Clearly, in the context of a basic financial primer, issues have to be reduced in scope and characterised rather than necessarily explained in details. However, in this final commentary, some attempt will be made to, at least, outline some of the wider issues that made have been omitted in the previous discussions. By and large, this primer has been orientated around an average income, partly because it reflects the situation in which many people find themselves and leaves little room for any financial mistakes. Equally, when finances are tight, the scope for exotic investment strategies and complex tax avoidance scheme are not a priority and any financial planning basically comes down to just two key investments:
However, in order to provide some initial examples, the income models that covered both of these topics were simplified in many aspects of the calculations, such that some corrections and clarifications need to be made.
As discussed, the topic of pensions covers both the pre-retirement and post-retirement phases of saving for a pension in work and then receiving a pension annuity in retirement. However, these phases now involve two completely separated investment choices, although many may simply used the same financial service provider for both without necessarily looking for the best deal. Give the direction of the ‘pension industry and regulation’, most people will have to decide on the level of contributions they can afford to make to their own ‘defined contribution (DC)’ pension pot. The examples cited have all assumed the NEST DC pension scheme based on a composite contribution of 8% against today’s UK average salary of £26,500, which it was stated would accumulate £84,400 over 40 years. However, in practice, any salary will probably be subject to some inflationary increased, e.g. 2%, even if we ignore any possible promotional increases during your lifetime. Equally, we might reasonably assume that this accumulating pension pot is subject to some saver’s interest rate, e.g. 3%, which if taken into account would return an inflated and interest adjusted pension pot of £223,448. However, if inflation runs at 2%, the pound (£1) in your money would have had to increase to £2.17 to maintain the same purchasing power, therefore, the normalised value of this pension pot will only be worth £102,031 in today’s money, as shown in the graph below.
To characterise how the pension pot is used to provide an annuity pension income, the original model simply divided the pot by the number of years of average retirement, e.g. 20 years, which basically aligns to a 5% pension annuity per annum. In practice, the actual figure used to calculate the annuity is subject to many actuarial conditions that may affect life expectancy. For example, a single person with no obvious health problems requiring no inflation indexing of their pension annuity may get close to 5%, while a joint pension that links the life expectancy to both partners, which is also index linked to inflation, may be reduced this figure to 3.43%.Therefore, while the model of a NEST pension yielding £84,800 after 40 years was on the low side to the normalised figure of £102,031 shown above, a 5% annuity yielding a pension of £4,240 is quite a bit higher than the £3,500 figure based on 3.43%. As such, the NEST DC pension scheme would only provide 13.3% of final salary, while the 1/60th per years systems associated with mainly historic ‘defined benefit (DB)’ pension scheme would have return 66% after 40 years service.
Note: As has been pointed out, comparison between DC and DB pension scheme are a stark example of the ‘brave new world’ of finances. When first introduced, DC pensions were advertised as a way of offering more flexibility in an evolving jobs markets, where few people worked for a single company for 40 years. However, in practice, it has allowed employers to transfer all the financial risk and responsibility of saving for a pension to its employees. Within this process, an employee on a final salary of £26,500 with a ‘defined benefit’ pension would have seen their annuity pension fall from £17,400 to just £3,500 within the 8% NEST ‘defined contribution’ scheme discussed.
While some may rightly point out that there were many other causes contributing to the demise of ‘defined benefits’ pensions, it might still be argued that there were powerful beneficiaries of the many pension reforms that have taken place over the last 30-40 years, both in the financial sector and in state government.
While these new options may be beneficial to some, it is unclear that it will really be that helpful in any of the models described for providing a better and sustainable pension income. For within added complexity introduced, there is the possible temptation of accessing the entirety of your pension as a ‘lump sum’ without fully understanding the additional tax implications. As suggested on several occasions, the financial service industry (FSI), and governments, appears to love complexity within which the average consumer may fail to understand all the long-term financial implications, normally buried within the small-print of some lengthy and legally binding agreement. Therefore, this option has been ignored at this time.
Note: Despite the importance of provisioning for some sort of pension income over and above the state pension, many younger people are now facing a stark choice, i.e. either a pension for some far off and unknown future versus the immediate ability to secure a home to live in via mortgage. There is an adage that can be used to described this stark choice: ‘the urgent often drives out the important’ that leads many to prioritise investing in a mortgage and deferring saving for an adequate pension until it is too late.
From a historical perspective, endowment mortgages were once popular, which required the borrower to negotiate two separate agreements. i.e. one with the lender of the mortgage and one with the insurer of the endowment policy. As such, the borrower paid interest on the loan to the mortgage lender and an insurance premium that was assumed to pay off the principal balance on early death or maturity of the policy after some fixed period, e.g. 25 years. However, what was not realised by many, as the details were again buried in the small-print, was the endowment policy did not necessarily guarantee to paid off all the principle balance, when the termination value was linked to market performance. If the market under-performed, the shortfall left many with an endowment mortgage with a large principal balance that still had to be paid, such that they enter their retirement years still in debt. Again, the providers of these financial scheme were invariably isolated from any risk as this debt was still secure against the equity within the property. Again, the watch-word of warning to all buyers is ‘caveat emptor’.
So if endowment mortgage are no longer available, what replaced them?
Based on the eventual recognition of the mis-selling of many endowment mortgages, the financial service industry (FSI) essentially reverted to the more traditional idea of a single loan agreement with the mortgage provider in which the balance and interest is paid off together as shown in the more detailed spreadsheet examples.
Note: The cost of life insurance has now to be negotiated separately and the payout decoupled from the the principal amount of the mortgage. As such, the scope of FSI products and potential profits essentially remains unchanged and, in many cases, increased with no further risk to themselves, while apparently allaying earlier concerns.
This said, the FSI was not slow to devise many variations on this model, i.e. fixed rate, tracker and discount mortgages etc, along with extended repayment periods of up to 40 years in some cases. As a broad generalisation, most of these options are usually intended to make the initial cost of a mortgage appear more affordable and/or fixed in price. However, as also indicated earlier, the primary goal of the FSI is to maximise its own profits with as little risk as possible. In this respect, tracker mortgage follow the interest rate set by the central bank base rate and so can be subject to frequent change, invariably upwards in volatile market conditions, while fixed rate mortgages are usually restricted to shorter time periods, e.g. 2-5 years, after which any new ‘remortgaging’ will be reset to the interest rate of the market. However, you can be assured that all mortgages that appear cheaper in the initial stages will charge more in interest over the full term of the mortgage, as there are no ‘free lunches’ in this marketplace. However, competition can make it worth shopping around, if you know what you are looking for when remortgaging.
But can fixed-rate short term mortgages be beneficial?
Invariably mortgage lenders are better position to assess future trends in interest rates than the average person, but even also they will normally charge you more for a fixed-rate mortgage than in a variable rate tracker mortgage. However, for many people, especially first buyers, the reassurance of a known cost for an initial 5 year mortgage, as in the model example, may provide the necessary time for them to come to terms with ALL the costs of house ownership and the necessity to keep within budget.
In essence, the process is described as ‘remortgaging’, which takes effects when the terms of the initial fixed or tracker or discounted mortgage ends. By default, your current mortgage company will, at this point, calculate the interest of your remaining principal based on a long term variable rate, which is often the lender's standard variable rate (SVR), which has been historically higher than the rates available on new mortgage deals. Of course, this is the very reason why many people are drawn to these ‘innovative’ mortgages and why many seek to renegotiate a better mortgage rate with another mortgage provider. However, you need to understand what is involved in switching to another mortgage lender as ‘remortgaging’ can involve further legal and valuation costs as your new lender may require a valuation survey and solicitor to handle the paperwork. This said, some mortgage products include a free valuation and legal work for those remortgaging, so it can still work out cheaper, in the long-run, to consider the remortgaging model, if beneficial interest rate can be negotiated. In the model example of our first-buyers, they are initially able to take out a lower fixed rate mortgage over 5 years with a reduced rate of 3%. Based on spreadsheet analysis, the following graph shows the reduction in the principal amount and the interest paid within the initial fixed rate 5 year mortgage.
So, based on the lower 3% rate often offered as an introductory rate to first-time buyer, our couple still owe ~£137,000 after 5 years, although this still means that they have effectively increase their net wealth or equity by £13,000 over this period. In addition, the example assumes that the apartment originally purchased for £170,000 has increased to £195,000 in the 5 year period. Therefore, in order to buy a new property for £220,000 they will need to calculate the amount of the new mortgage required:
|House Price||Required Mortgage|
So based on the table above, our example couple will need to remortgage for a revised amount of £162,000 and while possibly being young enough to have another 35 year mortgage,, However, we will assume that this second mortgage will incur an increased interest rate of 5%, while the attached spreadsheet may be examined for the details underpinning the next graph:
So there are various possibility for first-time buyers to get on the property ladder and we might add to the optimism by revising the income of the second partner back up towards the UK average wage of £26,500 to better reflect full-time employment plus the renewal of their pension plan.
|Additional tax relief||£0||£500||£500||0.9%|
|Minimal NEST Pension||£1,060||£1,060||£2,120||4.0%|
While this model might suggest this couple may even be able to afford a second child, there are many caveats associated with the assumptions underpinning this model, which might suggest it is overly optimistic for many. For, in reality, many young have now almost abandoned any hope of getting on the property and with the loss of growing equity associated with home ownership, they will have to face retirement still paying for rented accommodation, which will probably increase with inflation throughout their retirement. Clearly without some increased investment in their pension plan or some other financial windfall, e.g. an inheritance, which may change their financial predicament, they may well have to depend on state welfare to survive in old age.
In many ways, the current generation of first-time house buyers are the innocent victims of ‘machinations’ that have taken place in the global economy, as a whole, over the last several hundred years of so. If you wish to understand the justification for this statement, it is suggested that you read the following discussion entitled ‘The Evolution of Economics’ and the specific issues raised in ‘The Economic Model’ and ‘The History of Usury’ .
But how have this generation become ‘victims’?
While those whose working life spanned the horror and/or fall-out of the Second World War faced hardships, many still became beneficiaries of a growing economy, which led to house prices increase above monetary inflation. The first of the following charts reflects this trend over the last 50-60 years:
Having reduced house prices and inflation to a comparative index, we more clearly see how house prices have out performed monetary inflation in the UK economy. This performance is now show as a % gain in house prices over the retail price index (RPI) in the chart below:
What we might realise from these charts is that older generations, who may have been on the property ladder from the start of the time period shown, will have made the biggest gain in equity. However, as has been pointed, releasing this equity is not necessarily straightforward, as any alternative property will probably have escalated in price by a similar amount above inflation. Of course, many elder people have ‘migrated’ from high price regions around London, for example, to the rural villages where house prices can be considerably cheaper. However, the chart also represents a growing problem for anybody seeking to take their first step onto the property ladder as house prices outstripped wages, which may have only kept pace with monetary (RPI) inflation.
So why did house prices rise faster than wages?
While in the UK, there is an element of demand outstripping supply, which has caused house prices to rise, it is also true that house prices have been pushed up by the hundreds of billions of pounds of new money, created by private banks, in the years before the 2008 financial crisis – see ‘Private Bank Money’ for details. However, this seeming magically money-maker machine has not led to any increase in wealth being evenly distributed, as suggested by the following chart.
Of course, out of interest you might want to ask who have been the main beneficiaries of this money-making machine and not unsurprisingly it would seem that those working in the upper tiers of the financial service industry have remain well protected from the general stagnation affecting the average wage in the UK, as this extract from ‘The Economic Journal’ suggests:
“We analyse the role of financial sector workers in the huge rise of the share of earnings going to those at the very top of the pay distribution in the UK. Rising bankers’ bonuses accounted for two-thirds of the increase in the share of the top 1% after 1999. Surprisingly, bankers’ share of earnings showed no decline between the peak of the financial boom in 2007 and 2011, three years after the global crisis began.”
However, returning to the question as to why this generation has become the real ‘victim’ of global economics, we might begin to see that not only did the current younger generation lose out in the above inflation growth of the property market, but many have fallen into debt in their attempts to get onto the apparently ever upwards spiral of property prices. However, this increase in household debt, as suggested in the chart below, has not only been fuelled by the need for with ever-larger mortgages, but also by the financial service industry facilitating easier access to credit in many ‘innovative’ new products, many of which can charge extortionate interest rates.
Of course, this trend towards increase debt has not only affected people struggling with their personal finances, but has led to deficit and debt problems for governments around the world. As a consequence of the recognition of excessive government debt, state welfare programs are now being subject to severe cutbacks, which can also adversely affected the younger generation through the introduction of tuition fee loan, which may take years to paid back, assuming they can even get a job that pays an average wage. However, such issues are not really the subject of an personal finances primer, but rather a topic for the next section of discussions addressing the ‘evolution of economics’ .