Adjusting to retirement

Even if you are one of the fortunate people to have a decent occupational pension, and to have a reasonable amount of savings, the chances are that your retirement income is going to be a substantial drop from what you have been used to. Most of the people I talked to were worried about how they would cope. Thankfully, because they were worried, they became much more aware of financial issues, and hence adjusted to their new circumstances very successfully.

Having done my best to worry you, I can reassure you that things are almost certainly not as bad as you fear. The difference between your current income and your previous income, may have been taxed at a high rate so your disposable income drops much less than you might think. For example, in my own case I was paying nearly 50% tax (both income tax and National Insurance) on that difference. You will also probably find that many expenses are much less; areas you are likely to make savings include:

• travel costs of commuting
• cars – do you need two cars? Do you need an expensive car? Do you need to change it frequently? Do you need to buy new cars or can you buy second-hand?
• smart work clothes
• money you used to spend to save time – ready meals, take-aways, help to do jobs around the home and garden that now you can do yourself.

Managing your spending

The best person to open this section is Charles Dickens with his Micawber principle from David Copperfield:

Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.

What can you learn from the Micawber principle? If you, and your partner (if you have one), are not good with money, it is best to set yourself a budget. Even if you are very comfortably off then you will probably want to use some, or many, of the techniques from this section.

Almost every retired person I talked to said it is virtually impossible to predict how comfortably off (or how hard up) you will be until you have been retired for over a year. Almost everyone advised that you be cautious with your spending for at least the first year of retirement.

Your expenditure divides into two basic classes – essential and discretionary. We might argue what exactly is in each class, but you will probably agree that the following are essential:

• taxes
• household bills (electricity, gas, water, telephone/internet)
• clothes
• food
• household goods (washing powder, etc.)
• insurance
• household appliances
• building maintenance.

Discretionary expenditure items include:

• foreign holidays
• toys for boys (the latest electronic gadgets, etc.)
• entertainment (theatre, cinema, the pub, restaurants …)
• frequent changes of car
• paintings and other decorative items.

Prioritise your discretionary expenditure so you can protect the things you get greatest pleasure from.

Major savings are possible by curbing your discretionary expenditure and intelligently shopping/negotiating for the essentials. As an example, your weekly spend at supermarkets can be reduced easily by 30% (or more) if you do not currently shop in multiple supermarkets for special offers and reduced items, and if you do not make efforts to reduce waste. Likewise, by shopping around for energy providers and insurance you can make useful savings for just a few hours’ effort. Haggling for larger purchases again can deliver substantial savings (buy my book Brilliant negotiations if you are not a born haggler – which will also help my retirement income!).

Now you are retired you have time to make your money go further – many retired people make a hobby of bargain hunting, and get a lot of pleasure from bagging a great bargain.

When shopping around for insurance you may want to avoid constantly changing your car insurer. As you get older it is often worth building up a long-term relationship with a reputable insurer, because you do not want your insurer to withdraw insurance cover when you become elderly.

The potential savings on your discretionary expenditure will be very large indeed. This is one reason why it can be worth doing at least one budget – you will be shocked by how much some items cost you. You will probably find that items such as cars, wine, expensive holidays, eating out and take-aways have been swallowing a substantial part of your income. Remember the Micawber principle, and be prepared to cut your expenditure to fit your new income. One reason for shopping wisely is to leave more room for discretionary expenditure.

When my wife and I did a budget we were stunned by how much we spent on alcohol. We drank a bottle of wine most nights, and we found our average spend was £8 per bottle. When we had parties we liked to buy expensive wine for our guests. Add in the sherry, spirits and the like and we were spending about £4,000 a year. Since retiring we drink about a third less (as part of our healthy-living drive), and now shop almost exclusively for half-price offers, which we combine with case discounts and promotional coupons. We now spend approximately £1,500 p.a., and enjoy our booze every bit as much as we did before.

Generating earned income

Many people supplement their pensions and unearned income by part-time work. As I explained in Chapter 2 there are many non-financial benefits to continued work, but in this chapter I should certainly mention that the money you earn can be an important supplement to your income. As the years go by it is likely that many people will find themselves retiring with less generous occupational pensions, and the need to keep working part-time probably will increase.

I would like to highlight one particular situation where it is possible for retired people to have problems. Some retired people decide to start their own business; if you decide to follow this route then I have a few words of caution.

First off, you must think very carefully before risking a substantial part of your savings on a business venture. I strongly recommend that you do a detailed analysis of what you might lose in the worst-case scenario, and then decide if you can really afford this risk. Then you must ensure that you monitor your finances and don’t end up losing even more – it is much better to close a business than continue pouring good money after bad.

Even if you have modest aspirations and are not risking a lot of money, you will still want your business to be a success. I strongly recommend you take a professional approach to any business venture. I used to be in the difficult position where there was no book on start-ups that I was comfortable to recommend. I am happy to say there is now such a book, and I am even more pleased to say it is in the Brilliant series. It is called Brilliant start-up by Caspian Woods.

You must not ignore the tax, legal and regulatory implications of any business. Find out what you must do, talk to the tax authorities, take out any necessary insurance – it pays to be careful or, more accurately, it can cost you dear to be careless.

Financial planning

I think, for good reasons, this book is very upbeat about the excellent prospects you have for a great retirement. I have not dwelt on the sombre subjects of death, incapacity and other disasters. When it comes to your financial affairs you are, in my opinion, being negligent if you do not consider these issues in good time.

Make a will

There is an apocryphal story that at a solicitor’s dinner they drink two toasts; the first is to those who do not make a will, and the second is to those who make their own will. Yes, it is very uncomfortable thinking about what happens to your money and possessions after you die, but the misery it will cause if you do not make a will really makes it essential that you grasp this nettle. I would strongly advise you seek professional advice in drawing up your will, because you are likely to miss a number of key issues, and wills need to be properly drafted.

Having made a will you need to keep it up to date.

Managing your savings

When preparing to write this book I thought I would simply advise you to find a good independent financial adviser (IFA) and follow their advice. How naïve could I be? Your problem is that in some countries (including the UK) financial advisers get most of their income from commissions on the financial products they sell. Those investments that I believe will be best for you offer no commissions, so are seldom if ever recommended. In addition, even within a particular class of products such as guaranteed equity bonds, or unit trusts, commissions are often highest on products that are less attractive than those offering lower commissions. Even worse, or in my opinion much worse, are those financial advisers who are not labelled as independent, for example so-called personal bank managers and financial advisers of banks and building societies, who are little more than salesmen for their bank’s products.

The very best IFAs will work for fees and will refund commissions, but regrettably the whole market is so dominated by commission-bearing products that often you will still get less than optimal advice. In addition, commissions are substantial, and often use management charges to pay the IFAs annually for products they have sold in the past (so-called trail commissions). As a consequence, IFAs usually will make more money out of commissions than by working on a fee-only basis, and hence some IFAs tend not to be very motivated when working for fees. It is best to choose a financial adviser who openly advertises that they will work for fees. If an IFA is not totally open about commissions I urge you strongly to go elsewhere for advice. I also urge you strongly to ask your adviser about commissions and, unless the answer is clear and acceptable, again you will do best to go elsewhere.

There are a number of reputable discount stockbrokers who refund the bulk of up-front commissions on investment products such as unit trusts. I happily use such a stockbroker, and can think of no good reason to pay commissions unnecessarily.

There are a range of qualifications that indicate how much formal training an IFA has undergone. The minimum qualifications to advertise yourself as an IFA are very basic indeed. If an IFA has only a Certificate in Financial Planning, then they have not invested heavily in their own qualifications. The next levels up are the Diploma or Advanced Diploma in Financial Planning (formerly called the Advanced Financial Planning Certificate). The top qualifications are the Chartered Financial Planner and Certified Financial Planner qualifications. As is so often the case, you get what you pay for! Regardless of qualifications I suggest you ask some questions based on the contents of this chapter. For example, you might ask for a comparison of unit and investment trusts. Likewise, you might ask for a simple explanation of bonds. If you do not find the answers clear, accurate and jargon-free then just walk away.

At the top end of the market, there are wealth consultants from stockbrokers and prestige banks, who charge very significant fees, usually based on a percentage of the value of your savings that they manage. I suspect that some of these are very good. Again you need to check that they are not also collecting commissions on the products they recommend. This chapter will arm you with enough knowledge to be able to evaluate their advice.

As a final word of warning, you need to know that financial advisers have hardly ever been successfully sued, even when their advice has been reckless, incompetent or negligent. Some professionals, such as doctors, have to be very careful about their advice because there is a major risk of being sued for negligence; financial advisers do not have to be anywhere near so careful when helping you to look after a lifetime of savings.

My comments about financial advisers are correct at the time of writing, but the Financial Services Agency (FSA) in the UK has been considering reform of the legislation covering financial advisers for some considerable time. It is quite likely that they will grasp the nettle and force the top tier of IFAs to be funded totally by fees rather than commission. If the FSA implement such a reform it will become vastly easier to get truly impartial, expert financial advice.

As is so often true in this life, the best way to locate a good financial adviser is by personal recommendation.

This sounds bad, but I am afraid it gets worse. The financial press, for example in newspapers, sometimes tacitly toes the IFA’s line by not pointing out commission-free or low-commission products. In addition the financial press can be very faddish, often highlighting investment areas that are near the top of their financial cycles, whereas an investor usually will do better to buy into less fashionable areas. This is not to say that all the comment and advice in the financial press is bad, indeed I have found many gems – but, as the princess said, ‘I had to kiss a lot of frogs first.’

My advice is that you have to learn enough about investing to manage your investments yourself, and to treat any advice you read in the press or decide to pay for, as just that – advice. The good news is that it is not rocket science, and you can now read on for an elementary description of how to build rockets.

Read the money/business sections of your newspaper every day. Although it will contain a lot of faddish and dangerous advice, it will also contain many useful facts and a lot of sound advice. Once you understand financial matters quite well you will be able to spot, and benefit from, the good advice. It will also help you develop your financial knowledge.

Inflation – a dominant factor

Protecting your investments from the ravages of inflation is likely to be a dominant factor in your investment strategy.

If inflation stayed at a low figure of just 2.5% over a 10-year period then £50,000 would be worth only £38,800 at the end of the 10-year period. Obviously if inflation increases significantly above 2.5% the figures get far worse.

Putting your savings into low-risk investments such as government-backed savings products or the best savings accounts from banks and building societies will yield only a small percentage above inflation. So, if you need to live on the income from your investments, the low-risk option in real terms will mean you are eating into your savings and your income will decline as you get older. With increasing life expectancies most retired people would be well advised to plan to maintain a decent standard of living into their 80s. This means that most retired people have to invest for the long term and there is no truly safe option to managing your investments.

As you get older your savings have to last for fewer years, and you may find you are less comfortable taking risks and expending effort actively managing your investments. Consequently, you may want to readjust your investment portfolio so that it becomes lower risk.

Your attitude to risk

You have to decide how much risk you are willing to take. This chapter gives you a significant number of facts that will help you decide what approach to take. It is advisable that you get your finances ready for retirement well in advance, and if you have done so you will have got used to fluctuations in the value of your portfolio over a number of years.

There is a wide range of investment products, called structured products, that play on people’s fears about losing their investments. For example, there are products called guaranteed equity bonds, which pay a percentage of the gains in the stock market over a fixed period of years, but give you your investment stake back if the stock market goes down. You would be wise to avoid all such products. For example, guaranteed equity bond providers keep the income from investments and, as you will see, income from equities is very important indeed. There is a saying that ‘you don’t get something for nothing’, and you will pay a very high price for any protection provided. These products usually pay financial advisers big commissions, so they tend to be sold hard.

Everyone knows that you should not have all your eggs in one basket, and this sound advice is at the heart of any well-designed investment portfolio. It is also worth remembering that some of your investments will do better than others and what started out as a well-balanced portfolio can, after a number of years, become unbalanced. This means that you need to review the structure of your portfolio on a regular basis.

Structuring your portfolio

The advice published by the stockbrokers and independent financial advisers Hargreaves Lansdown in May 2008 about a possible structure for portfolios is as follows:

For a high-income portfolio they suggest:

• 50% in UK Equity Income unit and investment trusts
• 10% in non-UK Equity Income
• 30% in the safest (Investment-Grade) Corporate Bonds
• 10% in riskier high-yield Corporate Bonds.

The portfolio would be for your investments after you have set aside a suitable safety net in readily accessible, high-interest, cash savings.

For a balanced income and growth portfolio they suggest:

• 80% in UK Equity Income
• 10% in UK Growth
• 10% in non-UK Equity Income.

In my opinion the balanced income and growth portfolio would be the basis for a very decent high-growth portfolio if all the income was reinvested.

These are only guidelines, and other stockbrokers and IFAs will have their own ideas, but I thought it worth mentioning this advice because I suspect many readers will be very surprised by the high percentage that they suggest investing in the stock market in unit and investment trusts. I believe that this approach is sound advice – as you will see from the rest of this chapter.

The figure I find most interesting is that £100 invested in the stock market in 1899 on average will have increased to £213 if you took the income each year, but if you reinvested the income it will have grown to £25,022. Whereas £100 of government bonds (gilts) will have dropped to just one pound in value, and reinvesting income will have yielded only £323 after inflation is taken into account.

What about property I hear you ask? Over the 25 years up to 2008, house prices grew by 507% whereas the equity market’s value grew by 1,914%. Many people trust property because you can see it and touch it, but you should remember that a country’s stock market represents a very large proportion of the national wealth, so it is underpinned by something of great tangible value. Many people also have a much rosier view of rises in house prices than is warranted. For example, from the peak of the property market in the UK in 1989 it wasn’t until 2002 that house prices had recovered in real terms (including the effects of inflation).

Unfortunately the rise of the hedge funds in the twenty-first century has increased stock market volatility, but if the stock market does not continue to grow at historical rates over the long term then your country is in big trouble.

Having decided your basic strategy and appetite for risk, the next questions you face are what to buy and when to buy it?

What to buy?

The stock market – shares

If you want to invest in the stock market and to generate both growth and a high income from that investment, there are basically three ways to do it:

1. Buy individual shares with high yields. The remaining two options are collective investments where your money (and the money of many other investors) is invested in a basket of high-yielding shares (and occasionally bonds/gilts as well).
2. Unit trusts and open-ended investment companies (OEICs).
3. Investment trusts.

Individual shares are for enthusiasts and for well-off people who are paying for expert advice. Alternatively, if you are well off, you easily can research the 40 plus shares that dominate the portfolios of high-income unit trusts, OEICs and investment trusts, and buy those. It would be interesting to know if what you lose by not actively managing your portfolio is more or less than you gain from saving the costs associated with unit trusts, OEICS and investment trusts.

I have lumped unit trusts and OEICs together because I believe they are little different. OEICs have the advantage that they do not have separate prices for buying and selling, which typically is an extra 5% that you lose when you buy/sell unit trusts. There are other technical differences but I do not believe that they are very significant.

An investment trust is a company whose assets are other investments – shares, bonds, cash etc.

Comparing unit trusts and investment trusts shows that investment trusts are a clear winner. Choosing investment trusts over unit trusts has many advantages:

• Annual management costs are significantly lower, partly because investment trusts do not pay annual commissions to people who sell their products.
• There are no initial charges when purchasing the products, which typically can be 5%.
• There is a single buying/selling price, whereas typically you get 5% less when you sell a unit trust than when you buy it. Again this is because investment trusts do not pay commissions to sellers of their products.
• Unit trusts are more heavily regulated, which gives investment trusts more flexibility to take advantage of buying and selling opportunities. As an example, investment funds can build up large cash reserves, or borrow, to take advantage of the transitions between bear (falling) and bull (rising) markets.
• Unit trusts have to sell shares when there are many sellers of their unit trusts. Likewise they have to buy shares when many people buy into the unit trusts. As people tend to buy and sell in large numbers at exactly the wrong time, this can be a significant problem. As an example, unit trusts that invest in corporate bonds go up in value at a time when it is usually too late to buy such bonds advantageously.
• Investment trusts are often valued at a discount. A discount is when the value of the shares that an investment trust owns, less any borrowings, is greater than the sum of the value of all its shares (the investment trust’s market capitalisation). A substantial discount is seen by many investors as an indication that an investment trust offers good value.

The statistics support my view that investment trusts are better than unit trusts. Over 10 years up to 2008 the average investment trust returned £246 on a £100 investment, whereas the average unit trust returned £183.

There is a view amongst many analysts that the freedom to borrow makes investment trusts riskier than unit trusts. This can, however, be offset when an investment trust trades at a discount. In addition unit trust managers are under huge pressure to get to the top of the unit trusts’ performance league tables. When I researched the holdings of the best performing high-income equity unit trusts I found that their portfolios were often heavily biased towards individual sectors. For example, one had its two top holdings in tobacco companies, whilst another had its top two investments in oil companies. In contrast, all the high-income investment trusts I researched had well-balanced portfolios.

In addition to high-income investment trusts, those investment trusts that specialise in small companies usually offer high returns. This can be a useful source of diversification within a portfolio.

Having praised investment trusts I should warn you to avoid so-called ‘split caps’. These split an investment trust into two parts: one getting most of the capital gains, and the other getting most of the income. Historically split caps have not performed as well as standard high-income equity investment trusts.

Bonds

Bonds are when you lend the government, a company or other organisation, an amount of money, for a fixed period of time, at a fixed rate of interest. At the end of the period, unless the company has gone bust and defaulted on its bonds, you get your money back. Bonds usually pay interest once or twice a year.

Some bonds (e.g. from banks and building societies) can be redeemed early and you will lose part of your interest. Bonds from government (called gilts) and corporate bonds can be bought and sold on the open market and, like shares, their values can go up and down over time.

There are two main reasons why bond prices go up and down:

1. If you buy a bond that is yielding 5% and then your central bank reduces interest rates by 1% then your bond usually will increase in value so that its effective yield is roughly 4%. Likewise if the central bank rate increases then your bond usually will drop in value.
2. Bonds in companies that are more likely to go bust, and hence default on their bonds, are worth less than the bonds of more solid companies, which are less likely to go bust. This is the reason why very safe gilts pay less interest than corporate bonds. If a company hits trouble and the major credit rating companies (Moodys and Standard & Poor (S&P)) reduce their credit ratings, then its bonds usually will decrease in value. Likewise if a company stages a recovery and its credit rating goes up, then its bonds probably will increase in value.

The top-end bonds, in terms of safety, are called investment grade bonds. The bottom end bonds are called junk bonds. I would not get hung up on these titles, and would make your own assessment of whether a company is likely to go bust. Both Moodys and S&P have websites that allow you to register to see companies’ credit ratings, which may assist your judgement.

Bonds are the safest form of investment in companies. Even if shares are nearly worthless, a company will often recover, or will be taken over, in which case it will not default on its bonds. Ignoring junk bonds, default rates measured as a percentage are historically in the low single figures. In my view, unless you are a very nervous investor then corporate bonds are a better bet than gilts – provided you do not have too much money in any one bond.

It is surprisingly difficult to buy individual bonds, and many stockbrokers will recommend you buy a unit trust that specialises in bonds. Unit trusts specialising in bonds are not bad investments if you buy them at the right time of the market cycle, but personally I prefer to cut out the costs of the middle men and make the effort to buy individual bonds, just as the best wealth managers do for their clients. If you insist, then any reputable stockbroker will buy them for you, and many will have the facility to hold them in an ISA or self-invested pension plan (SIPP) for you. To get all the data on bonds in the UK either ask your stockbroker for the data or (in the UK) use the excellent website www.bondscape.co.uk, which provides a link to the previous day’s closing prices, together with all the key data you will need to choose bonds. You need to remember that corporate bonds pay their income gross (no tax deducted), so unless you have them in a tax-free wrapper such as an ISA or SIPP, you will need to declare them on your income tax return.

You also need to be aware that if you buy a corporate bond then the purchase price will be higher than the selling price. As most investors intend to hold bonds for a very long time this usually is not a big problem.

Yield: One of the nice things about bonds is that they are really quite easy to understand. There is only one complication that is worth understanding. There are two ways of measuring what percentage interest a bond yields. The current yield is the percentage yield you get in the years before maturity. However, when the bond matures you will make either a gain or loss depending on whether the price you paid was more or less than the issue price of the bond. The yield to maturity takes this gain/loss into account.

In the UK, if you invest in corporate bonds, or a unit trust that specialises in bonds, within an individual savings account (ISA) then your interest is tax-free (or it was at the time this book was written).

Property

The simplest way to make money from property is to rent out a room (or rooms) or flat in your home. Often it can be worth investing in some modifications to your house to create a separate apartment. The major downside is that this can be quite disruptive, but some people find the disruption tolerable, or indeed may welcome it – for example, if they live on their own. You will want to research (using the internet or by buying an appropriate book) the known pitfalls of renting out part of your home before you embark on this course of action; but the amount of money you can generate can be substantial.

You can downsize to a smaller house and invest the proceeds. Alternatively, you can do an equity release deal to free up capital from your property. You will want to research the issues relating to equity release before doing such a deal – for example, to ensure there are no problems if you want to move house later. However, most equity release deals allow you to free up a portion of your house’s value, with interest payable only after your death, which usually will be capped to the value of your house at your death. There is an organisation that self-regulates the industry called the Safe Home Income Plans, and their website may be helpful – www.ship-ltd.org. The amount you can release depends on your age – with typical figures at the time of writing being as follows:

Age	Maximum loan to value %	Maximum loan
55	23	£57,500
60	28	£70,000
65	33	£82,500
70	38	£95,000
75	41.5	£103,750

At the time of writing most equity release schemes seem to be a fair balance between the lender and yourself.

If you are entitled to government support, such as pension credit, then equity release will increase your savings so you will probably no longer be eligible.

You can invest your savings, or use savings plus a mortgage, to buy a property that you will rent out. Again you will want to research the issues involved very carefully. You will want to check that the net return (both income and potential capital growth) is acceptable and warrants the risk, worry and effort of renting out. As you are now retired you may well feel you have the time to devote to what can be a time-consuming business venture. Obviously, life will be easier if the property is local to you and you are skilled at DIY for when maintenance problems arise. Some people combine such ventures with the purchase of a holiday home – and yet again you should thoroughly research the potential problems before attempting this. The potential capital growth will be very dependent on the timing of your purchase, and this will be discussed in the later section Get your timing right. Remember that owning a rental property involves major financial risks. Just a few examples include:

• A collapse in house prices and great difficulty finding a buyer if you need to sell.
• Subsidence.
• Other major structural problems in a wholly owned or shared development.
• Environmental disasters such as floods and storms.
• Developments in the locality (new road, airport, sewer works, nuclear power station, power lines, wind farm, etc.).
• The neighbourhood’s desirability deteriorating.
• Tenants trashing the property, and other ‘bad tenant’ problems.
• Squatters.
• Local laws and market conditions if you purchase abroad.
• A major decline in the number of people renting in your property’s locality, or a sudden increase in other rental properties.

You can also buy a range of shares that are based on property. There are unit trusts, a few investment trusts, and also some major companies that own and rent out commercial properties, many of which pay substantial dividends. As with all property and equity investments, timing is crucial and these will be discussed in the Get your timing right section. It is, however, worth remembering that if you own your own home you probably already have an investment portfolio dominated by property.

Get your timing right

Probably the most difficult problem the private investor faces is knowing when to buy, or when not to buy, investments. For example if you put a large lump sum into the stock market just before the dot com bubble burst in 2000, it was 2007 before the FTSE had recovered. If you had put that lump sum into technology stocks you might well never see your money back. Earlier in this chapter I have given some even more frightening figures about how long the property market can take to recover after a housing bubble bursts.

There are some techniques that help regular investors to minimise these problems, plus you can learn from history and be aware of indicators that will help you decide if the time is right to invest a lump sum in a particular investment.

Pound cost averaging

This is just a posh phrase for saying that you should drip feed your money at regular intervals into an investment. Most reputable financial advisers recommend pound cost averaging for regular saving into the stock market. There is, however, less agreement as to whether you should drip feed a cash lump sum into the stock market or take the risk and get into the market quickly – which is where historical indicators may help. If in doubt, pound cost averaging seems to me to be the safest bet.

Price to earning ratio – p/e

One of the most useful statistics is how much a company or market’s valuation compares to the profit it makes. If a company’s value (market capitalisation) is 10 times its profit then it has a p/e of 10. There is also a statistic called the forward p/e, which is just the p/e worked out on a company’s published estimates for the coming year. I will not go into how the p/e for a market is calculated, but instead will list the historical values for the US stock market:

Standard & Poor
Year	p/e	S&P 500 index
2007	17.53	1468
2006	17.4	1418
2005	17.85	1248
2004	20.7	1211
2003	22.81	1112
2002	31.89	880
2001	46.5	1148
2000	26.41	1320
1999	30.5	1469
1998	32.6	1229
1997	24.43	970
1996	19.13	741
1995	18.14	616
1994	15.01	459
1993	21.13	466
1992	22.82	436
1991	26.12	417
1990	15.47	330
1989	15.45	353
1988	11.69	277

You do not need to be a mathematician to see that it seems better to buy into a market when the p/e is lower. The average of the last 25 years has been approximately 20.

Using p/e to spot good buys in individual shares is more complex but most skilled investors will know the issues so I will not repeat them here. However, remember that each market sector (financial, utilities, petrochemicals, etc.) will have its own historical market average for p/e. Also beware that p/e can be affected by one-off charges in a company’s annual accounts, so do your research carefully.

Stock market yield versus gilts

A stock market indicator that has often signalled the end of a bear market is when the yield from the UK’s FTSE 100 goes higher than the yield from 10-year gilts. You can see the logic in this indicator, because money tends to follow good returns, so if the stock market is yielding well then more people will want to buy shares. As with all these indicators, it should be combined with other indicators and your own, and your advisers’, instincts about a market.

Directors’ stock purchases

Another good indicator of the end of a bear market is when the ratio of buys to sells of directors in their own companies breaks through 13. Again, you can see the logic in this indicator. If lots of directors think their company’s shares are cheap enough to put their own money into them then the market as a whole may well be cheap.

Property values

There are two statistics that commonly are used to measure the housing market. The first, and more reliable in my opinion, is the ratio of average house prices to average earnings. The second is the percentage of an average person’s income that goes in mortgage payments when they first take out a mortgage. The average over the years of the first statistic is about 3.5. The peak at the 2008 crash was over 6!

Bond prices

Possibly the easiest market to predict is the corporate bond market. The financial press has spotted every major peak of interest rates that I can remember, and good commentators sensibly have recommended that their readers buy bonds.

Property companies

Companies, such as British Land, own commercial property, which they then rent out. Often the value of their properties, less their borrowings, are worth more than the sum of all their shares (their market capitalisation). If this discount to net asset value is high, and it can at times be as high as 40%, this can indicate that their shares are good value.

Bubbles, booms, crashes, bears and bulls

There is a tendency to underestimate how long all these phenomena last. The average bear market lasts 740 days and the longest one was 2,738 days. Looking at the housing market in the run up to the 2008 crash, the ratio of average house prices to average earnings was well over five for two years before the crash. The dot com bubble went on for at least six months longer than I expected, with companies earning no profits having phantasmagoric valuations. Time and again these trends last so long that many commentators start to believe that the basic laws of economics have been abolished.

If it looks like a bubble it probably is. So-called contrarian investors put their money in investments that are out of fashion, rather than the latest fashion. Most successful fund managers would describe themselves to a greater or lesser extent as contrarian investors.

When I started writing this book oil was selling at $150 a barrel and the papers were full of tips that the commodity market was the place to make big profits. Today, as I type this chapter, oil is at $97 a barrel and is still falling fast.

Takeovers

Although investors in individual stocks and shares probably will know what they are doing, I will conclude this section with two useful pointers. The first such pointer is that nearly all mega mergers and takeovers do not work out well. I would seriously consider selling shares in a company embarking on this risky course of action.

Things usually go from bad to worse

If a company issues a profit warning, it will usually be the first of a number of such warnings. Active investors may want to consider bailing out after the first profit warning.

Companies can ask their shareholders for extra investment by offering them additional shares at a discount – called a rights issue. This is a bit of a con but, unless the share price falls below the offer price, it is my experience that it is usually best to bite the bullet and buy the rights issue.

So what should you do about investments?

I have given lots of information and many tips, but I thought I ought to get off the fence and say what I am trying to do with my own investments.

First off, I hope you will have got your savings ready for your retirement well before you retire. I did not, and it will take me many years to sort them out without losing quite a lot of value or taking big risks.

Decide how much cash you need in instant-access savings accounts to cover emergencies. Personally I aim to keep more than £10,000 in instant access.

Then decide on how much you will keep in cash, but in higher interest accounts or bank and building society bonds, or savings certificates from NS&I. This will provide a safe buffer that will help you sleep well at night and that you can be sure will always be available to sell in order to cover any major expenses. Remember not to keep too much with any one institution – we now know banks and building societies are not totally safe from failing. Personally I aim to keep at least 20% of my savings in cash because I am quite risk averse.

Decide how much of the rest of your savings you want in corporate bonds. Ideally these should be in an ISA wrapper so the income is tax-free. The amount of bonds you invest in will depend on how risk averse you are, and how sure you want to be that you can maintain a good investment income even when interest rates are low. It is essential that you buy bonds when interest rates are high. The maximum I would advise putting into corporate bonds would be 20% of your savings.

I intend to put the rest of my savings into the stock market. If you are not a knowledgeable stock market investor I would recommend the bulk of your equities be in a wide range of high-income investment trusts. In my opinion these offer the best chance of getting a decent income and protecting your capital from inflation over the long term. They also have the added benefit that if you do not need all the income then reinvesting the income makes them one of the best high-growth investments available to you. Given I have warned against putting all your eggs in one basket, is this risky advice? I think the risk is acceptable for the following reasons:

• These are collective investments so really you are investing in many different shares.
• Investment trusts have a very good track record of combining both income and growth (although 2008 was a horrible year for them).
• High-income investment trusts will own shares in most market sectors, probably the main areas that will be missing are mining and technology stocks.
• Most market sectors have a number of companies paying high dividends so your investments will be spread over a large number of companies, so any one going bust is not going to hurt you too badly.
• If you are a UK investor then the bulk of your shares will be invested in the UK, but in an increasingly globalised world this is not a huge risk.
• There will be a majority of your investment in larger, safer (blue chip) companies, but there will be the diversity of some smaller companies.
• Companies that pay high dividends tend fiscally to be quite conservative.

Additional equity investments to consider are:

• small companies investment trusts
• shares in a commercial property company or investment trust.

You should build your portfolio using pound cost averaging, or using the knowledge I have given about how to buy at opportune times.

Spread your savings amongst many high-income investment trusts. There is plenty of evidence that picking such trusts at random is as successful as using their past performance to guide you. There is even a monkey called Leonard on US TV who on average does as well (or as badly) as an investment expert!

So what should you do about pensions?

If you have a pension fund of which you have to use a substantial part to purchase an annuity that will then provide a guaranteed annual income for the rest of your life, then check if you can shop around for the best deal. If you can shop around, usually you will be able to do much better than by sticking to your default provider who managed your pension fund. Any reputable IFA will provide you with the best deals on offer, or you can look on the internet. If you have significant health problems or are a smoker you should declare these as usually they will lead to you obtaining a better annuity. Also, think very carefully about the type of annuity you buy: it is often better to accept a significantly lower annual payment that is index linked to the annual rate of inflation; and if you have a partner they will be much safer in the long term if you accept a lower annual payment so your partner still gets all or part of your pension if you die first. Also check if you can take out a lump sum at retirement, because unless you can convert that into a pension on very favourable rates, usually you will do better to take the maximum lump sum possible.

If you are reading this book in your forties or fifties, then you need to be thinking very hard about your financial preparations for retirement. You have probably noticed that the years seem to spin round faster as you get older, and so you will not be surprised to hear me say that retirement is closer than you would like to think. You also will not be surprised by the fact that retirement probably will last much longer for you than it did for your parents – latest research suggests that around 50% of 50 year-olds will live until they are at least 90! So you’ll need to have made preparations for a lengthy retirement, or be prepared to work for longer.

The government and many employers provide incentives to invest in a pension. Contributions into pension arrangements (up to prescribed limits) attract tax relief and some of the investment returns and income are also free of tax. Many employers provide contributions to your pension savings. The best employer pensions are called ‘defined benefit’ and pay out a lump sum and annual income based on your earnings record and the length of your service with the company. Other employer pensions are called ‘defined contribution’ where your contributions build up a pension pot that will pay a lump sum and also will allow you to buy an annuity to give you an income for the rest of your life. In addition there are a range of personal pension plans for people who do not have a pension from their employer.

A common question I get asked, is ‘How big a pension pot, plus savings, do I need?’ Provided you accept that there can be no ‘one size fits all’ answer to this question, I will try and give you a ballpark figure. My rough calculation is based on an estimate that, in 2008, £100,000 will purchase a joint life, index-linked annuity of approximately £4,500 p.a. for a 65-year-old male – and this is also the sort of income you could generate from a £100,000 portfolio of equities. My feeling is that if you are a higher-rate taxpayer, you are unlikely to be able to live comfortably on a pension pot, plus savings, of much less than £500,000, and if you earn much more than a basic-rate taxpayer you will need correspondingly more – frightening isn’t it! How do you amass such a fortune?

Do not rely on what I am saying. Pay for expert, independent financial advice as well. Also read up about the subject, so you can make informed judgements. After reading this book and seeking advice make your own mind up.

Ask for an estimate of your, and any partner’s, state pension – which can be obtained from The Pension Service website. This will provide the baseline you can work from.

If you have access to a decent occupational pension scheme, where your employer makes relatively generous employer contributions, then usually it will be a no-brainer to join because your pension fund has the double advantage of tax breaks and the equivalent of extra salary. As you reach your mid forties you should be thinking about how you can make additional contributions to an additional voluntary contributions (AVC) section of your occupational pension fund. Make sure you keep an eye on the likely projections of your retirement benefits from such a scheme. I mentioned earlier in this chapter that many people do not feel confident about dealing with their finances – and if there is one area where lots of people feel least confident, it is pensions. No matter how boring or frightening you find the subject you really must not stick your head in the sand where your pension is concerned.

Sometimes you will have no control over the way your pension fund is managed. However, some pension providers give you a choice over which fund managers will invest your money, and also may allow you to choose the nature of the investment strategy that will be used. You might even have the ability to choose your pension provider.

A typical default pension investment option might be as follows: 65% of your funds in equities (UK and overseas shares), and 35% in less volatile investments. A mixture of actively managed funds and passive stock market trackers will be included in the equities. Some time before retirement, usually 6–10 years, your funds will start to be moved out of the stock market and into fixed interest investments (such as government and corporate bonds) and cash investments. This ensures that your final pension pot is exposed to much lower risk of sudden drops in the stock market as you approach the time when you will be buying an annuity and taking a tax-free lump sum. As you can see it is essential that you notify your pension provider if there is a high probability that you will retire early, so that they can move your fund out of the stock market in good time.

The typical default pension option is a balance between risk and return. You may think that the default option is too conservative, and you might want higher exposure to shares, and to take personal control over when, and how fast, you move out of the stock market as you approach retirement. If you are willing to invest the time, and risk, in taking greater personal control, then you may well want to look at exploiting any options that are available to you of selecting the pension provider, fund managers and investment strategy. Most people simply do not feel comfortable making such choices and around 80% choose the default option that is offered to them.

I would advise you strongly to get free of borrowing as soon as possible – this is a very tax-efficient use of savings. In short, pay off your mortgage as quickly as possible. Apart from paying off your mortgage, what should you do about pensions and savings if you do not have access to a good occupational pension scheme? I would caution strongly against the ‘property is better than pensions’ mindset – read the figures I gave earlier in this chapter!

In the UK you can join a stakeholder pension, or take out a personal pension (PP), or you can do it yourself in a self-invested pension plan (SIPP). I suggest you research the pros and cons of all these options, and seek independent advice from an adviser who will not take commissions from anything you decide to do. The UK also allows you, in some circumstances (for example by having a SIPP and transferring your other pensions into it), to drawdown from your pension pot without having to buy an annuity. This is a bit riskier, but gives you and any partner of yours some significant advantages. Drawdown makes pension funds a bit more like real money, but ultimately the price you pay for the tax advantages of pensions is that pension funds are regulated so that you cannot treat them just as your own wealth. As a consequence, I would recommend that you save for your retirement by splitting your money between investments and pension contributions.

Income drawdown is an alternative to buying an annuity. You draw income from the investments in your pension fund by taking out interest, dividends and/or capital. The amount you can withdraw annually is limited by the Government Actuary’s Department, which uses a formula that limits income to a little above the non-index linked, single life annuity that your pension pot could buy. The risks of income drawdown are obviously different to purchasing an annuity, but the big difference is that after your death your spouse or your estate will get access to your pension fund. For example, your spouse could continue income drawdown, or he/she could pay 35% tax and then get your pension savings as real money.

Warning – pension law is complex and changing all the time, so you need to check the details of income drawdown that are current when you are reading this book.

Make monthly contributions to both pensions and savings. Parkinson’s Law states that your expenditure usually grows to the size of your income, so it is best that you take the savings out each month so that you do not think of that as money that is available to spend. Keep increasing your monthly savings and pension contributions as you get older and (hopefully) better paid, so that you will have a decent-sized pension and savings to live comfortably in your retirement. You need to review regularly the projections of your retirement pot. You will also need to decide if you want to plan to be in a position where you have the financial resources to take early retirement if you want to.

If you receive lump sums, for example bonuses, inheritances or redundancy payments, then think carefully about how to invest them. A lot of people I talked to felt they had squandered lump sums. If you still have a mortgage you will seldom do better than using a lump sum to pay off part of your mortgage. Another good option if you are a higher-rate taxpayer can be to put all or part of a taxable lump sum into a self-invested pension plan to reduce the amount of higher-rate tax that you have to pay.

Please learn from my mistake and ensure your savings are well organised for when you retire.

• As you approach retirement you may decide to put most of your stock market investments into high-income investment trusts, with income reinvested. Indeed this may be your favoured approach for the bulk of your savings throughout your working life.
• Watch the market conditions so that you can buy some long-term corporate bonds at a propitious time in the run up to your retirement.
• If you have control over your pension fund then, if you see a bear market setting in as you approach retirement, you probably will want to get substantially out of the stock market so that you can buy the best possible annuity – this is much less important if you will be using income drawdown rather than purchasing an annuity.

As your retirement approaches it is well worth doing a budget of your outgoings, and rehearsing living on your retirement income.