Useful Changes to Contracting Out Rules

The government has just introduced new rules which will improve the choices available to millions of pension policy owners. The rule changes, which will come into effect on 1st October 2008, affect those with Protected Rights Benefits. These are acquired when an employee person opts out (known as Contracting Out) of the State Second Pension S2P (previously known as the State Earnings Related Pension Scheme- SERPS).

Protected Rights can be acquired in a number ways:
1. Via a Personal Pension or a Stakeholder pension. Employees pay the full rate of National Insurance Contributions. After the end of each tax year the Revenue work out how much has been paid and rebate a part of this into the employee’s plan (something I am frequently asked about and the subject of a later blog).
2. Via Contracted Out Money Purchase Schemes (known as COMPs). These are employer sponsored pension schemes. The employees pay reduced National Insurance Contributions and the employer makes minimum contributions to the scheme.
3. Via Final Salary Pension Schemes (also known as Defined Benefit Schemes). These are schemes that provide a promised level of benefits to members when they retire, typically based on their final earnings and years of service. Where the scheme has opted out of S2P, these are expressed in the form of a pension but they can be expressed as Protected Rights or converted especially if the benefits have been transferred.
4. On divorce or termination of a Civil Partnership where a Pension Sharing Order is made. In such circumstances the pension benefits of one of the spouses/civil partners is allocated under a Court Order to the other. The benefits can be provided within the same scheme but more typically the scheme will require that they be transferred out.

Successive governments have imposed restrictions on the way in which Protected Rights may be paid out. Quite a few rules have been removed in the last few years and the remainder should disappear all together from 2012. However, for now, benefits must be taken from age 50 (55 after 5th April 2010) and these must include a spouses/dependents benefit. It is also currently a requirement that they only be invested in insured pension arrangements.

On 1st October 2008 the new rules will allow Protected Rights Benefits to be transferred into a Self Invested Personal Pension (SIPP). Until recently these types of schemes were not regulated and as a consequence transfers of Protected Rights into them were prohibited. SIPPs allow investment in a wide range of assets including stocks and shares, investment funds and commercial property. It is also possible to borrow 50% of the value of the assets in the fund to assist with the purchase of new investments, such as buildings.

The ability to invest in commercial buildings is particularly useful to business owners wanting to invest in new premises. SIPPS can even be used to buy the premises already owned by the business, thereby releasing the capital locked up in the building. The proceeds received by the business can be used to help finance expansion, or even to simply pay off accumulated debts.

If the SIPP buys trading premises for the business, the business is required to pay a market rent which is fully relievable against its taxable profits but received tax free by the scheme. As the scheme does not have to pay tax on its rental income all of it can be used to reduce its borrowings. This results in the earlier repayment of the borrowing which means less interest will be paid.

A group of SIPPS owned by different individuals can collectively purchase premises. This is a method used by quite a few professional firms such as lawyers and accountants as well as doctors and dentists.

This is not just an opportunity for new investments but also for top-ups to existing schemes. These can be used to make additional investments. Alternatively the additional funds can be used to reduce scheme borrowings.

As with any transfer of benefits it is important that professional advice is taken from an appropriately qualified independent financial adviser. They will be able to review all of your options for you as well as make sure that you are fully aware of any adverse consequences of transferring your benefits.

Shop Around when you retire

BBC Breakfast on Saturday 21st June featured a piece on the importance of shopping around to ensure that you get the highest possible income when you retire.

This applies to those of you with private investment linked pensions. These operate on the basis that you make contributions during your working life to create a pot which you use to support yourself in retirement. At that point, you can typically take 25% as a tax free cash sum and the rest must be used to provide an income in one of a variety of ways. For most people of relatively modest means the most appropriate option is likely to be an annuity.

Annuities come in all sorts of shapes and sizes. They can be paid monthly, quarterly, half yearly and yearly, in advance or arrears. Payments in arrears tend to be greater than in advance. For example a pension yearly in arrears will be better than a pension monthly in advance. They can be level or escalating and can include various levels of provision for spouses and dependents. They can also include a degree of capital protection so that the fund is not all lost should you die shortly after retiring. Enhanced annuity rates are available to smokers as well as to people in poor health.

A key aspect of annuities is that once you have made your choice and the annuity has been put into force, you cannot change your mind. It is therefore critically important that you carefully consider your requirements – and those of your dependents- before you commit yourself. If you suspect that your health may qualify you for a better rate check out enhanced rates.

The Financial Services Authority, the body which regulates the financial services industry, has produced a useful booklet which summarises your choices on retirement. You can access it here

The thrust of the BBC piece was that a large number of people do not appreciate that when they retire they do not need to buy an annuity from the company with which they built up the pension fund. All pension providers are required to offer what is known as the ‘Open Market Option’, which is the facility to take the fund to another company where an improved annuity can be provided. As a consequence they are losing a substantial amount of money.

The importance of checking out the Open Market Option cannot be overstated. Most pension companies do not offer good annuity rates. Prior to retirement they issue a pack of information containing a range of options and this will mention the open market option. However too many people ignore this to their cost.

So how do you find out more about the Open Market Option? See an independent financial adviser. They will not only be able to shop around for you but they will also be able to advise you on which on the other benefits you should include such as a spouses/dependents pension, escalation etc. They will also be able to liaise with the various companies involved to ensure that your pension comes into payment with a minimum of delay.

As a practitioner I can assure you that this is not merely a theoretical exercise. Barely a month goes by when I don’t help someone shop around for the best rates. Most recently this has resulted in a pensioner increasing their income by some £3000 per year.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Waiting Longer for the State Pension

A little known fact is that the government have fairly quietly increased state pension ages for men and women so that for all people retiring after 2024 will increase from age 65 to age 68. What does this mean to you?

Well, if you were able to retire now you would receive £90.70 per week plus any increases due to the State Second Pension (previously known as SERPS)This equates to £4716 per year. Therefore if you are one of the unlucky ones you could be loosing out on £14,149 over the three years.

The Pensions Service have put together a useful little calculator on their website so that you can find out how much extra you will have to wait for your state pension. If you would like to find out, click here

What can you do about it? Well… the starting point is to have a plan. Of course, the state pension should only be a part of your income when you retire. You need to assess what you require to maintain a comfortable standard of living and then compare this with the level of income which you think you will get. If there is a shortfall, something needs to be done.

Alternatively you could consider making use of a financial planner who can prepare a cash flow based model for you which will show you where you stand and help you to create a plan to make sure that you don’t descend into penury when you retire.

Where to find full fund cost data

In my previous posting entitled Hidden Costs of Investment I mentioned that that details on portfolio turnover rates are to be found in the Short Prospectuses of the fund management companies.

This blog will contain links to the short prospectuses. As I find more I will add more, so make sure you visit regularly or by subscribing here. Readers are more than welcome to help with this by providing additional links in the comments to this posting.The companies periodically change the links. Whilst I will try and keep on top of these, if readers spot any that no longer work please post a comment.

Links to Short Prospectuses


Credit Suisse




GAM You need to accept the terms, select ‘Funds’ and then choose ‘Library’ from the left hand menu where you will find the simplified prospectus.

Invesco Perpetual This links to the table on charges from which you can go on to see the PTR. Simplified Prospectuses are in the library section of the site.


Legal & General


New Star

Norwich Union

Old Mutual


Schroders This takes you to the funds section of the simplified prospectus containing the charging details for each fund. If you want to see the generic section look here

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you

Hidden Costs of Investment

Hidden Costs of Investment

Passives and Index Trackers are vastly cheaper than Active Funds. It is not just a question of the Total Expense Ratios but also the cost of turnover.

Take the UK All Companies Sector as an example. Most actively managed funds have an Annual Management Charge of 1.5% pa. In addition they have other expenses declared of typically another 0.1% to 0.2% pa. Let’s be nice to them and say, on average, the combination known as the Total Expense Ratio (TER) amounts to say 1.6% pa.

Compare this with say Fidelity Money Builder UK Index Tracker with an AMC of 0.1% and a total TER 0.28% pa. Before even considering portfolio turnover costs the average Actively Managed fund has to deliver a further 1.3% or so per annum without taking any more risk than the index as a whole in order to simply match a tracker. Of course, there is no point in paying extra simply to break even with what you would have got if you just tracked the index.

Let’s now look at Portfolio Turnover Rates (PTR). These describe the proportion of the fund that has been turned over due to sales and purchases and is calculated according to a formula prescribed by the FSA. It is now a requirement for these to be published for UK unit trusts and OEICs within the Simplified Prospectus. You still have to hunt around for these figures as they are often quoted separately to other cost data. I am collating details of these prospectuses and will publish links in due course.

In the FSA Occasional Paper on the Cost of Retail Investments and, in particular on page 28, the average cost of a deal in a UK fund has been estimated at 180 basis points (1.8% to you and me). To find the cost of turnover you have to multiply the above cost by the PTR.

If you take the average PTR of an Active UK fund of 70%-90% (page 47 of the FSA paper) you end up with costs in addition to the TER of between 1.26% and 1.62%. If you take the Fidelity Special Situations Fund PTR of 137% you get an overall portfolio turnover cost of 2.46%. Quite a few active funds have PTRs of over 200%.

To get the total annual cost you have to add the PTR cost to the TER. This means that the actual annual cost of the average Active UK Fund amounts to between 2.86% and 3.22%. In the case of the Fidelity Special situations Fund you get total annual fund costs of 3.96% pa.

Contrast this with some trackers. The F&C FT All Share Index Tracker has a PTR of 0% and a TER of 0.39% and the Fidelity Money Builder with a TER of 0.28% and a PTR of -2.3%. These mean that the average active fund has to outperform them without taking any more risk by up to 2.94% per annum.

The sad truth is that most active funds can’t even achieve index levels of returns let alone beat them. So, why would you pay extra for that?

Markets are basically efficient

Markets are efficient

My core belief is that markets are “efficient.” The efficient markets hypothesis holds that markets are full of people trying to make a profit by predicting the future values of securities based on freely available information. Many intelligent participants compete to trade at a profit. The price they strike in trading a share is the consensus of their opinions about the share’s value. Since the price is the same for everyone, so is the value. The price the market strikes is therefore based on all the available information about a share, everything the investors know that has happened in the past and everything they predict will happen in the future. In this sense, markets assemble and evaluate information so effectively that the price of a share is usually our best estimate of its intrinsic value.

Prices are not always perfectly correct, nor is that a condition for market efficiency. The consensus view of investors can temporarily result in prices well above or well below a share’s intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants do not consistently profit over other participants. Since “mispricings” tend to occur in both directions and since managers seem to over- and under perform with random frequency when adjusted for risk and costs, markets seem to be efficient.

Optimum Portfolio Structure

The optimum portfolio structure is based on, and supported by, a substantial body of academic research into the sources of investment risk and return which has reshaped portfolio theory and greatly improved understanding of the factors that drive performance.

Three Equity Factors

Market: Shares have higher expected returns than fixed interest.
Size: Small company shares have higher expected returns than large company shares.
Price: Lower-priced “value” shares have higher expected returns than higher-priced “growth” shares.

The notion that equities behave differently from fixed interest is widely accepted. Within equities, it has been found that differences in share returns are best explained by company size and price characteristics.

Two Fixed Interest Factors

Maturity: Longer-term instruments are riskier than shorter-term instruments.
Default: Instruments of lower credit quality are riskier than instruments of higher credit quality.

In the realm of fixed interest, two factors drive returns. Though these two factors characterise interest-sensitive investments, they do not have substantially stronger long-term expected returns. Therefore, fixed interest is best kept short in maturity and high in credit quality so risk exposure can be increased in the equity markets, where expected returns are higher.

The Benefits of Diversification

One of the best-established methods of risk management in investing is diversification. The concept is simple: holding only one share in your portfolio makes you directly susceptible to its price changes. If its price plummets, so does your entire portfolio. Hold two shares instead and, unless they both plummet, the portfolio is still afloat. The key to diversification is the age old adage, “don’t put all of your eggs in one basket.”

The main point of diversification is to reduce risk rather than improve expected return. For many European investors, the MSCI Europe Index represents the first equity asset class in a diversified portfolio. Although this index is diversified in European companies, investors can benefit by adding further components. Take, for example, a portfolio that holds just European shares, a portfolio that holds international shares (ex Europe), and a portfolio that holds a third in both regions with a third in international bonds (Citigroup World Government Bond Index Hedged). The diversified portfolio has a substantially lower standard deviation – risk to you or I.

MSCI Europe Index: 18.6%
MSCI World Ex Europe Index: 17.7%
Balanced Portfolio: 11.7%

(Balanced Portfolio is one-third MSCI Europe Index Gross Div., one-third MSCI World ex Europe Index Gross Div., and one-third Citigroup World Government Bond Index 1-30+ Years Hedged. Data in USD.) MSCI data courtesy of Morgan Stanley Capital International.

Citigroup data courtesy of Citigroup Global Markets Inc. Performance data represents past performance and does not predict future performance.

This is the power of diversification: the whole is greater than the sum of its parts

The Importance of Asset Allocation

Capital markets are composed of many classes of securities, including stocks and bonds, both domestic and international. A group of securities with shared economic traits is commonly referred to as an asset class. There are several asset classes, all with average price movements that are distinct from one another. Investors can benefit by combining the different asset classes in a structured portfolio.

I believe investors should not only diversify across securities within an asset class, but also across asset classes themselves. This should include the full range of strategies: small and large stocks, domestic and international, value and core (growth), “emerging countries,” global bonds, and even real estate. Because the asset classes play different roles in a portfolio, the whole is often greater than the sum of its parts. Investors have the ability to achieve greater expected returns with lower standard deviations than they would in a less comprehensive approach.

However, because no two investors are alike, there is no single “optimal” asset allocation. Each investor has his or her own risk tolerances, goals, and circumstances that dictate the weightings in each asset class. In general, the greater the proportion of stocks a portfolio holds, especially small cap and value stocks, the more “aggressive” a taker of risk it is and the greater it’s long-term expected return.

Adding Value

Many investment managers either believe they can actively exploit “mispricings,” so they engage in traditional active management; or they believe they can do nothing to add value over benchmarks, so they engage in traditional index management. I believe in a different approach. This combines the broad diversification, low cost, and reliable asset class exposure of passive strategies and adds value through engineering and trading.

Multifactor Investing

Academic research has shown that the three-factor model on average explains about 96% of the variation of returns among fully diversified professional US investment plans. Investing is therefore largely about deciding the extent your portfolio will participate in each of the three risk factors. In general, the greater the risk exposure, the greater the expected return.

Chris Wicks CFP
I help you achieve your lifetime goals for reasons that are important to you
Experienced Personal Finance Comments My Ecademy Blogs
Contact me

Do Winners Repeat?

A common method of choosing active funds is to look at past performance. This can be done with varying degrees of sophistication. The ratings agencies such as Standard & Poors and Morningstar issue star ratings and these essentially combine past investment performance with an assessment of risk in arriving at the number of stars awarded to a fund.

A recent survey has assessed the effectiveness of using past performance in fund selection by investigating to what extent performance is repeated over a series of 5 year periods from January 1982 until December 2006.

I have summarised the results of the survey of top 30 funds for each five year period below:

Initial 5 year period Still in the top 30 five years later Still Top Quartile

Jan 1982-Dec 1986 0/30 4/30
Jan 1987-Dec 1991 5/30 15/30
Jan 1992-Dec 1996 1/30 12/30
Jan 1997-Dec 2001 2/30 6/30

What it tells you is that the chances of selecting an active fund manager who will still be outperforming his peers even five years later are slim to the say the least. This validates the view that active fund managers in general fail to add value. Whilst there are undoubtedly some that have demonstrated out performance the likelihood that you will choose one is remote.

In summary spending time on selecting active fund managers is a fool’s errand as it is unlikely to add value to the performance of a portfolio. If you are a serious investor your efforts are likely to be better rewarded by investing in the market as a whole and aiming for out performance by allocating some of your investments to under valued and smaller companies. Whilst these expose you to greater risk that investing in the whole of the market there is a reasonable probability that this will be rewarded. See my I help you achieve your lifetime goals for reasons that are important to you
Experienced Personal Finance Comments My Ecademy Blogs
Contact me

Asset Allocation: What’s it all about?

The basic premise behind asset allocation is that it is generally accepted as being the most significant factor behind the performance of investment portfolios. At its highest level this is literally the split between growth (equities) and non growth assets (cash and fixed interest). There are other factors including market timing, stock selection, momentum, value tilts, smaller company tilts etc. which have varying degrees of significance. Significance is used in this case to mean statistically meaningful or measurable.

The rationale for investing in anything other than risk free (e.g. cash/Treasury Bills) is to make extra returns. Therefore the more that you add to risky assets the more you should reasonably expect to make above risk free over time. A very basic asset allocation model could therefore be to simply have a split between a UK FT All Share Index Tracker and say Cash/Bonds. The more you add to the Tracker the more risk you take but the greater the returns you expect.

You could also add a Value and/or Smaller Companies tilt if you believe the evidence provided by French and Fama that, in return for additional risk (above just investing in the market as a whole), these two factors have demonstrated a tendency to generate additional returns (in excess of the market as a whole).

A decision that you will need to make is whether to take some fund manager risk. Obviously the reason why you would do this is because you believe that there is empirical evidence to indicate that you should make some extra profits in return for the extra risk and cost to which these expose you. Most readers will already be familiar with my views on this. For now I will simply quote from the FSA Occasional Paper on the Price of Retail Investing page 47 ‘That is, it appears to be the case that, on average, resources devoted to actively managing a fund do not create any off-setting improvement in fund performance’.

We are all familiar with the term diversification but do we really understand what this means? It does not just mean splitting a portfolio between different fund manager’s offerings so as to avoid having too many ‘eggs in one basket’. Rather, it is the method by which you blend asset classes which behave differently to each other in order to reduce the risk profile of the portfolio as a whole. It can be demonstrated that if you take a number of asset classes with given risk levels (typically measured using the standard deviation) that the risk profile of the portfolio composed of them will frequently be less. So it is useful, when constructing a portfolio, to ensure it contains a range of asset classes which behave differently i.e. they are uncorrelated.

Asset classes which tend to be fairly uncorrelated with equities include property and commodity futures. Both of these can be accessed via collective investments such as OEICS and Unit Trusts as well as Exchange Traded Funds.

Interestingly, alternative investments such as hedge funds appear to potentially have the potential to substantially worsen potential portfolio returns and make their risk profile increase rather than reduce overall. This is before you take into account the relative lack of information about what they actually do or the very high charges levied by them.

You will also need to decide on the extent to which you bias the portfolio (if at all) in favour of the UK market. In general if you are dealing with UK based investors you may want to increase the weighting to UK equities beyond their actual weighting as a function of the value of world markets as a whole. If you are dealing with expats, either non Brits or maybe Brits who are likely to retire abroad you have to ask yourself whether a portfolio with an overweight UK allocation would be appropriate.
There is no hard and fast rule about exactly what splits you should adopt. In general it is better to have any asset allocation strategy than none. Once you have adopted your asset allocation strategies you need to periodically rebalance the allocations to ensure that the risk profile of the portfolio is maintained. There is evidence that many private investors loose substantial sums by chopping and changing and following the market when they would have been better off simply adopting a long term buy and hold strategy.

A good source of information on asset allocation as well as many other aspects of investment is and in particular this article.. I would also very much endorse Tim Hale’s book which you can find here. I have also found this presentation given by Tim on Asset Allocation which you may find useful.

One final point on this. You will always find conflicting views on the most effective methods of investment and many of these will be given by extremely credible people. All I can say is that you have to look where the weight of the arguments lie and then take a view.