.surveymonkey.co.uk/r/SQTNNMT). If you are so inclined, you can respond to the call to evidence, which closes on 8 June 2018 (https://www.gov.uk/government/consultations/inheritance-tax-review-call-for-evidence-and-survey).

My view on Inheritance Tax

In summary, I think that Inheritance Tax needs reform. It is too complicated. Has too many loopholes and exemptions. It has no defined purpose or underlying principle. And it is poorly understood by the greater public – both through poor communication and due to its complexity.

Before I go into more detail, let’s have a quick look at the history of IHT in the UK.

A short history of UK Inheritance Tax

1984 Estate Duty

The concept of modern Inheritance Tax as we see it today dates back to 1894. Back then, the Government at the time created a levy on the land estates to pay off a burgeoning deficit caused (in part) by several centuries of increasingly expensive wars.

This tax, however, was a replacement for a number of (and complicated) levies dating back to the 17th century. These were mainly brought in to fund our involvement in the Napoleonic Wars.

In promoting the 1984 reforms, Sir William Harcourt, the Chancellor of the Exchequer, noted:

The whole system is admittedly difficult and complicated. The Death Duties have grown up piecemeal, and bear traces of their fragmentary origin. They have never been established upon any general principles, and they present an extraordinary specimen of tessellated legislation. Various measures have been made at different times to redress some of their inequalities. Here a patch and there a patch, but each successive modification has only left confusion worse compounded.

Sounds familiar…

1949- Reforms

The Estate Duty continued for about 50 years, with various tweaks until 1949. In 1949 Sir Stafford Cripps scrapped the legacy and succession duties. In his 1949 budget speech he also railed against the complexity and unfairness of the Estate Duty:

The Legacy and Succession Duties also have the drawback that they impose a proportionately heavier burden on the small than on the large estate. For example, an estate of £6,000, passing wholly to brothers and sisters, pays a total charge of 3 per cent. Estate Duty and 10 per cent. Legacy and Succession Duties, equivalent to a rate of nearly 13 per cent., or 10 per cent over the Estate Duty rate; whereas, at the other extreme, an estate of £3 million would pay only 2½ per cent. over the rate of Estate Duty. It is, no doubt, because of this unequal incidence of the duty that testators, in fact, leave about two-thirds of the total legacies and bequests free of duty, and in all such cases the Legacy and Succession Duties merely become a wholly illogical, extra Estate Duty, falling upon the residue.

Sounds familiar…

Over time, the Estate Duty was tweaked, becoming increasingly progressive over time.

1975 Capital Transfer Tax

In 1975 Dennis Healey and the Labour Party scrapped Estate Duty and replaced it with the Capital Transfer Tax. The idea behind the change was that to try to shut loopholes that meant very large estates were avoiding paying inheritance taxes.

Sounds familiar…

The Inheritance Tax (1986)

The current modern-day Inheritance Tax dates back to Nigel Lawson’s reforms in the mid-80s. He scrapped some of the taxes on lifetime gifting brought in under the Capital Transfer Tax. He also increased the three-year rule on transfers before death to the, now infamous, seven-year rule. In introducing the new Inheritance Tax Lord Lawson decried the unfairness of the Capital Transfer Tax:

My last proposal in this section concerns capital transfer tax which, ever since its introduction by the Labour Government in 1974, has been a thorn in the side of those owning and running family businesses, and as such has had a damaging effect on risk taking and enterprise within a particularly important sector of the economy.

There have been some tweaks over the years. The most notable being the introduction of the Residential Nil Rate Band (RNRB) by George Osborne in 2015. The idea behind that being it was unfair for children to pay tax on their family home.

In short, we’ve come almost 150 years without being able to successfully create a fair or simple inheritance tax. Despite the repeated efforts of several governments and chancellors of all stripes.

The reasons why Inheritance Tax needs reform

I think there are 5 broad reasons why Inheritance Tax needs reform.

1. There’s no defined purpose for Inheritance Tax

The original Estate Duties introduced to fund overseas wars. Over time the reason we still keep an Inheritance Tax has changed. The most oft-cited reason is for redistribution: so that the rich don’t get richer. Instead, sharing some of that wealth for the benefit of all.

But the rationale or underlying principles behind IHT aren’t particularly clear. Redistribution alone is more helpful in designing the tax, but not really for defining why it should exist in the first place.

To illustrate with a tax that has a very clear purpose: Value Added Tax (VAT) has a clear underlying principle. It is a contribution towards the shared services and infrastructure provided by a government that facilitated the good or service to be created. Whether you agree or not with that concept, it’s pretty clear. And the method by which you capture it – taking a proportional cut of the value of goods commensurate with the value of the state provided environment – is intuitively simple.

And this is why we’ve muddled along with a tax that seems unfair and overly complex. We don’t know what we want to achieve with it. As with all things in life, if you don’t know what your aim is you end up flapping about. Much like a lying politician being grilled by Jeremy Paxman.

2. Inheritance Tax fails at the only purpose its supposed to achieve

Even with the purpose, we are left with, redistribution, Inheritance Tax, utterly fails. It’s widely acknowledged that IHT is not paid by the super-rich. Without wanting to pick on somebody, when the late Duke of Westminster passed away, almost no inheritance tax was paid on his estate.

If the purpose of IHT truly is to prevent the perpetuation and concentration of wealth, then it surely fails when the very richest people will not pay a penny. The reality is that IHT is easily avoided with some planning. In fact, it’s arguably negligent to have an accountant or financial planner who doesn’t help you think about some aspects of IHT planning.

Finally, IHT often hits those who just meet the threshold most. These people have spent their lives creating a financial nest egg for their family only to have it hugely taxed upon death.

3. Inheritance Tax is poorly understood

The biggest misconception with Inheritance Tax is that it is paid only on death. IHT is actually a tax on the transfer of value from one person to another. And it’s calculated based on the value of the loss to the transferor’s estate. This means, of course, that IHT can be payable when making gifts during your life.

However, it’s most common on death – the whole estate is bequeathed as the deceased no longer exists (remember, ghosts don’t need to own a house to be able to haunt it). The value of the estate is reduced to zero.

Part of the issue is that most lifetime gifts are exempt. There are a huge number of exemptions and loopholes. Most of those have been created because it seems unfair, and counter-productive, to punish people giving away their wealth during their lifetime.

4. The rules and exemptions are incredibly complex

Because we are trying to avoid punishing people for being good and gifting money, we had to come up with some exemptions. But to prevent those exemptions being abused we had to come up with exemptions to those exemptions (and in some cases exemptions to those exemptions to those exemptions, a double Quick Succession Relief being a potential example).

It also means that the rules you think are simple and universal aren’t. The most commonly known rule is the “seven-year rule” – any gifts made prior to seven years before death are not subject to IHT. But really it’s the “seven-year rule(ish) plus maybe the 14-year rule if it’s a PET”. The (ish) because taper relief reduces the IHT payable if the gift was more than three, but less than seven years, before death. The plus maybe the 14 year rule is because if you made a Chargeable Lifetime Transfer (called a CLT) prior to the seven years followed by a Potential Exempt Transfer (a gift that is exempt from IHT, the PET above) because you need to then look back seven years from the PET to assess whether the donor’s NRB should be reduced.

Starting to get a headache?

5. It is double taxation (?)

The most unpopular aspect of Inheritance Tax is that it is often thought to be double taxation. It is a tax on money taxed somewhere before. I don’t think this is strictly true (see Richard Murphy for a pithy take-down http://www.taxresearch.org.uk/Blog/2006/07/31/lets-be-clear-inheritance-tax-is-not-doube-taxation/).

But these concerns come in part because IHT is a completely different tax to all others. Firstly, its wealth based, rather than income based (like Income Tax, National Insurance). Secondly, its calculated differently to the only other pseudo-wealth tax, Capital Gains Tax (CGT). IHT is calculated as the loss in value to the estate. CGT is measured by the value of the asset. This difference is exasperated by how different assets are treated. Your main home is exempt from CGT, but not (subject to the RNRB) from IHT (not to mention Gifts with reservation of benefit).

Here’s what I would do

Before I start, I should say that I don’t think I have all the answers, and I fully expect (and hope) people will disagree with me. Here we go:

  1. Come up with a defined purpose for IHT: For example, I think a better purpose for IHT would be something like: “encouraging the transfer of assets between individuals so that greater value is achieved.” That is, if widowed Grandma Doris has a 5-bed townhouse, surely it would be better to gift it to her daughter and her grandchildren than it laying half-dormant. Likewise, Mr Albert of Albert & Sons may want to gift half of his company to his son so that he can continue building the business when Albert wants to retire.
  2. If we want IHT to redistribute, it actually has to redistribute: The super-wealthy can dodge IHT by making transfers into trust. In legal form, that means they no longer own the assets, but in substance they still do. In all other aspects of accounting, substance trumps form. As long as trusts exist, IHT can and will be dodged. Any IHT rules which don’t account for the trust-fund shuffle will be flawed from the start. Further, parking huge amounts of money into real estate should not be a force-shield against the principle of redistribution.
  3. Scrap IHT and merge it into CGT: This will eliminate the need for most of the painful probate process. CGT would become payable on death (subject to Nil-Gain-Nil-Loss or Hold-over relief) and most estates will continue to be exempt. Principal Private Residence relief would still be available, and applied on transfer to a spouse and, if desired, the RNRB could be added in for transfers to children. I would scrap the relief for AIM shares, which seems bizarre to me. BPR and APR would be scrap-able as Hold-over relief and Entrepreneurs’ Relief can be utilised. This would hopefully limit the number of lawyers and bankers buying farmland in Montgomeryshire.
  4. Avoid arbitrary rules as much as possible: Moving IHT into the CGT regime would remove the need for lots of the rules and exemptions. But we must avoid creating arbitrary rules like the “seven years rule” – why seven years and not eight? six?
  5. Whatever we do, keep it simple: IHT is just too damn complicated. When things get complicated it goes wrong. People get confused. People get angry. Angry and confused people are dangerous (Donald Trump?) Any new system or reform must be simple to understand and easy to communicate. That won’t suit the accountancy and legal firms. But that’s probably a good thing (says the Chartered Accountant…)

Closing comment

I hope you found the post interesting. I’d encourage you to take the short survey by the Office for Tax Simplification (here’s the link again: https://www.surveymonkey.co.uk/r/SQTNNMT).

I’d love to know your thoughts. Should we reform Inheritance Tax? Would you scrap it altogether? If you were in charge, what changes would you make?

 

All the best,

Young FI Guy

I’ve got a confession to make

I’ve got a confession to make… I didn’t really FIRE (Financial Independence, Retire Early). I didn’t quit my job because I thought I was Financially Independent. Nor because I wanted to retire. In fact, I wasn’t even sure I wanted to quit. It was Mrs YFG who talked me into it.

Why I quit my job

I actually enjoy the work I do. As you can probably tell from lots of my posts – I really enjoy finance. But I had stopped enjoying my job in the corporate finance world. I was really struggling to sleep during the week. For as long as I can remember I have suffered from bouts of depression and anxiety. The 9 to 5 (or really the 9 until I had got all my work done) was taking a physical and emotional toll on me.

I wasn’t in corporate finance for the long game. I didn’t want to become a partner or work until I was 50. But I did want to work hard, do interesting work, learn lots of cool stuff and get paid a fair whack at the end of it. I had hoped to work until I was in my 30s maybe 40s and then call it a day – perhaps winding down as I got closer to retiring early.

But over time I started to dislike the ‘job’.

Reason 1: Admin

I really disliked the admin and bureaucracy. Paperwork and compliance was becoming about a third to half of my daily ‘work’. It’s boring and, if I’m being frank, I didn’t like charging my clients so much for ticking boxes. Over time, the regulatory burden was becoming more time-consuming. It’s only going to get worse. I looked at my bosses who spent even more (the majority) of their time jumping through hoops. I was fine with sacrificing some of my happiness to work I enjoyed. But not for filling in forms.

Reason 2: The clients

I had also started to dislike a lot of the clients I worked for. I worked in a niche part of the finance world where you are more pre-disposed to working with some shady characters. Over the years I’ve worked for some of the most unpopular people and companies in the world. But I didn’t mind that so much, because I was performing a valuable service. I was helping people, and society (yeah I know that sounds like a load of tosh, but I still believe it true).

Things turned when I had a string of cases where, even the ‘good guys’, were just acting difficult and – being frank – not very nice. These were people and companies I was helping, but they couldn’t help themselves from being ‘bad dudes’.

I’m a reasonably smart guy, and I had lots of experience and skills. I wanted to help people who needed it. Rather than adding zeros to a company’s balance sheet or a billionaire’s net worth.

Reason 3: Health

As I mentioned up top, I suffer from depression. I was very fortunate in my last job that I had great bosses who really supported me. But there’s only so much they can do. I just wasn’t myself, and I was deeply unhappy at work. The culture and environment of The City/Wall Street just wasn’t conducive to me. I had avoided banking out of university precisely because it was a terrible fit for my personality. The work I did – deeply methodically, requiring lots of patience, thinking and planning – was very suited to me.

But the companies I worked for wouldn’t just let me do the job I was good at. There was the politics, the annual appraisals, the ‘networking’. All a load of rubbish that I was forced to endure. And it ground me down. I had spoken to my boss earlier in the year around my career and asked him for his most important career advice. He said: “Number 1 you must look after your health. Everything else is secondary. If you are unwell, your career and your life will suffer.” His advice (inadvertently) led me to leaving – but I am so grateful for it!

Making the jump

The thing is, I was still going to slog it out. One day Mrs YFG saw that I was particularly glum and asked me what was up. I told her that I was thinking how many years I should keep doing the job before I quit. She responded by calling me an idiot. “If you are unhappy, and want to leave your job, then leave. Working more years isn’t going to make it better.” She was (as always) right. So I quit.

There was no plan – other than what I was doing wasn’t what I wanted to do. I was candid with my bosses and colleagues. There was no new job lined up; I wasn’t leaving to a competitor. Most of my colleagues knew that I saved and invested a lot (I didn’t go as far as to say ‘technically’ I was FI). I was just going to take time to think about things.

The reaction

I got two types of reaction.

The first was very supportive. Particularly from wiser old heads. I spoke to about half a dozen partners and they understood why I was doing what I was doing. Some wished they could do the same – if only they had the financial capabilities to do so (…) Others commended me for making a decision most people are unable to do, because they get trapped by the firm. Partners in other departments (and firms) offered me jobs. I joke to my old bosses that by quitting I ended up getting more jobs.

The second reaction was a mix of confusion, and perhaps jealousy. They get very confused at the idea that I can kind of do what I want. They were confused why I was giving up the chance of earning more money and why at such a young age I was quitting work. A common statement was: “Ohh you’re very brave…” or “I would never do something like that”. Almost as if they would never do something that made them happy?

Mrs YFG’s reaction

Most importantly, Mrs YFG was very happy. Not only because she’s the main breadwinner (she always has been anyway)! But she loves seeing how confused people get when she explains that her husband quit to be a “home-maker”. We unfortunately still live in a time where the woman (even if she earns many times what her husband does, or more importantly, enjoys her job far more!) is still thought to be the person who should be “at home”.

I’m not going to lie, it annoys the crap out of us. I doubt anyone would ask me these kind of questions if Mrs YFG, the female, had quit work. In any case, regardless of societal norms surely we should both be in it together?

You might be asking, quite rightly, why didn’t I wait until we reached FI together?

1. We want to do what we want to do

I enjoy being a lazy layabout. I get to do more things of what I enjoy doing, and less things I don’t enjoy doing.

Mrs YFG wants to not have to worry about certain things. She doesn’t have to worry about getting milk or putting the washing on or paying the bills. I do all that and it makes her life a hell of a lot easier. Being at home gives her the freedom to prioritise her work without having house jobs to contend with. If a task needs doing, I sort it.

We emotionally support each other.

2. It gives me the time to do things I want to do

I haven’t worked it all out yet. But I’ve done a number of things. I studied some professional qualifications that I’ve always wanted to do. Including the qualifications to become an IFA and/or Financial Planner if I wanted to. It’s also meant I could start reading and writing for enjoyment. Including this blog. Where I hope I can help other people with my experience and knowledge. It also gives me time to track our joint FI journey. And I can so in a more positive way: not crossing days off the calendar.

3. Mrs YFG earns more than me

And always has done. She also enjoys her job (most of the time). If one of us is going to stay at home it makes sense for it to be me. We quite frankly, have no time for this nonsense attitude that it should be the woman who gives up her career for caring for her family or home.

4. It reduces our expenses

I haven’t read “Your Money or Your Life” by Vicki Robin. Somehow I managed to stumble on lots of her conclusions. I was ‘making a dying’. I had already worked out that my Real Hourly Wage was much lower than my ‘take home pay’.

By not working I don’t have to buy a travel season ticket. There are no lunches, no work clothes or dry cleaning (thank the lord). No expensive nights in the City ‘networking’. Less delivery fees for postage or late delivery and fewer takeaways. We buy less stuff because we are stressed. Fewer meals paid for in central London because that’s the only chance we have to see our friends. Fewer holidays booked at inconvenient expensive times because that’s the only combined holiday we can get off work.

By my calculations, my expenses halved after quitting my job. (I would recommend listening to her appearance on the Choose FI podcast which was excellent.)

5. It improves our marriage

When we both worked I would come home about 7pm (and sometimes later). Mrs YFG would usually finish work later still. I’d eat some sort of processed food because I was too tired to cook and didn’t want to just for myself. Mrs YFG would drag me out of bed in the morning. And we’d spend a few exhausted hours in the evening together.

Mrs YFG is happier because she can dedicate herself to her job and not feel guilty that she’s not doing things at home. We can talk to each other during the day as I’ve got time to respond. She knows I’m safe at home and more relaxed. I can support Mrs YFG and can be there for her when wants to release her madness and ranting when she gets home from work. My work stress is lifted and I’m able to make our home more comfortable, tidy and clean. I can get a lie in. We’re both not just exhausted ships passing in the night.

So what have I done since quitting the job?

Firstly, I learned to ride a bike. I hadn’t ridden a bike since I was about 10 and had almost completely forgotten how to do it. That way Mr Money Mustache won’t face-punch me if I ever get the pleasure of meeting him.

As mentioned above, I also studied some professional qualifications. I thought for a time about becoming an IFA. But I’ve cooled on that idea for now due, mostly, to the regulatory hassle (I want less paperwork in my life!) In part, that lead me to starting this blog, after encouragement from Mrs YFG (see my post: “Why we write“).

Not too long after leaving, my old boss approached me to do some contracting work. The work was something a bit different. And I’ve really enjoyed doing it. I got to work to my own schedule, at home. Together, the end product we produced was really good. And I got paid a nice amount of money to cover my share of the bills. From time to time, there have been enquiries into other contracting roles – mostly full-time. But, for now, I enjoy the time-off too much to want to commit to working full-time.

A hat-tip

I was inspired to write this post after reading “The Fireman’s” guest post on The Escape Artist (Can you become a millionaire on a fireman’s salary?). I found his candour as well as his sanguine reflections on a life of ups and downs very touching and inspiring. So I’m immensely thankful to him for sharing his story. I feel that often the ‘numbers’ in a FI journey overshadow the story and the person behind them. That’s certainly how I felt when I previously shared (now deleted) my ‘numbers’ and ‘story’.

I hope you found my “confession” interesting! And hopefully an example that not all “FIREs” are clear-cut! I’m interested in hearing your thoughts. Particularly if you’ve quit your job: Why did you leave? Were you “FIREing”? What things have you learned since? For those who haven’t finished work yet: What’s holding you back? Do you have any particular worries or concerns?

All the best,

Young FI Guy

Drawdown: Lamborghinis and holidays

In my previous post I set out five reasons why I think annuities don’t deserve the bad press they get. In that post I focused specifically on the positives that are often overlooked in assessing annuities. I was challenged, both here and at Monevator, on setting out a similar style argument for drawdown.

I think that’s fair. Because, for my money, drawdown gets a lot of bad press that it too doesn’t deserve. The pension flexibilities introduced in 2015 continue to get hammered for retirees blowing their money on Lamborghinis and holidays. Even when the evidence from the FCA says that’s not the case. In its 2017 interim report on pension flexibilities the FCA found that (emphasis mine):

Over half (53%) of pots accessed have been fully withdrawn: 90% of these pots were smaller than £30,000. Over half of fully withdrawn pots were transferred into savings or investments. Overall, we did not find evidence of people ‘squandering’ their pension savings.

I also want to highlight: “90% of these pots were smaller than £30,000”. The FCA picked £30,000 for a reason. That’s because before the flexibilities you could (and still can) take a small pot commutation – immediately drawing down three small pots of £10,000 for a total of £30,000 – the flexibilities made no difference. In addition, if you had a total pension pots of £30,000 or less, you could take a trivial commutation – immediately drawing down the £30,000 (trivial commutation still exists for DB pots). What the FCA are saying is that, for the vast majority of people who have fully withdrawn their pots, they did so using options that were available to them before the flexibilities (they would or could have done it anyway). The FCA are due to publish their final report later on this year.

So lets get on with it: here are five reasons why drawdown doesn’t deserve the bad press it gets.

1. Drawdown provides total flexibility

Of course, that’s the point. As I’ve noted before, there are four key factors to consider when planning savings and investments: risk, time-horizon, access and affordability. Using drawdown provides a huge amount of flexibility – and therefore access – to your savings. That access allows clients to take money from their pension to make payments they might otherwise not be able to do. Such as meeting debts, paying-off the mortgage or making capital investments in their home or business.

2. Drawdown is the best way to match a retiree’s risk profile

That’s because you can tailor the investment approach in a drawdown fund to meet your attitude towards risk and capacity for loss. We can use the assets left to target growth, income or both. After taking an annuity, your retirement income is, in effect, tied to a gilt-like investment. Whilst suitable for many people, it might not be suitable for those who have a higher risk tolerance and want growth (and not income) from their pension pot. Likewise, long-term investing is the best way to protect against inflation risk. I appreciate that non-crystallised pots would be invested anyway. But we should be conscious that, for many people, there will be a need to access some money on retirement.

We can also plan our investment approach to help with matching time-horizons. For example, we can divide pension assets into three pots for different time-horizons. A short-term pot for paying income over the next year to 2 years. A mid-term pot for balancing income and growth requirements over the 5-10 period. And a long-term pot focused on long-term growth beyond 10 years. Over time, a retiree would move money between pots to balance their assets with their time-horizon requirements and income needs.

3. Expenses aren’t flat and smooth

We may like to think that our living expenses are predictable. But in reality, they are not. Particularly in retirement where there is larger possibility of critical illness or disability. But also for happier reasons, such as: providing for children and grandchildren or doing things that might have been put off due to working full-time. In that respect, drawdown is quite suitable. You draw the money when you need to, and you don’t when you don’t need to. In short: it’s easier to match your income to your expenditure. In addition income requirements typically decline in retirement. As we get older, we spend less. With that the case, a retiree can more comfortably shift their investment focus between income and growth generation depending on their circumstances.

4. Drawdown can help with tax and estate planning

The most important aim with pension decumulation is to have enough income to cover living expenses and support an adequate standard of living level. But that may not be a retiree’s sole aim. A retiree may also want to maximise the wealth they can leave to their family. In 2015, the Government removed the 55% “pensions death tax” with a more favourable regime. This made passing down pension funds inheritance tax-free depending on age of the retiree at death. For more info: https://adviser.royallondon.com/technical-central/pensions/death-benefits/death-benefits-from-april-2015/.

In addition, some retirees will benefit from using drawdown as they can vary the income they take to keep them within certain tax thresholds (i.e. within the tax-free allowance or at nil-rate). We should be careful however, in letting the tax-tail, wag the pensions dog. There is a risk, however unintended, that in trying to cut our tax bill we end up making decisions that harm our most important financial goals.

5. With drawdown you have the money (unless you spend it)

One of the most cited criticisms of annuities is that you “give up” the capital. Whilst I don’t necessarily agree with that wording, with drawdown you keep the capital. It means it’s always there if you need it. Of course, the flip-side is that it’s not there if you spend it. You can have the money or spend it on things. If you buy things, you don’t have the money.

Final words

I appreciate that this article may feel one-sided – rest assured – it is! There are downsides to drawdown. Whether they make sense for you will depend on your circumstances. I’ve not gone into detail on the downsides. It’s very easy to find a lot written about those! And given the evidence so far, a lot of it has been overblown. There are issues with drawdown: we are poor at self-control; we struggle to understand risk; it requires continuing to make investment and financial decisions. That doesn’t mean we should discount it as an option.

I’ll probably aim to wrap this mini-series up with a third post, perhaps  directly comparing annuities and drawdown. But I do want to stress: it’s not an either/or option. Annuities and drawdown can be combined. Potentially, giving a “best of both worlds“. The best decumulation strategy will depend person to person. But both drawdown, annuities or a combination of the two may all provide suitable ways to meet your financial aims in retirement.

 

All the best,

Young FI Guy

Annuities: Is their bad press deserved?

In short: No.

I had planned-out an article with reasons why I think annuities don’t deserve the bad press that they get. But, in a fantastic guest post over at Monevator, Mark Meldon, a South West UK-based IFA, makes a far more eloquent case than I could. So instead, I’m going to cheekily piggie-back off his great post. Before you read on, I would 100% recommend you read Mr Meldon’s post on the Monevator site.

Here are five reasons why annuities don’t deserve the bad press they receive.

1. Annuities provide the best method of securing a guaranteed income for life

Mr Meldon makes a compelling case in his guest post. In doing some background reading for this post, I looked at what my regulatory body (the Chartered Institute of Securities and Investments) had to say. It was pretty emphatic:

Annuities are still the best method of securing a regular guaranteed income for life

2. Annuities are (somewhat) unfairly compared to investment products

Whenever I explain how annuities work to people, I always describe them first as a kind of insurance policy. As Mr Meldon explains:

If you buy a life assurance policy you make small regular payments to your life office and, should you unfortunately die during the term, they send you a big cheque.

The reverse is true with an annuity. Here you send the life office a big cheque and they send you little bits of money until the day you die.

[…]

We can see, therefore, that an annuity insures the annuitant against longevity risk, because of the guaranteed lifetime income stream.

You simply don’t get that with any other kind of investment – period.

In effect, an annuity is an inverse life assurance policy. Instead of paying annual premiums, you receive annual payments. Instead of a lump sum payment on death, you make a lump sum payment on commencement.

Looking at annuities from this viewpoint shows us its greatest strength: it provides protection. Specifically, it provides protection against longevity risk – the risk that you outlive your money. Longevity risk is difficult to quantify. That’s why Actuaries get paid so well and have brains the size of two watermelons. And as individuals we underestimate how long we will live. Annuities also give certainty. As we saw under point 1, annuities provide the best method of securing a guaranteed income for life. In this respect, annuities do a very good job at covering two of the important factors in saving and investing: covering your risk tolerance and matching your time-horizon.

I think an element of why annuities get bad press is because the downsides of an annuity are compared to the upsides of investing. But the converse isn’t:

  • In buying an annuity you sacrifice the ‘upside’ of an investment portfolio. This being where the insurer makes some of its money. But, you are protected from the ‘downside’ of the portfolio. Your income is the same even if the stock market tanks.
  • Annuity rates are compared to the returns from the stock market. Whilst the annuity rate is lower than you’d get from sticking your money in an equity index fund, the annuity return per year is certain. The return from the stock market is not.
  • The return over the life of the annuity is, of course, less certain. This is where people sometimes say: “I have to live X years for the annuity to pay off“. Whilst mathematically that is true, from the viewpoint of your financial goals this is less likely to be true. As I noted in my Safe Withdrawal Rate post: “For most people, [financial] success is having enough income to cover living expenses and support an adequate standard of living level.” In that respect, an annuity which covers your living expenses and provides enough income to support your standard of living is, de facto, a success.

3. We are very bad at self-control

The godfather of behavioural economics, Richard Thaler, was inspired, in part, by our lack of self-control.

The guests while waiting with cocktails for the meal, were devouring the cashews—the entire bowl half-eaten in minutes. So Thaler, worried that his guests would fill up on the salty snacks, whisked the bowl away.

He recalled that when he came back, his friends thanked him for it (and found themselves with room to enjoy a big dinner). “But then, since we were economics graduate students,” Thaler recalled, “we immediately started analyzing this. Because that’s what economists do.” Even cashews could hold the key to unlocking insights about our idiosyncratic behaviors.

Without the temptation of the nuts, he said, “We realized that a.) we were happy, and b.) we weren’t allowed to be happy, because a first principle of economics is more choices are better than fewer choices.”

I’m sure most readers manage some or all of their own investments. The urge to tinker and tweak is often irresistible. I struggle to resist the lure of the biscuit jar. An annuity takes all that off the table.

4. Annuities remove a lot of hassle

A key to life is to avoid doing things that cause unhappiness. For me, and I think a lot of people, paperwork and doing taxes will come high up their list of unpleasant things. With an annuity there is almost no paperwork once its set up. In the UK, tax is taken off at source and each year you get a P60. If you need to fill in a tax return you just bung in the number – all done. There’s no capital gains calculations, no dividend calculations, fiddling with tax sheltering, no top-slicing (*shudder*). Many readers, myself included, may enjoy managing their investments now. I’m less willing to believe I’ll be happy doing that when I’m 70/80/90+ years old. Not to mention, that as time passes by, there is no guarantee that I’ll be compos mentis.

5. There’s more to annuities than just a level annutity

There are many flavours of annuity. With different products tailored for an individual’s specific needs. To name just a few:

  • Index-linked annuities: which increase in-line the payments inline with an inflation rate or other fixed percentage. These are typically the most costly option, with the starting income  30%-50% lower than a level annuity.
  • Joint annuities: which continues to pay out after first death to, such as, a surviving spouse. These can also be used to pay out to children or other dependants. And you can also usually define what proportion is paid out on death. Bear in mind, that the longer the annuity is likely to pay out, and the proportion of income on death, the lower the starting income will be.
  • Guaranteed annuities: these pay out for a guaranteed number of years depending on the insurer. Again, the longer the annuity will pay out, the lower the starting income will be.
  • Short-term and fixed-term annuities: which pay a regular income for a specific-term. Short-term annuities can last for up to 5 years. When the term ends you can buy another annuity or invest elsewhere.
  • Investment annuities: As opposed to traditionally gilt-back annuities, you can buy investment annuities which can add a potential benefit from investment growth in the stock market (or from other investments). These give the potential for a higher level of annuity, but come with some potential downside. It’s possible to add downside protection, but again this costs more.
  • Enhanced annuities: which pay out higher rates for those with reduced life expectancy (e.g. smokers). If this is the case for you, think carefully about whether purchasing a life policy or leaving your pension pot for inheritance might be more beneficial.

In addition, you can buy an annuity using only part of your pension pot. This means you can mix and match an annuity with flexi-access drawdown, your other investments, or even to buy several different types of annuity. For example, you could use part of your pot to buy an annuity and provide a guaranteed income floor, whilst keeping part of your pension invested to generate long-term returns.

Final words

I appreciate that this article may feel one-sided – rest assured – it is! There are downsides to annuities. Whether they make sense for you will depend on your circumstances. I’ve not gone into detail on the downsides. It’s very easy to find a lot written about those! But I’ve touched on those downsides now and again. Principally they relate to the two other key factors of saving and investing: access and affordability. In some ways, you can mitigate issues with access by considering a short-term annuity option or using only part of your pension pot to buy an annuity. Affordability, is the elephant in the room. A number of the options (particularly index-linked annuities) may be unaffordable. It’s important to consider all the options available, but an annuity may be a very suitable option for you.

I’ll leave the final words to Mr Meldon:

Finally, annuities offer something priceless – peace of mind!

 

Please let me know your thoughts and comments. I’d like to hear from you!

All the best,

Young FI Guy