Chapter 3

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Investment Outcomes

Why invest?

‘In the long run, it’s not just how much money you make that will determine your future prosperity. It’s how much of that money you put to work by saving it and investing it.’

Peter Lynch

Whilst in the previous chapter we covered savings, in this chapter we move to investing. Saving means putting your money in cash products, like deposit accounts. Investing means buying things that may increase in value, such as stocks and property. Generally, investing is riskier than saving, but we will see how to control risk and what risk level is appropriate for you. Following the four-step investment management process, Chapters 3, 4 and 5 will help you to establish your investing objectives.

When beginning saving for retirement, the amount you save is by far the most important aspect. Good or bad, early investment returns have a relatively small impact on the amount of money with which you end up.

For example, compare the decision whether to save £500 or £1,000 in the first year and whether you make 10% or lose 10%. The saving decision has an impact of £500 on your savings. The investment return has an impact of between a £100 loss and a £100 gain on your savings.¹

Spend the first decade of your saving and investing life focusing on maximising savings. Experiment with investing, comfortingly knowing that whether you make good or bad investment decisions, this is, primarily, a learning experience.

Over the long term, however, investment returns have a big influence on the final outcome – the amount you save and the income it can generate. When having £100,000 in your savings, a 10% return is meaningful.

Why should you invest and not just save?

You can earn an annual interest rate of about 1.5% on cash ISAs (variable, easy-access, not fixed) in the current low-yield environment. The base rate of the Bank of England (BOE) is 0.5%. Most cash deposits pay a higher rate than that, but not much more.²

The BOE targets a 2% annual inflation rate. With cash deposits you are unlikely to beat inflation. UK Government bonds with a 10-year maturity currently yield below 2%. When taking into account inflation, it is nil growth (although current inflation rate is far below 2%). That is one reason to invest.

Another reason is that with investing you can generate a return of cash plus 4% or even more. That could be considerable when investing over many years.

You invest to make money. You want your money to work hard for you, generating more money. You participate in capital markets to win.

Investors typically care about nothing else but the return or outcome of investing. The results you desire to achieve are your return objective.

The first step of planning your investments is thinking about why you are investing and what you are trying to accomplish. Before planning a trip, know your destination (unless you are after an aimless wander).

This is the same as investing and most other things in life. First, figure out where you want to reach. Then figure out how to get there. There are no guarantees you will reach your destination, but at least you have a general direction.

Investment outcomes are divided into four groups:

1. Growth.
2. Beat inflation.
3. Income.
4. Hedge liabilities.

Growth

The most commonly sought investment outcome is growing the portfolio’s value. This outcome should be expressed as a return in percentage over a specified time period, usually a year.

For example, savers for a retirement nest egg should, typically, aim to generate 5% or 6% on average every year. With such a return, £100,000 will grow on average by £5,000 or £6,000 annually.

The nature of investing is that, in some years, returns are high whilst in others they are low – this is investment risk. The important point is to aim, on average, over time, for an annual return that is broadly in line with the return objective.

This is one reason to invest for as many years as possible. The larger the number of years, the higher the chances are of hitting the average yearly return. The other reason is that time is money.

With 5% average return per year, a £100,000 pension pot grows to £265,330 in 20 years.³ It will reach £432,194 in 30 years’ time.⁴ More time is more money.

These calculations assume no cash inflows or outflows. Typically, up to retirement your employer and you contribute every month to your pension, helping it grow. If you are self-employed, you need to contribute.

After retirement, cash flows go in the opposite direction as you draw pension income. If cash outflows outpace growth, the pension pot gradually depletes. Investment returns can prolong its life.

It is perfectly fine not having a precise target growth rate, especially when you are far away from the finishing line. Aiming to grow your portfolio as much as possible, given some constraints, such as a risk level, is a reasonable return objective. As retirement is getting closer, however, and you know roughly how much you want to save, you should formulate a more accurate target return.

Table 3.1 demonstrates how a pension pot would grow over different time horizons with three different annual growth rates of 1.5% (cash or deposit rate), 5% and 6%. It assumes annual contributions of £20,000.⁵ A decent growth rate working for many years is the winning formula for long-term savings.

Table 3.1

Pension growth over different horizons and growth rates	10 years	20 years	30 years	40 years
1.5% return pa	£217,265	£469,410	£762,035	£1,101,638
5% return pa	£264,136	£694,385	£1,395,216	£2,536,795
6% return pa	£279,433	£779,855	£1,676,034	£3,280,954

Note: Assuming £20,000 annual contributions, including tax relief, with annual compounding pa = per annum

Beat inflation

Inflation reflects changes in the amount of money needed to buy a basket of goods and services. For example, today you buy weekly groceries for £100. If the annual inflation rate is 2%, next year you will need £102 to buy the same groceries. The purchasing power of £100 is 2% less than it was a year ago. You need more money to buy the same basket; your money is worth less.

Now, 2% does not seem a lot. But inflation is insidious. If you are a long-term saver, and the average annual inflation rate is 2%, in 20 years’ time £100 will be worth only £67.3.⁶ That is 32.7% less – a third of your money’s value has evaporated. That is a lot.

Losing a third of your money seems unfair. You did not do anything reckless or risky. But that is exactly the problem. You did not do anything with your money. Doing nothing is reckless and risky.

Therefore, an important outcome of investing, in particular over the long term, is keeping pace with inflation.

Inflation is actually one of the motivations to invest. The least you should expect your investments to earn is the inflation rate. Otherwise, you will lose money just because of the passage of time and the ravages of inflation. Do not put your money under a mattress or leave it idle in a current account. Make it work.

Here is a good point to introduce two terms: nominal return is return including inflation; real return is return above the inflation rate. Real return represents growth in purchasing power.

nominal return = real return + inflation⁷

For example, a 5% nominal return when the inflation rate is 2% means a real return of about 3%.⁸ If nominal return is 3% and realised inflation turned out to be 4% real return is −1%. You lost money in real terms. This is inflation risk.

Income

Some investors design their portfolio to generate regular payments or income. When expressed as a percentage of a portfolio's value it is called yield. If you retire without other regular sources of income (such as salary, annuity, DB pension payments or rent) or want to top them up, you may desire to earn a yield on your investments.

For example, with a 4% yield a £100,000 pension pot pays a £4,000 annual income. That is not much. You cannot live off £4,000 per year. With the same yield £1 million provides an annual income of £40,000. That is more like it.

Table 3.2 Annual income for different yields and portfolio sizes

Portfolio size/yield	3%	4%	5%
£100,000	£3,000	£4,000	£5,000
£250,000	£7,500	£10,000	£12,500
£500,000	£15,000	£20,000	£25,000
£1,000,000	£30,000	£40,000	£50,000

A general rule of thumb is that to maintain your current standard of living after retirement you need at least half of your current income, depending on the way you want to live.⁹ Table 3.2 shows annual income for different yields and portfolio sizes.

Replacement rate (replacement income) is pension as a percentage of earnings. Another general rule of thumb (there are many rules of thumb, some contradicting) says that an adequate replacement rate is two-thirds of salary. Achieving this replacement rate needs a contribution rate of about 15% (depending on time andgrowth rate of savings).

The Joseph Rowntree Foundation, a British social policy research and development charity, publishes an annual minimum income standard (MIS) for the UK. In 2015 the MIS for a single pensioner without mortgage or dependents is £9,515 a year and for a couple it is £13,730 a year. Use the minimum income calculator at www.minimumincome.org.uk to check your MIS.

To accumulate a pension pot of £500,000 to £1 million, start saving early, contribute regularly to your pension and aim to grow your savings through investing. Nobody said it was going to be easy.

Some investments pay regular cash flows. For example, bank deposits and bonds pay interest, stocks pay dividends. However, even if investments do not generate regular payments, you can do it yourself by selling some, raising cash when needed.¹⁰ Drawing investment income (taking natural yield) is more sustainable than drawing capital (selling investments), in particular during volatile markets. It allows markets to recover.

Selling investments is possible as long as they are liquid, meaning you can sell them at a reasonable cost and time, turning them into cash (liquidating them). Property, for example, is illiquid. Selling it can take a long time and a substantial amount of money. You also cannot sell small parts of it to raise your monthly cash needs. It is normally all or nothing.

If your investments are liquid, generating income is possible even if they do not pay out regular cash flows. For example, you hold a £500,000 portfolio invested in stocks. Every month you can sell stocks worth £5,000 to generate income. But there are caveats.

The two main differences between income-generating investments and the DIY method are costs and taxes. Selling investments incurs transaction costs.¹¹ The tax treatment on capital gains is different from that on income. CGT is typically lower than income tax, so the DIY method can be tax advantageous (although taxes do not matter when assets are in tax-exempt wrappers).

When considering income avoid depleting the value of your portfolio so much that it cannot continue generating income for as long as you live.

For example, spending £50,000 or 10% of your £500,000 pension pot, next year its value will be £450,000. The same 10% will generate only £45,000. The income-generating capacity of your portfolio diminishes unless you preserve its capital. Drawing the same percentage every year, instead of a fixed amount, is a strategy to mitigate depleting your portfolio. However, income will decrease over time.

When thinking about income, think about preserving your portfolio’s value, as well as keeping pace with inflation. In other words, retain your portfolio’s real value. If you target a 4% yield and the inflation rate is 2% your portfolio needs to grow by 6% just to pay the annual income and keep pace with inflation.

The ultimate desired outcome of a pension is accumulating and growing assets over your working lifetime so assets provide income in retirement and this income maintains its real value.

Annuities

In 2014 UK pension regulations dramatically changed. No longer must you purchase an annuity with the bulk of your DC pension when retiring. Nevertheless, consider using an annuity as part of your pension solution.

An annuity is a financial product, usually sold by an insurance company, promising to pay a guaranteed retirement income until death. Essentially, annuities are like insurance in reverse. You pay a lump sum (from your pension) to an annuity provider and, in return, receive regular monthly payments for the rest of your life. It is like buying a DB pension (with some differences).

Payments are based on the annuity rate. For example, on a £100,000 lump sum with a 5.3% annuity rate (current rate for a 65-year-old non-smoker in good health), you receive £5,300 a year. It does not matter how long you live; payments are guaranteed.

Annuity rates depend on several factors, such as bond yields, the annuity’s terms (such as guarantee, which continues to pay for at least the guarantee period, even if you should die before that time, or linking with inflation) and your condition (age, marital status and health).¹² Standard annuities are available to all. Enhanced annuities are available for people with a lower life expectancy, generally smokers or those with a medical condition.¹³

Rates of enhanced annuities are more generous since the insurance company estimates that the payments are not going to last for a long time. Smoking eventually kills you, but you can get a higher annuity rate.

When buying an annuity, shop around. Before reaching retirement, you will receive a letter from your pension provider with the value of your pension and an annuity quotation. You do not need to accept this offer.

Different insurance companies offer different annuity rates. Annuities have been criticised for the fat profit margins some providers make. Choosing a provider makes a difference.

Currently, you have one chance to buy your annuity. Then, it is with you for life. Annuity switching is a controversial topic and is not available yet in the UK.¹⁴ Make the best choice you can when you can.¹⁵ You also need luck with the timing of your retirement since annuity rates vary.

Annuities’ main advantage is certainty and peace of mind; knowing how much income you are going to get, however long you live (longevity insurance). The main disadvantages are inflexibility (no switching, no access to the lump sum); most annuities are not linked to inflation; and annuity rates have decreased over the years.

A 5% annuity rate requires living 20 years to break even – the time it takes to receive back the lump sum (income/life expectancy calculation). The rate of an inflation-linked annuity is currently about 60% lower than that of standard annuity – it will take much longer to break even.

With a 5.3% annuity rate, £5,300 per year for every £100,000 is not likely to be enough for achieving your financial goals post-retirement (unless you are off to live on a beach in Thailand). You will want to have a decent quality of life, to travel, to spoil your grandchildren – you want to enjoy a pleasant retirement.

Because of the low rates of annuities and their rigidness, more pensioners look for other ways to generate income, such as high-yielding investments. The main downside of such investments is that they risk capital to generate satisfactory returns. It is a trade-off between annuities’ low risk/low yield and these investments’ high risk/high yield.

One way to benefit from both worlds is blending an annuity with higher yielding investments.

Another disadvantage of annuities is their inheritance rules. When someone with an annuity dies, the deceased’s spouse can continue receiving annuity pension payments, as long as the deceased asked for it to happen and paid extra (joint life annuity or death-depended annuity).¹⁶ When the spouse dies, or if the deceased did not sign up for this deal, the insurance company offering the annuity takes the remaining pot. Children get nothing (they typically do not inherit DB payments, either).

This means that another advantage of income drawdown pensions is the ability to pass them to children.

Deferred annuities

Deferred annuity is purchased but its income payments start at a later date. A possible scenario to use it could be if you take a 25% tax-free lump sum from your pension but do not need income. Another scenario is blending flexible drawdown and a deferred annuity. The annuity payments will kick in when you are older and less likely to be able to manage your finances, perhaps due to dementia, or when other assets are exhausted.

By deferring annuity payments, when you start taking them their level will be higher as the period for which they are paid is shorter.

Variable annuities

Variable annuities (investment-linked annuity) are a relatively recent innovation in the UK. Popular in the USA, variable annuities are financial products where, in exchange for a lump sum, the insurance company guarantees a minimum income for a fixed term, usually not for life like standard lifetime annuities.

The product allows you to invest in a portfolio of stocks, bonds and, perhaps, other assets with a prospective upside. Any income and gains above the guaranteed minimum payments vary, depending on the portfolio’s performance.

The objectives of variable annuity are providing an element of a secured income, with some flexibility of accessing part of the lump sum used to purchase the product and potential gains. Some variable annuities guarantee a certain level of value at the term’s end to purchase a lifetime annuity.

Each variable annuity is different. Carefully read and understand the terms since there are risks. The guaranteed income is not for life. The portfolio’s value can go down as well as up. Variable annuities are markedly different from lifetime annuities.

If you purchase an annuity to guarantee a minimum income level for your entire life to address longevity risk, variable annuities might be inappropriate. Instead of a variable annuity, blend a standard annuity with investments, giving you some minimum income with flexibility and potential upside. Do it yourself.

Hedge liabilities

We all have liabilities. We need to pay for food, utility bills, transportation, rent, mortgage, education and so on. Income should cover ongoing liabilities – if it does not, spend less or earn more; balance your budget. But for larger sums, such as a down payment on a house, replacing a car or tuition for kids’ university, we need to prepare cash.

It is possible to design investments so they generate cash flows when large payments are due – if you know their timing and amount. For example, you plan to replace your car in five years. You put aside, in a five-year time deposit, the car’s expected price. If the price is £10,000 and interest on the time deposit is 5% per year, put aside £7,835.¹⁷ In five years you should have £10,000.

The 5% is a nominal return, including the expected inflation rate. If inflation exceeds expectations, you may fall short of your objective as the car’s future price may be higher. In that case, you will need to take some cash from another source or settle for a cheaper car. Anyway, it is always good to have a contingency plan. If plan A does not work, have a plan B.

Portfolios can be divided into growth assets and matching assets. The role of growth assets is producing capital growth and income. The role of matching assets is maintaining a value in line with that of liabilities and generating cash flows matching those of liabilities.

Some DB pensions divide their assets in such a way. Matching assets are commonly called Liability Driven Investment (LDI).¹⁸ DB pensions must pay a stream of payments to members. This is a DB scheme’s liability. If it does not have enough assets to meet liabilities, it is the sponsor’s liability – the sponsor will need to inject (contribute) money into the DB.

Since the money in your pension is effectively locked until you retire, you cannot use it to hedge liabilities before retirement. You can withdraw money from your ISAs at any time. However, if you withdraw money, you need to put it back in in the same tax year to enjoy the tax shelter. The best approach is using money outside your pensions and ISAs to hedge liabilities before retirement, if possible.

If you consider buying a buy-to-let property, for example, and you must access your ISA savings to do so, then it is down to a cost/benefit analysis.

Say you expect an annual 6% pre-tax rental profit on a property. You are on the 40% tax bracket. The net annual profit is 3.6%.¹⁹ If you expect to generate a tax-free return of 8% per year on your stocks and shares ISA, then, based on these calculations, you might be better off keeping the ISA.

However, a property should appreciate in value. Its after-tax total return may surpass 8%. Also, consider the risks of the two alternatives. Stocks’ returns may deviate substantially from the expected 8%, whilst property’s rental profit may be closer to its expected 6%. A property may be safer than financial assets in a bank. Property rights protect your ownership. A property cannot go bankrupt, while a bank can. Additionally, estimated expected returns are not the sole consideration. Owning a property when retired can be the prevailing argument, tilting the balance in favour of buying it.

One advantage of ISAs is flexibility to make such decisions. You can access your ISA money whenever you want.

Blending outcomes

Often, investors target a combination of some of the four investment outcomes, not just a single one.

For example, when young and working, you cannot access your pension for a good number of years. Your focus is inflation-beating high growth. You are looking to increase your portfolio’s purchasing power. This investment objective often is termed long-term capital growth or aggressive growth.

When retired, you want your pension not only to pay a steady income stream, but also to grow over time, at least keeping up with inflation. You are looking to preserve capital and your portfolio’s income-generating power in real terms. This combined outcome often is called income and growth or income and capital preservation.

Alternatively, perhaps you do not need income yet from your pension since you work part time or earn rental income. You are seeking your pension to modestly grow and beat inflation, without incurring large losses. You are looking to retain your portfolio’s purchasing power for later years when needing it. Such a combined outcome often is named capital preservation.

Maybe you wish your portfolio to grow and generate a big cash flow when you retire. You can then take a tax-free lump sum to buy that red Ferrari you have always wanted. This combination of outcomes is customised to your unique financial desires.

The outcomes and their combinations are personal. Form a set of investment objectives based on your individual circumstances and aspirations.

Total return

When defining return objectives, think in terms of total return (TR). It includes both change in market price (capital appreciation or price return) and income. Income includes interest on cash deposits and fixed income investments, dividends on stocks and rent on property.

For example, you want your portfolio to produce 2% income and 3% growth per year. Your total return objective is 5%. You can choose either spending the 2% income or reinvesting it, putting it back to work. When spending the income, your portfolio grows by only 3%.

When comparing an investment’s performance with that of a benchmark, compare like with like. Total return with total return or price return with price return. Do not mix the two. Total return can look deceivably good relative to price return.

For example, the FTSE 100 Index measures the performance of the 100 largest listed (exchange traded or quoted) companies in the UK. The index’s return can be reported as price return, excluding dividends, or as total return, including reinvestment of dividends.

A big difference between the two is likely, especially over the long term.²⁰ Dividends can make up over 3% or 4% of total return every year.

Compound return

‘The most powerful force in the universe is compound interest.’

Albert Einstein

Compound return is the return investments earn over a time period considering not only the original principal, but also the impact of gains and losses.

For example, your £1,000 deposit earns 5% per year. Each year you spend the earnings. After 10 years you will have £1,500.²¹ Conversely, leaving the earnings in the deposit, you earn every year 5% on a growing amount (5% on £1,000 in the first year, 5% on £1,050 in the second year and so on). After 10 years you will have £1,629.²²

You made an extra £129 or 12.9% by reinvesting earnings, letting compound return do its magic. The longer the time horizon, the higher the effect of compound returns. That is one reason it is recommended you start saving as early as possible. Time is an invaluable force.

Figure 3.1 shows the accumulated savings of three savers. Each saver contributes £10,000 each year to a pension. The first saver started at the age of 25, investing in a portfolio returning 5% per year. The second saver started 10 years later, at the age of 35, investing in the same 5% return portfolio. The third saver started also at the age of 35, but invested in a more conservative portfolio, returning 3% per year.

The first saver managed to save over £1.2 million by the age of 65. This is over the lifetime allowance. Well done.

The second saver, who started later, managed to accumulate about £700,000 by the age of 65. That is £500,000 short of the first saver. Starting early is beneficial, letting compound return to work on the savings for longer, as well as to contribute more. However, the first saver’s excess contributions account for only £100,000 of the £500,000 difference. It is mostly due to compound return.

The third saver started late and invested in a portfolio generating 2% less than that of the second saver. The third saver managed to save only £500,000. An annual lower compound return of 2% over 10 years made a difference of £200,000. That is a lot of money.

The conclusions are straightforward – start early and aim to increase your compound annual growth rate (CAGR).

Required versus desired outcomes

Some financial goals are required (essential). Others are desired (non-essential).

For example, generating regular income after retirement to maintain a reasonable standard of living is required. Beating inflation is required, especially over a long investment horizon. However, buying that red Ferrari when you retire is desired.

Achieving required objectives is critical. Failure can mean compromising a comfortable life. Plan carefully to achieve your required objectives, minimising the risk of failing to do so. As for your desired objectives, they would be nice to have, but you can risk not achieving them.

For example, an annuity can generate an income stream for the rest of your life to maintain a minimum standard of living. You are not taking risk to achieve this required outcome. A diversified portfolio of stocks and bonds can generate high returns and income to finance holidays and discretionary spending. You are taking some risk to achieve this desired outcome.

Relative versus absolute return

Relative return does not live in vacuum. It is measured in comparison with some benchmark.

A relative return objective can be, for instance, beating the FTSE 100 Index by 2% per year. One problem with this objective is that you do not know what the level of return is likely to be over the short term. Can you know whether the FTSE 100 Index is going to return +15%, 0% or −15% next year? All are plausible. The index’s average return over the long term is more predictable.

Another problem is that the magnitude of a relative return objective is small compared to the potential benchmark return. The total return of the benchmark plus the relative return is determined largely by the equity market return, not the objective.

The final and most acute problem with such a relative return objective is that it is not linked to your financial goals. If next year the FTSE 100 Index falls by 20% and your investment returns −10% is that good or bad? The investment exceeded its relative return objective fivefold – a 10% outperformance. However, you still lost 10%. That is not a great result. Surely, it is not what you hoped your investment to do.

Absolute return, in contrast, is not measured relative to any benchmark or index. It is benchmark agnostic. Some examples of absolute return objectives include 5% per year, cash (LIBOR) +4% and inflation +3.²³ The advantage of an absolute return objective is that it is outcome-oriented. It focuses on a result linked to your financial goals.

If you are a long-term saver, targeting an average annual return of about 5% or 6%, such absolute return objectives match your financial needs. The return is not guaranteed. It is unlikely to achieve its return objective every year. However, at least it aims to achieve what you need, rather than what the general equity market happens to do.

Watch out for a return objective detached from inflation. The advantage of an objective expressed as cash or inflation plus a percentage is that it is linked to inflation. It is a real return, rather than nominal. If your return objective is just 5%, for example, whether inflation is 2%, 4% or 6% makes a big impact on results in real terms.

An ‘inflation plus’ objective is obviously linked to inflation. What is less obvious is that a ‘cash plus’ objective should also be linked to inflation. When inflation rises, short-term cash rates should rise with it as part of the central bank’s efforts to control inflation.

The best way to express your return objective is linking it to your specific target outcome, including an element of inflation.

Gross versus net return

‘In investing, you get what you don’t pay for.’

John Bogle

Gross return is before and net return is after charges, costs and taxes. Net return represents your investing experience, your take-home money.

You cannot control many things in investing. But you can control expenses. Every penny you save on charges, costs and taxes is another penny added to your net return.

Estimating your target return

Estimating your portfolio’s target return entails a number of assumptions and a calculator. Conveniently, the Citizens Advice offers a free savings calculator at www.citizensadvice.org.uk (as well as free, independent, confidential and impartial advice on a range of topics, including savings and pensions).

Begin with estimating the income you will need when retired. The following steps can help:

1. Add up all expected expenses (outgoings) in retirement for one year. Consider housing costs (mortgage, rent), dependents (spouse, children in education, as more people have children later in life, elderly relatives who might need support), transportation, holidays and hobbies. You are likely to spend more time at home, so expect higher heating costs and utility bills. You may have more free time to spend on social outings and activities. Private healthcare costs (not covered by NHS) might rise. Travel costs can decrease due to cheaper fares on public transport for senior citizens and with no need to commute to work. Expenses can initially drop soon after retiring, but then rise again later in life when care costs kick in.
2. Subtract State Pension and other income (DB, rental income).
3. The result is the annual shortfall. You need your pension savings to generate the annual shortfall. Check the expected income in your annual Pension Benefit Statement from your pension administrator. Use the current annuity rate as benchmark for flexible drawdown. Are you on track to generate the annual shortfall?

A rule of thumb is that 20 times the annual shortfall is your savings goal.

Using the online calculator, input your savings goal (target portfolio size); date when you need your savings (target retirement date); how much you have saved already (current pension savings); and gross annual interest rate (target return). The calculator outputs the monthly contributions needed to achieve your target portfolio size.

Play with the calculator, entering different target returns until, through an iterative process of trial and error, the monthly contributions match those you and your employer pay into your pension.

For example, your target portfolio size is £1 million (with current annuity rates it is expected to generate the income you need), you are 35 and wish to retire at 65 (30 years from now), you have no pension savings and you assume a 5% return per annum. The calculator says you need to save £1,220 per month.

However, your annual salary is £40,000 and you and your employer contribute 10% each. That is £8,000 per year or £667 per month, way below £1,220.²⁴ Going back to the calculator, you change the target return, whilst keeping the other variables constant, until the output matches monthly contributions of £667.

The result is a total real net return of 8.3%. If you expect contributions to increase with inflation, you need 8.3% total nominal net return. Contributions are a fixed percentage of your salary. Salaries normally are not adjusted for inflation every year. However, promotions or changing jobs can bring salary increases.

Now, decide whether your objectives are reasonable and fit your financial plan. You can amend the target portfolio size (change lifestyle post retirement) and perhaps your retirement age or plan to continue working part-time. Maybe you can adjust the contributions, in particular yours if total contributions (including your employer’s) are below the annual allowance.

Unfortunately, an 8.3% return, net of charges and transaction costs, is aspirational. Since January 1998 to December 2015 the FTSE 100 Index’s average annual total return was 4.9%. And this is a gross return, before charges.

Being more realistic, given your contributions, time horizon and a reasonable 5% average annual return, your expected target portfolio size is £550,000. Judge whether it is enough. You can try maximising it within pragmatic constraints.

Split the target portfolio size into two buckets: one satisfying your required needs and a second satisfying your desired needs. Consider splitting your savings into two portfolios: one to generate the required return to reach the required bucket and a second to generate the desired return to reach the desired bucket. Make every effort to achieve the required return.

Importantly, evaluate whether your target return is achievable and whether the risk level you will need to tolerate it is too adventurous. The target return is a function of investment risk. Careful, the next chapter is risky.

Summary

• Investors seek four types of investment outcomes: (1) growth; (2) beat inflation; (3) income; and (4) hedge liabilities.
• Your pension pot’s final value is a function of contributions, growth rate, time and charges and costs.
• The minimum to seek from your portfolio is keeping pace with inflation.
• Annuities are not compulsory any more. Annuity gives certainty of regular income for life. However, annuities are inflexible, normally they are not linked to inflation and their rates have decreased over recent years. Consider blending annuities with higher yielding investments.
• Hedge known liabilities (large cash outflows) with matching investments.
• Tailor your investing outcomes for your specific needs.
• Compound return is powerful. Let returns accumulate over a long time and reinvest income and profits so they work for you.
• Focus on achieving your required return. Not achieving it can adversely affect your quality of life. Desired return is nice to have, but you can live without it.
• Do not measure your return objective relative to some generic index. Rather, it should be absolute, linked to your personal investment needs and expressed in real terms (above inflation).
• Given your target portfolio size, expected retirement age, current pension savings and monthly contributions, you can easily calculate your target return using a free online savings calculator.

Notes

¹−£100 = −10% × £1,000; £100 = 10% × £1,000.

²The base rate (official bank rate) is the interest rate set by the Bank of England for lending to other banks. It is used as a benchmark for interest rates generally in the UK. The Monetary Policy Committee (MPC) makes decisions regarding the level of interest rate. In July 2007 the base rate was 5.75%. In a series of MPC decisions, it was cut all the way down to 0.5% in March 2009 and has been at this level since.

³£265,330 = £100,000 (1 + 5%)²⁰.

⁴£432,194 = £100,000 (1 + 5%)³⁰.

⁵For a basic-rate taxpayer on an annual contribution of £16,000 HMRC adds a tax relief of £4,000, making it £20,000. £16,000 = (1 − 20%) × £20,000.

⁶£67.3 = £100 ÷ (1 + 2%)²⁰.

⁷The precise formula is (1 + nominal return) = (1 + real return)(1 + inflation).

⁸More precisely, the real return is 2.94%. (1 + 5%) = (1 + 2.94%)(1 + 2%).

⁹Those earning between £32,000 and £51,000 a year should aim to retire with an income worth around 60% of their salary. Those earning more than £51,000 a year may need only 50% of their salary. Those earning less than £32,000 a year may need more than 60%. Check the paper ‘Framework for the analysis of future pension incomes’ at www.gov.uk.

¹⁰Modigliani and Miller’s irrelevance of dividend policy theorem claims that dividend policy does not matter since investors can generate income by selling stocks. This is true in a frictionless world. In the real world, frictions like taxes and transaction costs make a difference.

¹¹Transaction costs of selling securities include broker commissions and bid-ask spread.

¹²Index-linked annuity payments are linked to the Retail Price Index (RPI). Young savers should consider index-linked annuities, although their initial payments are lower than those of standard annuities. Escalating annuities can have a fixed annual income increase (such as 3% per year). Level annuity’s rate does not change over the annuity’s life.

¹³Innovative enhanced annuities can be based on postcode and lifestyle. Fixed-term annuities pay back a lump sum at the end of the term. U-shaped annuities’ level of income increases over a time period until a set date and then decreases until death. Some planned modern annuities allow withdrawing lump sums.

¹⁴The Government will soon allow people to sell their annuities if they can find a buyer. A secondary annuity market is planned from April 2017. Marginal income tax rate will apply.

¹⁵You can find current annuity rates on the internet. For example, www.ft.com/personal-finance/annuity-table and www.sharingpensions.co.uk. The free website moneyfacts.co.uk compares annuity rates and provides useful information on a variety of topics.

¹⁶Joint life annuities come with different percentages, indicating the amount that will be paid to the surviving spouse upon death of the annuity holder. For example, a 50% joint life annuity means that 50% of the income is paid to the surviving spouse.

¹⁷[£7,835 = £10,000 − (1 + 5%)⁵.

¹⁸The value of matching assets in LDI is designed to move in tandem with the value of liabilities. If interest rates fall, for example, the value of liabilities rises and the value of the matching assets should rise as well to minimise a mismatch between assets and liabilities.

¹⁹3.6% = 6% (1 − 40%).

²⁰The average annualised total return of the FTSE 100 Index between January 1993 and December 2015 was 7.4%. The average annualised price return was 3.5% over the same period. That is a difference of 3.9% per year.

²¹£1,500 = £1,000 + 10 (5% × £1,000).

²²[£1,629 = £1,000 (1 + 5%)¹⁰.

²³London Interbank Offered Rate (LIBOR) is a benchmark rate that banks charge each other for short-term loans. LIBOR is based on one of five different currencies (US dollar, euro, British pound, yen and Swiss franc) and one of seven different maturities (such as 1 month, 3 months). Often it is used as a benchmark rate for cash deposits and financial instruments.

²⁴£667 = £8,000 − 12; £8,000 = 20% × £40,000.