Optional Annuities Could Mean Working Pensions

Odd that Will Hutton should claim in The Observer, of all places, that making the purchase of pension annuities optional will end in long term social disaster. UK pensions are already a long term social disaster. Hutton himself points out that "400,000 people buy £11bn of annuities every year", yet "the annuity market [has become] overstretched, offering indifferent and often wildly different rates." 

This is because consumers have no choice. There's no competitive pressure at all on the insurance companies or their agents to remove unnecessary middlemen, reduce fees to customers or simplify products. In fact, the Financial Services Consumer Panel recently found that the annuities industry continued to focus on increasing its revenues through product complexity, even when consumers were given the option to shop around. No one in the industry seized the opportunity to make annuities more transparent and better value for the consumer. [Update on 26 March: Legal & General has suggested the market for individual annuities will shrink by 75% - rather endorsing the government decision to make them optional!].

Will Hutton argues that rather than make annuities optional "the response should have been to redesign [the market] and figure out ways it could have offered better rates with smarter investment vehicles". But that seems naive, given the FSCP findings. The industry had that opportunity and declined it. 

It's equally naive to suggest that less demand for annuities will mean losing a valuable opportunity for insurance companies to 'pool the risk' of funding pensions. The industry merely sees risk pooling as a chance to exploit asymmetries of information to line its own pockets. 

The only way for the government to shake up the cosy annuities cartel was to remove the implicit guarantee that everyone would have to buy an annuity. 

Mr Hutton then seeks to set up some kind of moral panic that the 'freedom to buy a Lamborghini' instead of an annuity will result in people simply frittering away their life savings. Not only does this suggest that he'd rather your life savings were placed in the grubby mitts of the annuities industry so they can buy the Lamborghinis, but it also insults the consumers who face the abyss of the annuities market. Their concern clearly arises from the lack of decent returns, not because they're eager to spend the cash on exotic cars.

Finally, Will suggests that the State is entitled to control how you invest your pension money because it allowed you to avoid paying income tax on your pension contributions in the first place. If you agree with that, then presumably you would say the State is entitled to control how you spend every penny of your income that it has allowed you to keep. This of course places a great deal of trust in the State's financial management capabilities that we know from bitter experience is ill-deserved. As a result, it's more likely that citizens will gain greater control over the allocation of 'their' tax contributions, not less (as I've joked about previously). But regardless of whether it's the State or the taxpayer who is in control, neither party wants the State to be saddled with the consequences of an uncompetitive and opaque annuities market. That would only suit the annuities spivs. Again, the only alternative is to expose the market to competition from all manner of transparent savings and investment opportunities. 

Importantly for economic growth, the freedom to avoid annuities opens up the potential for £11bn a year to be invested directly into the productive economy at better returns in much the same way that the new ISA rules will liberate 'dead money' from low yield bank deposits. Not only could we see some pension capital crowd-invested into long term business and infrastructure projects in a way that won't be interrupted by the need to purchase an annuity, but those in draw-down might also consider some 3 to 5 year loans to creditworthy borrowers as a way to generate some additional monthly income.

Fundsmith: Low Cost, Diversified and Contrarian?

We didn't need Terry Smith to tell us that the fund management industry is 'broken', but at least he's put his money where his mouth is. His new Fundsmith Equity Fund will have no initial charge (where typical charges are around 5%), a 1% annual management fee, no performance fees, and he says it will try to keep stock trading/turnover low to prevent dealing costs eating into investors' funds.

All well and good, but Terry gives an interesting response to a query on diversification:

"All of the research shows the standard deviation on an individual stock is approximately 49%, the market is at 19%. On 20 stocks, the standard deviation is 20%. So if you buy 20 stocks, you get 19/20ths of the diversification benefit of being in the market, so you do not need to own 100, 200 or 300 stocks to get the market diversification benefit. But the great thing about 20 is that you know what they are doing. I know there is no chance that I would be able to, in significant detail, follow the details of 100 or 200 companies."

This sounds dangerously like Terry expects that the fund's returns will be normally distributed, when surely he doesn't believe that - even if he still clings to the efficient markets hypothesis. Holding at least 20 stocks might be a start, but one would need to know a lot more about the size of the holdings, distribution by industry, geography, correlation and where the herd is in relation to each stock/sector and so on to judge whether Fundsmith fully complies with John Kay's edict to "pay less, diversify more and be contrarian."

It would be more interesting to see Terry Smith turn his hand to a fund of Exchange Traded Funds, since they offer an opportunity to pay less, diversify more and be contrarian, yet retail investors need help figuring out and adjusting to how correlated the various sectors are from time to time, and what's in or out of favour.

Green or Greed Investment Bank?

I wonder whose problem(s) would be solved by the public sector 'green investment bank' being touted by both the Tories and Labour. 

I mean, do you believe the British Private Equity and Venture Capital Association is a staunch advocate of completely open and transparent financial markets? Or do you think it could be helpful to have a captive investor on which to off-load one's less than spectacular speculative green investments as a last resort?

Perhaps more importantly, would the creation of a public sector green investment bank allow or encourage individuals to buy-in to alternative energy projects, financing them in the process?

The current "problems" in the financial services markets - excessive fees and bonuses, lack of transparency, poorly understood products, the credit and pension crises - are the result of the sort of institutional tinkering epitomised by the proposed 'green investment bank'. We funnel investment opportunities and funding into a zone in which relatively few firms are permitted to operate. The results are increasingly complex products, less transparency, increasingly concentrated risk and less competition.

This situation won't change until the clear objective of the regulatory regime becomes the delivery of simple, low cost financial products that are accessible to us all. Rather than vainly trying to educate an aging population to become more and more financially literate, we need to vastly simplify the process for the average individual to invest/save in a fully diversified way.

Surely the successful investment firms of the future will be the ones who race each other to demystify and simplify the funding/investment experience, rather than those who enter into cosy, self-serving institutional arrangements like this one.

Diversification Challenge

Some of us have been discussing the need to diversify more.

There are numerous tips on how to make sure that not all your eggs are in one basket. But they all assume that you have a great deal of time and a pretty sophisticated understanding of finance and financial services.

Like it or not, even with plenty of time on his/her hands, the 'man on the Clapham omnibus' is no financial giant.

So most people need diversification explained as simply as possible, and in a way that enables them to achieve it easily and conveniently.

What is diversification? The eggs in one basket idea is pretty simple, but needs some numbers: you are less likely to have all your eggs broken if you have 10 eggs in each of 10 baskets, rather than 100 eggs in one basket. Following this principle, you become automatically better off every time you add another basket for the same number of eggs. So you’d be much better protected against egg breakage if you had 5 eggs in each of 20 different baskets.

An interesting challenge would be to start with what a truly diversified portfolio of assets looks like, based on using a small amount of money. For argument's sake, one could start with a figure of £10,680 - the most the government allows you to salt away without locking it up til you're 98 years old, or paying tax on the returns.

But such government policy actually prohibits diversification, yet heavily subsidises regulated investments at the expense of alternatives.

That’s because most people with surplus cash should use up their tax-free allowances first, and few will have anything left over. Research cited by the Guardian in June 2011 suggests the average UK person can afford to save £97.10 per month.

The list of asset classes is long, yet the money allocated to those tax-free allowances can't be invested in the full range of potential assets, even by putting their money in the hands of managers who can invest more widely. Generally, you may only invest your tax-free allowances in regulated investments. And all sorts of rules, policies and other restrictions limit the types of assets in which regulated fund managers can invest. So even regulated fund managers are unable to adequately diversify the investment pots they manage. This must necessarily affect the value and performance of the funds they manage. Such effects may be market-driven and/or behavioural.

Then there's the tricky subject of asset correlations: if all the assets you've invested in behave the same way at the same time, then you aren't diversified. Apparently the correlation in the performance of assets has been increasing of late, but may be about to unwind in some cases.

First step along the way to meeting the diversification challenge should be to figure out a reasonably detailed list of asset classes. Then we should modify the regulatory framework to enable people to invest at least their tax free allowance in each of them. The list of assets can divide and divide, but I don't think we start out with a sufficiently granular picture. In reality, I think such a list might look like the following - note that I include different types of 'funds', and separate regulated from unregulated, because their performance can be affected by the differing levels of regulation and permitted classes of investments they can make. However, I'm not including instruments like spread bets, contracts for differences or futures, since these are merely contracts that get you exposure to the various assets. Am I right or wrong?

1. cash
2. savings accounts
3. fixed interest savings/bonds - government, corporate
4. person-to-person loans
5. shares listed on a regulated or 'recognised' exchange
6. shares not listed on a regulated exchange
7. exchange traded funds (ETFs) listed on a regulated exchange
8. ETFs not listed on a regulated exchange
9. regulated managed funds
10. unregulated managed funds
11. regulated hedge funds
12. unregulated hedge funds
13. venture capital funds
14. venture capital trusts
15. regulated funds of funds
16. unregulated funds of funds
17. commercial property
18. rural property
19. residential property (owner occupied)
20. residential property (buy-to-let)
21. perishable commodities (e.g. cocoa, wheat)
22. non-perishable commodities (e.g. oil, gold and other precious metals)
23. art
24. classic cars
25. fine wine
26. currencies

Fat Cat, Long Tail, Trial and Error

I'm struggling slightly with John Kay's latest article "Counting errors: from the fat cats to long tails."

I understand the point about power laws, and to be careful making assumptions that one is dealing with "normal" data in any given scenario. But a problem I have with this article is John's claim that the long tail of book sales, is "truncated" because books that would only sell 1,000 copies don't get published.

"If book sales are governed by a power law, then if 10 American books sell 1m copies in a year, and 400 sell more than 100,000, then about 16,000 titles will sell more than 10,000 copies.... The rule would predict there would be 640,000 books selling more than 1,000 copies. There are not, and for an obvious reason. Most titles that might sell 100,000 books get published but most titles that would only sell 1,000 do not."

But surely lots of books get published that don't (initially) sell 1,000 copies, because publishers don't accurately predict sales. And surely that's the real point here: only 10 books might sell more than 1m copies a year, but you don't know ahead of time which 10 books. So it's still worthwhile listing on digital platforms titles that initially sell very poorly, because they might yet resonate with enough people who share the same taste and 'work their way up the tail'.

Similarly, John claims that:

"Companies that would have only a few thousand pounds of sales do not continue to exist: people who would have incomes below a certain level are supported by social benefits. To choose appropriate models you need to understand both the maths and the business environment. Media industries and financial institutions have both been unsuccessful in marrying these two skills."

This may be true, but the challenge of non-normal data is that you can't accurately predict which company will not continue to exist, or which people who are on low incomes today might strike it rich tomorrow, like J K Rowling (or they could be wealthy benefits cheats). You can't write off anything or anyone until it or they have actually failed.

On this basis, the conclusion ought to be that participants in the media and financial industries should be prepared to experiment - and fail - a lot before reaching any conclusion about what will necessarily be successful. That was one of my takeaways from The Black Swan.

Or am I missing something?

You're On Your Own: Pay Less, Diversify More, Be Contrarian

Heeding John Kay's timely warning, I've been paying a lot more attention to what's happening to my meager store of pension and ISA money and how much is being left in the hands of so-called "managers" who merely track an Index and their peers.

News on that front is getting worse. According to the FT, fund managers are finding it tougher to gain distribution through European retail banks, who are the dominant sales channel in continental Europe. The banks are cutting the number of fund managers whose products they distribute, and the fund managers are "scrambling" to be included. "Some fund managers are likely to have to pay higher charges to distributors...," the head of UK sales at JPMorgan Asset Management is quoted as saying. And the head of international retail business at BlackRock says, "Investors feel let down by what has happened in the financial sector as the industry has been focusing more on its own needs than those of clients."

In the same article, Lipper estimates that UK retail banks only distribute about 4% of investment products sold in the UK, and IFA-advised sales remain dominant at about 53%. But we all know that IFAs get a decent whack for the service they provide, so we're probably only seeing European banks playing catch up.

This news again signals the need to get more active, and use discount and execution-only providers to invest in cheaper products like Exchange Traded Funds. Doing the opposite of what the mainstream investment advertising suggests is also worth a shot, according to Mr Kay. This is not easy in the context of a full-time job and family commitments. While I've previously used a discount investment broker and began a stakeholder-friendly pension, only recently have I woken up to the "DIY ISA" and a low cost Self-invested personal pension (SIPP) that allows me to get off piste. But that's where I need to go. Next stop: ETF's in out-of-favour, non-correlated sectors.

I feel like this guy:

Pay Less, Diversify More, Be Contrarian

Just finished John Kay's "The Long and the Short of It". Lots of decent, straightforward explanations as to why retail investors should "pay less, diversify more, and be contrarian," without pushing some kind of snake oil that allegedly delivers the same financial result.

In fact, he says, "You are on your own". That's not a great outcome after a decade of New Labour fiddling that was supposed to result in "treating customers fairly".

In essence, Mr Kay explains that financial markets have a mind of their own, unrelated to fundamental value. Financial models that purport to predict performance over time may be illuminating but they are not true... "frequent small gains [are] punctuated by occasional very large losses." He calls these occasional events "Taleb distributions," on the basis that Nassim Nicolas Taleb explained this problem fully in his book Fooled by Randomness (and again more recently in The Black Swan). Not only are faulty financial models accepted as being more than illuminating, but also the urge amongst financial services firms to compete on relative performance moves their markets "too far, too fast" for most of the participants to realise they should take the profits and check out. To call a halt puts one's job at risk. "It is better to be conventionally wrong, than to be unconventionally right." So, while it pays to understand the "mind of the market", your purpose in doing so as a retail investor is to do the opposite of what "the market" is suggesting.

Interestingly, Mr Kay's recommended regulatory response to the credit bubble is to "firewall the utility from the casino, by giving absolute priority to retail depositors...in the event of the failure of a deposit-taking institution." He says:

"The additional rules which will be introduced as a consequence [of 'more effective' regulation] will be irrelevent to the next bubble, just as the Basle I and II capital requirements imposed on banks - the subject of so much regulatory and academic debate over the last two decades - were irrelevant to the credit bubble."

The more one is diversified, the less regulation should matter. Right? Well, that's easier said than achieved, given the marketing might devoted to cross-sell in retail financial services.

Maybe the financial regulators should simply dedicate themselves and their budgets to pushing the line:

"You are on your own. Pay less. Diversify More. Be Contrarian."

But there won't be very many international meetings or compliance jobs in that...

Your own personal economy

The red wine was flowing last night, thanks to Simon, Bill and the other fine folk at CVL, and some of the chat turned to how much of the goods and services that we buy and sell will be person-to-person in 5 or 10 years.

While I doubt that I was terribly informative last night, I'm now able to recall that, personally and professionally, I'm aware that people are already connecting economically speaking in education, complementary healthcare, event organising, lending (as a proxy for investing or saving) and borrowing, music, financing music production, stuff, accommodation, jobs and more stuff, legal services and home improvement. There must be loads more, but I'd have to start actively searching and my emails are piling up...

Could you get through the day, week, month, year only dealing with individuals?