How do you fancy building a pension pot up to eight times larger than what you might achieve by going through a mainstream pension provider? This may sound like the stuff of fantasy, but it's entirely possible.
Table 1: Building it up
The first priority is to think different. The traditional approach to pension provision consists of two stages: amassing a fund and then converting that fund into an annual pension income in the form of an annuity. Amassing a fund typically involves making regular contributions into funds run by fund managers. In the decade to December 2010, the median annual return after inflation achieved by commercial UK equity funds was feeble - just 1.23 per cent. That's partly down to the impact of charges, and partly down to the fact that most fund managers just don't beat the market.
At retirement, the accumulated fund is traditionally used to buy an annuity to provide a regular income. Because of the low market interest rates and high costs, annuities currently offer very low incomes. For a 65-year old male in normal health, with a life expectancy of 18 years, the best value inflation-protected annuity that I could find provided an income of 2.6 per cent below RPI inflation on the amount invested in the annuity: an inflation-protected annual pension of £4,301 on an investment of £100,000 for an average of 18 years.
Another way
My approach to providing a pension is quite different. Rather than making contributions to a traditional pension provider's managed fund, I recommend paying regularly into a self-invested personal pension (Sipp), which if you use a basic wrapper keeps costs rock-bottom, and then drawing down pension income from the fund, while continuing to manage it once you retire.
And, if you are unfortunate enough to die early on in your retirement, the remainder of your fund (albeit after some pretty swingeing taxation) can pass to your heirs. By contrast, a deceased annuity holder's family get nothing unless the annuitant has paid extra for some form of guarantee.
This approach won't be suitable for everyone. You'll have to be comfortable with the idea of managing everything yourself. This strategy may not suit your circumstances - particularly if you are already enrolled in a company scheme, or any plan that links pension to salary at retirement. You should always consult a qualified pension adviser before making any decisions about your pension arrangements, as it can be tricky and expensive to change your mind later.
Some pension advisers are very cautious about using income drawdown instead of annuities to deliver a pension. They stress that, in the short term - say, up to five years - a market crash may severely reduce the value of your pension fund and hence the amount of annual income which you can draw. An annuity, on the other hand, is guaranteed irrespective of market conditions, assuming the annuity provider does not go bust.
But I still think that if you have enough funds, apart from your pension fund, to tide you over a short-term reduction in your income from drawdown, in the long run you are likely to be much better off with a low-cost, self-managed fund than with an annuity. You pay a high price for the certainty of annuity income.
The investment strategy
It's not enough just to keep the costs down, important though that is. You also need to generate real investment returns. Many people will do this by investing actively in a portfolio of assets such as shares, bonds, funds of both or either, property and cash. Investors building up positions in stocks will often evaluate potential investments on the basis of company-specific valuation metrics like price-earnings ratios, yields and prices to book values.
That's all very well and I'm sure it works well for many investors. But it's labour-intensive and highly subjective. My approach to allocating assets is different. It revolves around valuation, but of the shares in aggregate, not individually. This strategy invests in equities as an asset class when they are priced below their intrinsic, long-term value and is based on investing in the FTSE 100 index - buying in whenever its intrinsic valuation is more than 5 per cent above the current market price, and moving into cash whenever its valuation is 5 per cent or more below the current market price. To keep costs down, the strategy uses a FTSE 100 index tracker, such as an exchange-traded fund (ETF) - these typically have total expense ratios of less than 0.5 per cent per year. To arrive at the all-important intrinsic valuation, you can use a spreadsheet system, which I detail in my book How to Value Shares and Outperform the Market. This system is based on ShareMaestro software which I developed myself.
The system calculates valuations based on the FTSE100’s dividend prospects, as well as the inflationary environment, gilt yields, and stock market risk. All these data inputs are readily available. It's not the only way to arrive at market timing decisions, of course - there are many others - but I think its strength is that it produces clear and unambiguous valuations, allowing you to see instantly whether the FTSE100 is dear or cheap in relation to its 'true' value.
Comparing the results
To compare the prospective pension provided by the traditional commercial approach and my self-managed approach, I have made the following assumptions and extrapolations:
• Real annual contributions of £2,500 are made by a 20-year old male for 45 years;
• The respective real returns net of costs applied to the two funds is the compound annual growth achieved by each method (with dividends reinvested) in the decade ending 2010. These returns were 1.2% and 5.3% respectively. Comparative commercial fund performance figures are not available for longer periods than this. It is assumed that this rate of capital growth continues for the self-invested fund after drawdown commences;
• A pension is taken at age 65 and, because of increased life expectancy, is expected to be taken for 25 years until the age of 90.
The self-managed approach produces an annual pension nearly eight times greater than the traditional approach. If you do not believe these startling results, you can use the PMT function in an Excel spreadsheet to check it, inputting the data from the tables below.
| Traditional approach | My approach | |
|---|---|---|
| Real value after 45 years | £149,797 | £457,752 |
| Real annual rate of return | 1.20% | 5.30% |
Table 2: Drawing it down
| Traditional approach | My approach | |
|---|---|---|
| Real annual pension income | £4,238 | £33,462 (average) |
| Real rate of return | -2.6% | 5.3% |
The much greater pension from the self-managed approach arises from the increased value provided at each stage:.
• Because the annual return is over four times higher, the accumulated value of the self-managed fund after 45 years is 3.06 times greater than that delivered by the commercial fund.
• For every pound in the accumulated fund, the self-managed income drawdown approach delivers on average 2.6 times more income than the best annuity available, including the residual value at death. All these figures are expressed in today's money. Actual figures would be a lot higher because of inflation.
The assumed real returns of the FTSE 100/cash-switching fund cannot, of course, be guaranteed for the future, although there is a 27-year track record to support this strategy (real annual return of 6.3 per cent). And it's vital that the fund keeps growing after you start drawing income - without further real capital growth, your money would run dry inside 14 years. But equally, the returns assumed for the commercial funds and annuities cannot be guaranteed. I have used the median return achieved by commercial funds and the best return available from an annuity provider. There are many commercial providers which deliver much worse returns than these.
