Before you can make any real progress financially you need to optimise your financial service providers. Many people are quite understandably bewildered by the complexity of the financial services industry. Much of the industry likes to keep it that way so they can charge you high fees for bad products.
If you are going to flourish financially you need to have a much better than average grasp of the type of accounts available to you and the best ones amongst them. To optimise your finances, you will need to make the best arrangements with your current account, pension and, most importantly, ensure you have an excellent ISA account.
1. Your current account
You would arguably have to be living in a cave not to know what a current account is. We all have them. It is, however, fair to say that most UK current accounts offer an astonishingly poor service. First, they offer appalling interest rates: I confess I actually laughed out loud recently when I was waiting in line at a major high street bank and there was an enormous poster proudly advertising an account that paid 1.8% gross interest.
This was for an account that had a monthly charge “from £7.95”. Assume, for simplicity, you are a basic rate taxpayer and that you were “lucky” enough to be paying “only” £7.95 a month for this account. Your net interest rate with this bank would be 1.44%.
On this basis you would have to keep more than £6,625 in that account just for the interest you earned to pay off the monthly charges.
I’m amazed a bank would even advertise such a completely terrible product but there it was on a big poster in their branch. Why do we let them get away with it?
You will probably be aware that the big UK banks have also been caught red-handed time and time again mis-selling bad products. At the time of writing one of the major UK banks has just been fined several million pounds for mis-selling a product to pensioners. There has also been the payment protection scandal and a long-standing consumer campaign against unfair overdraft charges.
Importantly, their other financial products tend to be nowhere near as good as those offered by other less well know players in the market. As we will see below, their ISA accounts for example, tend to offer a tiny fraction of the flexibility and choice of other far better players, often at higher fees. The only reason they can get away with this is because they have such a captive client base. Many people have no idea that they can (and should) go elsewhere. We will discuss this more in the section on ISAs below. So their products are pretty awful, how about their service? I have no comment but I’m sure you have your own views.
Despite all the above, I do not advocate changing your current account. In my experience it is virtually impossible to get away from these issues, no matter which bank you use in the UK. What is key, however, is that you optimise how you use your current account. I would hope that you will never accept a return of 1.8% gross on your money. My advice with your main bank is simply to keep as little money with them as possible.
Work out what you need to live on each month, add a margin of error and then ensure that any surplus is automatically paid away every month from your high-street bank to accounts that will enable you to make real money. For most people in the UK, the most important of these will be your ISA account but we should also consider your pension situation, so let us look at that first.
2. Your pension
I would be surprised if anyone reading this has not heard the word “pension”. Nevertheless, I hope you will forgive me if I suggest that the vast majority of people have, at best, only a basic understanding of what a pension is, what they can do with it and what issues they need to be aware of in the years ahead. This fact is another invitation for much of the financial services industry to sell you bad products with high costs.
There are two main types of pension:
- One provided by the government or state.
- Private or occupational pensions built up by an individual, sometimes with the help of their employer.
Government / State Pensions
I have been know to make the point that state pension systems all over the world are completely bankrupt. To many people this seems like a controversial statement. I think it is worth demonstrating quickly why it is not. The state pension is unquestionably doomed due to a combination of enormous demographic change and a complete failure by a generation of politicians to address the implications of that change.
In the UK, the government started to provide a small pension to people over the age of 70 in the year 1909. If you think about it, this wasn’t actually that much of a financial commitment. Life expectancy in 1909 was far shorter than it is today. Relatively few people survived into their 70s. The ratio of workers to old age pensioners was very high: That is to say that a high percentage of the population were working and paying tax and a very small percentage indeed were retired and drawing a pension.
In the one hundred plus years since then, this reality has completely changed. There is perhaps nowhere more illustrative of this change than Japan. When the Japanese launched their generous welfare state after the Second World War there were around forty five workers for every pensioner. By 2020 this number is forecast to be 2:1. Arguably, it is this fact more than anything which accounts for the fact that Japan’s stock market today is still trading miles below it’s 1989 peak and its economy has struggled for decades. It is a huge and inescapable black cloud on the Japanese economy’s horizon.
Sadly, this same phenomenon is happening all over the developed world. Modern countries are burdened with social security systems that were put in place when the entire structure of those societies was completely different to what they are today.
Faced with this demographic reality, what governments all over the western world needed to do in the last few decades was ensure that, more than ever before, we all saved and invested for a rainy day. Sadly, most of them did the exact reverse. Rather than running budget surpluses and saving and investing to provide sorely-needed capital for our future, governments all over the developing world have consistently spent far more than they have earned in tax receipts and made up the difference by borrowing on global bond markets and “inventing” money. They have also done a terrible job at ensuring that people make the effort to sort their own financial affairs out, primarily because finance is such an unpopular subject: You don’t win elections telling people they need to spend less and save more. Here is a graph showing the sheer scale of what the US have done in terms of borrowing:
This graph is pretty extraordinary, especially when you look at the incredible acceleration in borrowing of the last few years, but even it fails to tell the full story. If you add up the unfunded liabilities of the US government, that is to say, the money they are committed to spend on pensions, health care etc. in the future, the number is well over $200 trillion.
This is why Niall Ferguson, Professor of Economic history at Harvard University, describes government accounts as “essentially fraudulent”.
To put this in perspective: The US economy generates about $15 trillion of economic output each year. If we use the $200 trillion number, this implies the US owes 13.3x what it makes.
This is like someone earning £30,000 a year having £400,000 of credit card debt.
The interest alone costs you most, potentially all, of your annual income (depending on the interest rate). Many analysts think the situation is even worse and the $200 trillion figure could prove conservative in the long run. Even on the official numbers, below is an excellent illustration of just what a mess American finance is in and, most importantly, how the politicians are totally failing to deal with it:
An illustration of just how little politicians are doing:
U.S. Tax revenue: $2,170,000,000,000
Federal budget: $3,820,000,000,000
New debt: $1,650,000,000,000
Official national debt: $14,271,000,000,000
Recent budget cuts:$38,500,000,000
Thirty-eight and a half billion dollars of budget cuts might seem like a good effort from Washington until you take away eight zeros and pretend this was a normal household budget.
This makes things much clearer. The numbers above are basically the same as:
Annual family income: $21,700
Money the family spent: $38,200
New debt on credit card: $16,500
Outstanding balance on credit card: $142,710
Total budget cuts: $385
The point I’m making is that year after year these problems get worse and there is no political will whatsoever to take steps to solve them. The situation in the UK is no different. I find the debate about “austerity” quite maddening given that the current coalition government are actually spending significantly more than the government were ten years ago as a percentage of GDP. On both sides of the Atlantic, the only way out of this situation, for politicians at least, is by printing (inventing) vast sums of money.
The problem with this, as we have seen, is that inventing money devalues it through inflation. We have actually seen this happen time and time again throughout history.
Conclusion: You will not get a pension you can live on from the government
As a result, western governments have basically two choices when it comes to pensions:
- Own up to the fact that they can’t afford to pay people a pension any more, or
- Print vast amounts of “science fiction” money with which to pay people a “pension” thus creating rampant inflation.
The result for you will be the same: Either you don’t get a pension, or you get a pension paid in money that can’t buy much of anything any more.
So far, governments on both sides of the Atlantic have taken the money-printing option and it is extremely likely this will continue for the simple reason that because so few people understand what is going on they can get away with it.
For obvious reasons a politician who stands up and says: “Sorry, you can’t have a pension, we just can’t afford it any more” has a much shorter life span than one who says: “We are taking positive steps to solve the financial crisis with a £100 billion package of quantitative easing”.
Both statements have essentially the same result but only a relatively small minority of people understands this. Today, no matter what your political inclinations, no matter how you view the role of government, the simple fact is that we can’t afford to pay for society’s pension and health care requirements in the way we have in the last few decades. There are just too many retired and retiring people compared to productive workers. If you are younger than about fifty-five and want to have enough wealth to live on in the future you will have to make your own provision for that future. Let us, therefore, turn our attention to private pensions.
Private / Company Pensions
Even in the days before the state pension was at risk of disappearing it had the problem that it wasn’t very much money anyway. Many people aspired to retire on a much higher income than what they would get from the state.
Understandably, it was realised that it would be a good idea for the state to encourage anyone who wanted to save and invest to provide for his or her own future. As a result, for several decades now governments have permitted individuals to have their own private pension arrangements, often organised through their employer.
The main differences between saving your money in a pension fund compared to elsewhere is the tax treatment and access to your money. Money saved in a pension account is not taxed when it goes in. This is obviously good news. The quid pro quo, however, is that you are not able to touch that money for many years. This is less good news as we shall see.
Many of you will have a company pension scheme where a percentage of your salary and, if you are lucky and have a generous employer, possibly some additional “matched” money from your employer is automatically paid into “something” every month, usually a “fund” of some description. Some of you, particularly if you are self-employed, may have a private pension scheme. For those of you who do have a pension, do you know what it is invested in? British shares? American bonds? Cocoa futures?
If you are anything like most people, you will either have no idea at all where this money is being invested or only a relatively vague idea. You will also almost certainly have no idea what fees you are paying for these funds. These are often significantly higher than they need to be. Remember how quickly your money is eroded by high fees. Don’t worry, only one person out of several hundred I have asked in the last few years has ever had detailed knowledge of their pension arrangements. Amusingly, this has includes nearly everyone I know who has a high-powered job in finance and me for the first several years of my career.
Your pension is the first thing you need to sort out and it won’t take long. You simply need to ensure that you are doing the best you can with your pension money. If you don’t know what your pension is invested in or what costs you are paying, it is unlikely that any pension you are building up is working anywhere near as hard for you as it could be doing. Over time, this could have a seven figure impact on your life.
There are broadly two categories of pension I want to focus on here:
- Occupational pensions, provided by your employer and
- Self-Invested Personal Pensions (SIPPs)
SIPPs have existed since 2006 and “do what they say on the tin”. A SIPP is simply a pension account that gives you the tax benefits of a pension and allows you to invest in a very wide variety of assets and make your own decisions about what to invest in.
Although it is by no means always true, very few occupational schemes are as a good a vehicle for pension investment as a SIPP. This is simply because SIPPs are so flexible and likely to be far more so than the pension scheme your company has. Companies tend to outsource their pension schemes to one pension provider. The result is that employees in a company scheme will tend to have quite a narrow range of options to invest their pension in. They also often have rather high fees compared to what you will be able to pay within your SIPP account and we have seen already what a large negative affect high fees will have on your money over time. This is a very similar point to the one we made earlier in the book about the limited range and excessive fees of most investment products you might be offered by your high street bank.
Those of you who have an occupational pension with your employer are unlikely to have much freedom to invest your money how you like. Your company will most likely offer a limited product with fairly tight parameters on the type of funds you can choose. If this is the case, don’t worry too much. There will still be a way to optimise what you do have in that scheme. We get to this elsewhere on the site when we look more specifically at how to invest and what to invest in. Your approach will be broadly the same for your pension and ISA money.
If you do not already have an occupational pension, I am going to make a controversial suggestion:
If you have less than £1,270 (in 2015) a month to save I do not think you should organise a pension at all.
If you are self-employed or working for a company that does not have a pension scheme then I am very strongly of the opinion that your first priority, with any money you can save, is to put as much as you can into an ISA account each month.
The reason for this is quite simple: Although you get a tax break on any money that you put into a pension, you are essentially not able to access it until your retirement, which could be many years from now. Given the uncertainty we are currently dealing with, I would much rather have immediate access to my money.
If you are in your twenties, thirties or even forties, I think it is a substantial gamble to assume that the UK pension system will exist in anything like its present form by the time you retire. Remember that the government is essentially bankrupt. To me, there is too much uncertainty about what may or may not happen to any money you commit to a pension account.
There are many examples throughout history of governments passing laws that permit them to take control of pension assets. If you think this is something that hasn’t happened for decades, think again. The most recent example was in Argentina in late 2008 when the government passed a law to nationalize $30 billion of private pension money. Thousands of middle class Argentinians who were saving diligently lost control of their own money.
Closer to home, few people remember that Gordon Brown changed the tax treatment of dividends in pension accounts in 1997.
This resulted in £5 billion a year less money for holders of pension accounts. To me this is an excellent example of how careful we must be to assume that highly regulated savings vehicles such as pensions will remain the way they are.
Using Argentina as an example of what might happen in the UK might seem like a crazy comparison but it really isn’t. By some measures, Argentina in 2008 was actually in a better position financially than the UK is in today.
It is hard for us to predict the future, which is why, unless you already have an occupational pension arrangement I would far rather you keep your savings as accessible and mobile as possible despite the tax advantages a pension has.
To conclude on pensions
To summarise then, you will fall into one of the following categories with your pension:
You have a pension with your employer and can only invest in products offered by your employer’s pension scheme.
Action to take: Ensure you own the best funds available to you under your employer’s existing scheme. We look at how to do this elsewhere on the site. If you are paying a reasonable chunk of your salary into the pension scheme and have the option to take that money as cash, you may want to consider changing this and paying that money into an ISA account for the reasons mentioned above. Whether you decide to do this or not will depend on what you think of the pension arrangements your company has after you have read what follows, what your past performance has been and what the costs of the pension product are as compared to your ISA account.
You are now self-employed or working for a company which does not provide you with a pension but you have a pension pot built up from previous employment.
Action to take: Do not make any further contributions to a pension unless you can afford to save more than your ISA allowance of £1,270 a month. With your existing pension pot, ensure you own the best funds available to you within your scheme. Again, you will get a better idea of how to do this once you’ve been through more of the courses on the site.
You may also consider opening a SIPP account and transferring across what you have saved so far. This will give you enormous freedom with what you can invest those funds in and very likely cut down the fees you are paying, thus improving your performance.
You do not currently have any pension arrangements.
Action to take: If you don’t have a pension at the moment and have less than £1,270 a month to save and invest, which describes the vast majority of people, do not open a pension account. Focus instead on your ISA arrangements.