This is the story of how I found myself over the pension Lifetime Allowance (LTA) and what I’m doing about it. It does not constitute investment advice. I use ‘pension’ and ‘SIPP’ interchangeably to mean a Defined Contribution pension. (Sadly, I’ve no experience of Defined Benefit schemes.)

I started with the best of intentions. Sometime back in the 1990s I began putting all my earnings above the higher-rate tax threshold into my pension.

I was fairly sure the higher-rate years wouldn’t last long – my nagging imposter syndrome was itself no phony!

After a while I’d still not been found out. And so with other calls on my money – ISAs, property investment, family – I moderated my contributions.

All told, there was only a few hundred thousand pounds in my SIPP when the £1.8m Lifetime Allowance for pensions was introduced in 2006. So it didn’t seem particularly consequential at the time. There was certainly no urgency to worry about going over the pension lifetime allowance.

The LTA felt even less consequential in the immediate market wreckage of the Global Finance Crisis. Everything was down, including my portfolio.

Pumping up my pension

Fast-forward a few years. Asset prices recovered, and I continued to squirrel away my contributions. The chances of my hitting the LTA increased.

As the tax system got more draconian, I therefore got more tactical. I only contributed to my pension when I was getting an effective 50-60% rate of relief. When paying the ‘additional’ rate, for example, or because of the annual allowance taper or the child benefit claw-back.

It was starting to look like I might be a higher-rate tax payer in my retirement.

Nevertheless, I kept contributing – because who ever knows what’s going to happen?

Psychologically I’d prefer to see money go into my pension – even if it faced an uncertain future – than to see it wiped out today in tax.

Once it’s gone it’s gone, after all.

Allowance down. Portfolio up

I didn’t apply for LTA protection for a couple of reasons. But the main one was that once you take this action, you have to stop contributing.

I had ended up in a job with the sort of arrangement where my employer put in 4% if I put in just 3%. So even if more additions did take me over the LTA, contributing still seemed just about worth it.

By this time they’d cut the allowance to £1.5m. Meanwhile my SIPP was worth about £800,000.

Still plenty of room, you’d think?

Tax tail wags investment dog

What investments did I hold in my SIPP?

Well, US equities.

And why US equities?

Because under the reciprocal tax-treaty, UK pension funds, including SIPPs are treated as tax-free entities by the US tax authorities (the IRS).

Even more amazing, some brokers and custodians are actually sufficiently well organised that they apply the correct rules so that you don’t pay dividend withholding tax on US equities in a SIPP. 

There was a time when this really mattered; when you got a 4% yield on US stocks, that’s a 60bps per annum uplift (15%x4%).

I appreciate that doesn’t sound like much. But it’s £6,000 a year on £1m. Every little counts.

The US equities market is roughly half the world market cap. So I’d keep that half in the SIPP and the other half in ISAs and suchlike.

Even better – you can hold foreign currencies in a SIPP. This means that when your US stock pays dividends, you can re-invest 100% of those dollars back into more US stocks, paying more dividends. All without your broker gouging your eyes out with a currency exchange spread that you could drive a bus through. 

Lovely, you would think.

Or perhaps more an example of being too clever by half?

2016: Under a cloud and over the pension lifetime allowance

All at once, a bad thing and then a very bad thing happened in quick succession.

In April 2016 the LTA was reduced to £1m. That was annoying.

But not half as annoying as what came in June, which, for me personally, was pretty devastating: Brexit.

Sterling, predictably, depreciated sharply. The pound value of my completely US Dollar-denominated SIPP soared up and over the pension lifetime allowance, without even touching the sides.

Not that this was any silver lining to the Referendum result for me. I’d rather live in a rich multi-cultural society and be well-off in hard currency terms, than live in a poor insular one and be nominally rich in a devalued currency.

But apparently not everyone felt the same way.

No point crying over spilt milk

Apart from a brief market swoon in March 2020 – when it looked like my LTA problem might be solved for me – I’ve been well over the pension lifetime allowance ever since.

In retrospect I should have done things differently. Perhaps there are some lessons for the reader in here: 

• I shouldn’t have contributed so much when I was younger. But in my defense, there was no LTA then. So it is, in effect, a bit like retrospective taxation – especially with respect to the 25% tax-free amount. Lesson: don’t trust the government. 

• My wife has fewer pension assets than me. I should have had my employer contribute to my wife’s pension, out of my salary sacrifice. This would have got money into her pension, with tax relief at my marginal rate. I only found out this option when I read about them closing the loophole! Lesson: pay more attention.

• I shouldn’t have concentrated my non-Sterling exposure in my SIPP. But in my defense, what other country in history has voted to devalue its own economy? Lesson: populism doesn’t work for complicated issues.

• I should have changed my asset allocation, maybe in the depths of the March 2020 crash. But in my defense, I didn’t know US equities would go on to nearly double while the world economy largely stayed on its knees. Also rebalancing is difficult. Some of the US-listed ETFs in this portfolio are irreplaceable, because of – cough – an EU rule called PRIIPS. (The irony isn’t lost on me) Lesson: pay more attention, again. 

• I should have given more serious thought to this issue before The Investor asked me to write an article about it a couple of weeks ago. Lesson: pay more attention, again, again. 

I guess the meta-lesson for readers is to start thinking about this issue early.

Where we are today

The value of my SIPP is now far over the pension Lifetime Allowance.

• At the margin it’s a reasonable assumption that gains in my SIPP will eventually incur a 55% LTA charge.

• Outside the SIPP, assets that don’t produce an income will attract a 20% capital gains tax (CGT) rate. 

Let’s first run through the conventional wisdom of what one should do in these circumstances.

Stop contributing 

There’s no point now I’ve hit the LTA – a bit of convoluted maths indicates the 55% penalty rate I’ll pay on taking my money out will at the least undo the 40% tax relief I got putting money in.

But… I’m in an employer’s matching scheme that means it costs me 20p for every £1 in my scheme (up to a fairly low limit).

I’ll get 45p of that, after the LTA charge. 

[Editor’s note: Individual tax situations vary hugely, and the maths may be different for you. Read the comment thread after this article for a good discussion of this!]

Decrease risk in the SIPP

Wise heads say I should concentrate my growth investments outside the SIPP, and just use the SIPP for the bond allocation.

We all hold a 60/40 equity/bond portfolio, right? So I should have the bond bit in the SIPP, high-yielding equities in my ISAs (or my Family Investment Co), and no-yield equities outside of the tax wrappers.

With bond yields where they are, returns from that asset class aren’t going to shoot the lights out after all.

With any luck the LTA will rise with inflation again. Eventually it could catch up with the value of my SIPP, which will have had very little growth in the meantime from those bonds. Heck, I could just leave it in cash. 

This is all fine in theory. But I have a few issues.

Firstly, it assumes that there’s a couple of million pounds outside the SIPP for the equities allocation.

Then there’s psychology. I’ve noticed that it’s easier for me to stomach high volatility in the tax wrappers than outside. There’s some mental accounting, whereby losses in the tax wrappers are somehow less real (and therefore less painful) than losses outside them.

Why? I guess because the funds in tax wrappers won’t be touched for a very long time, if ever. In contrast funds outside are money I could use to pay for groceries or school fees.

Tellingly, my SIPP was my best performing investment account by a country mile for a very long time – and also the least accessible. (Though perhaps this was down to me being (un)lucky. It was only the withholding tax issues drove the asset location decision.)

Finally, rebalancing out bonds into equities from this pot is a problem, should it be required, because we effectively can’t move money out of the SIPP any time soon. 

Increase risk in the SIPP

On the other hand, all losses in the SIPP now effectively get a 55% tax rebate.

Short-dated out-of-the-money call options on a meme stock like AMC? Why not? YOLO! HMRC is going to pick up more than half the tab if it goes bad!

This feels wrong. But I’m still giving it some thought. 

Get a divorce

This would be quite a bit of paperwork, but under certain circumstances pension assets are split on divorce. And my my wife’s pension assets are only about 15% of the way to the LTA…

There’s a point at which divorcing Mrs Finumus and then immediately re-marrying her might save us hundreds of thousands of pounds.

(I’ve not run this one by her yet).

Take the tax-free lump sum as soon as possible 

Taking the tax-free lump sum at least reduces the extent to which the problem is compounding. The trouble is that that’s deemed an LTA benefit crystallisation event. 

Do nothing

Currently, the first mandatory LTA test is at age 75. Fortunately that’s nearly 25 years away for me. It’s possible the rules will change during that time – probably for the worse, but possibly for the better.

The SIPP still has many advantages, including the multi-currency capabilities, the freedom from US withholding tax, and minimal paperwork compared to doing CGT submissions on a trading account.

My SIPP also falls outside my estate for IHT purposes (albeit after paying the LTA charge). 

What have I actually done to my SIPP?

I’m still contributing to my pension to get the matching contributions.

I’m slowly reducing the risk level in my SIPP and increasing risk outside. In fact I’m going to explicitly let my leverage run a little hotter than previously, and offset this with short-term treasuries (essentially cash) in the SIPP. 

And I’m practicing gratitude. I’m acutely aware of how fortunate I am to be in this position. 

Other implications of going over the pension lifetime allowance

I’ve also made some wider changes in light of all this.

Decreased risk in my children’s SIPPs

My children are in their late teens. They’ve had SIPPs since they were born, and various people have made contributions on their behalf, contributing a maximum £3,600 p.a., gross and including basic rate tax relief. (How do they get tax relief when they pay no tax? Don’t ask me.)

These SIPPs are now worth over £100,000 each.

Whilst this still seems like a long way from the LTA, they might be lucky enough to be paying very high marginal tax rates sometime in the future. Compounded growth of all these early contributions might rob them of the opportunity to avoid those high tax rates by contributing themselves – because it will bring them closer to the LTA.

But who knows? They’ll be much regulatory uncertainty over their lifetimes. 

Increased risk in the (grand)parents’ SIPPs

Note: What follows is based on my current, slightly hazy, understanding of the rules.

Now this might seem even more orthogonal to the original problem. But since we’re in the neighborhood anyway, let’s drive by.

Between my wife and I we have three surviving parents. All are comfortably off, all over 75, and all, sadly, mortal.

Each of the three have substantial sums in their SIPPs – which are in ‘flexible drawdown’ – but the sums are far below the LTA threshold.

In addition, in all but the most extreme of circumstances they likely have sufficient assets outside their SIPPs to last them out.

Historically we’ve taken a fairly standard approach to their investments – reducing risk steadily as they have aged and stopped working.

However, my review of the LTA situation suggests a slight change of direction.  

The rules are complicated, but SIPPs can be inherited, fall outside the estate for IHT purposes, and the beneficiaries (in this case because the benefactors will be over 75 on their death) can draw down at their marginal tax rate (it’s treated as regular income for the beneficiaries).

The last time the LTA  ‘benefit crystallisation’ test is applied is on death. The beneficiaries can pass on the SIPP, generation after generation, and weirdly, as soon as one of them dies under age 75, the whole lot can be taken out tax-free by their beneficiaries.

In case you missed it… the last time the LTA test is applied is on the death of the original beneficiaries. 

What does all that mean? Clearly, as a family, we want the high return stuff in the oldies’ SIPPs. In an ideal world they’d be worth exactly the LTA on the day of their demise.

And then? This seems like a gaping loophole… but as I read it the pot can grow tax-free – forever. Theoretically, under the current legislation, you could leave it compounding, untouched, and completely tax-free, for centuries. 

Of course they’ll change the rules long before that. 

Any other ideas?

This has been a classic example of a ‘you only understand it if you can explain it to others’ situation.

Just writing this all down has forced me to properly confront a looming issue that I’d just been sort of ignoring for a while now – that my excess over the pension lifetime allowance isn’t going away, and some mitigation measures are appropriate.

I’m sure there are many other things I could do. Let’s hear some of them in the comments!

If you enjoyed this, follow Finumus on Twitter or read his other articles for Monevator.

What caught my eye this week.

The FIRE1 gospel has probably spread so widely because people can quickly grasp the point of Retiring Early, even if they struggle with the airier notion of Financial Independence.

Wrap-up it up in a catchy acronym like FIRE and boom! A meme was born.

Just compare FIRE to a standard DCMPA strategy – that’s Defined Contribution to Minimum Pension Age, and no, nobody ever typed that before – and it’s obvious why FIRE is massive on TikTok, while sorting out your DCMPA paperwork is at the bottom of most people’s To Do list.

Yet I’ve been reluctant to subscribe to the FIRE terminology myself. Partly that’s due to my inherent hipster snootiness, but it’s also because being Financially Independent was what got my imagination going, and that always seemed second fiddle in the FIRE sales pitch.

For whatever reason, thoughts of a bucolic early retirement just aren’t as inspiring to me as staying economically active but with a F-U fund / Death Star in my back pocket.

I’ve tried the term Financial Freedom, but that phrase always seems to come with connotations. Maybe it sounds vaguely hippie-ish?

Also, if what exactly qualifies for Early Retirement is a can of worms for pedants to kick about, then Financial Freedom is a mass of fish in a barrel to shoot.

How free is financially free? Free to get a bus when and where you’d like to? An Uber X? Free to catch your own private jet?

Debating an early retiree with a side hustle is child’s play by comparison.

Time Bandits

I’ve now learned of another term for the ‘economically purposeful semi-loafing but with a healthy bank balance’ lifestyle I aspire to.

Apparently, we’re time millionaires.

According to The Guardian this week:

First named by the writer Nilanjana Roy in a 2016 column in the Financial Times, time millionaires measure their worth not in terms of financial capital, but according to the seconds, minutes and hours they claw back from employment for leisure and recreation.

“Wealth can bring comfort and security in its wake,” says Roy. “But I wish we were taught to place as high a value on our time as we do on our bank accounts – because how you spend your hours and your days is how you spend your life.”

A quick skim reveals the term ‘time millionaire’ to be ill-defined, of course. But I can definitely get behind the notion.

I’ve always valued my time (especially the ability to do nothing ‘productive’ whenever I want) more highly than putting extra money in the bank – after a certain point anyway.

At my best as a freelancer I was a samurai-level time-manager. Not in order to squeeze more work in, but to squeeze more work time out.

When friends ask why I quit my little leg of the rat race, it’s hard to explain that the ability to wander into the British Museum on a Tuesday afternoon – or just to pop to Waitrose for one of its middling free coffees, whenever I wanted – inspires me as much as writing a novel or founding a startup.

Even when I was employed I’d make a point of taking the whole hour for lunch, wherever I worked. Nobody else did – not consistently.

Their loss!

Worse still, some co-workers put in very long hours, and it’s especially silly to throw 12 or more hours at work every day. Studies show that doing more than 55 hours or thereabouts actually makes you less productive. The extra effort is pointless.

Even if you do manage to squeeze out some useful effort, Parkinson’s Law will get you in the end.

The living is easy

I doubt the Time Millionaire lingo will catch on. But I am on-board with the idea and my money is where my mouth is.

Or rather, the money I haven’t got because I wasn’t working is!

(Okay, that’s a moutful – or is it literally not? Hey, we’re talking about ‘time millionaires’ so we’re already off the reservation.)

Regular readers with great memories might recall I quit my main work contract a year ago. I thought I’d put many more hours into growing Monevator, as well as a couple of other nascent projects.

But 12 months in and that hasn’t really happened. Not yet, anyway.

There are some good personal excuses for this, which we won’t go into today.

Not least because I can’t help thinking it’s mostly that I’ve been busy doing nothing (much).

Thank goodness they don’t tax free time!

What do you think? Would you rather be a money millionaire or a time millionaire? Can these two systems be fused with a Grand Theory of Everything Financial? Or does the FIRE lingo already do that?

Let us know in the comments below. And have a great weekend.

[continue reading…]

1. Financial Independence Retire Early. [↩]

Every now and then someone sends me their portfolio for thoughts and suggestions.

One particularly stuck in my mind because it’s the type of portfolio I could have had if events had turned out differently.

Reviewing it made me feel like I’d been transported to an alternate timeline.

One of those parallel universes where the US and UK had fallen to fascism. Everybody wears military uniforms and clipped moustaches, including the women.

The letter ‘K’ has replaced the letter ‘C’ to prove we no longer live in the free world. Y, know – people get their burgers from MkDonalds, and their propaganda updates from Fakebook. (And there’s one fewer episode of Sesame Street.)

I’m not saying this portfolio was overweight authoritarian states (unless you count contemporary Britain, right kids?)

But this is the place I might have wound up in if I hadn’t found the passive investing freedom fighters early on.

Where – instead of the Bogleheads – I’d fallen under the sway of nefarious choice architects such as newspapers and stock brokers – all broadcasting their wealth-lists like martial marching music across every channel.

Time for a debrief.

What a state

The portfolio under interrogation comprises 25 actively managed funds. 

Now to be fair, some of these funds handed out a beating worthy of a brownshirt to anything I own.

Beneath those headline victories, though, all is not well.

Alarm bells ring for me when I see a long tail of micro portfolio allocations as in the screenshot below.

Dwindling portfolio weights undermine the overall contribution each holding can make, and imply a chaotic strategic approach. 

Do not adjust your set! The holding names have been redacted for privacy reasons. The red box shows the majority of holdings make up less than 5% of the portfolio’s weight, while 44% of holdings weigh under 1%.1  

Remember those winning active funds I mentioned? Alas these stars made only a minor overall contribution, because they were typically held in very small amounts. 

This doesn’t say much for the forecasting skill of whoever picked most of these funds. Spray a target with enough bullets and you’ll get some hits. 

The offset, I suppose, is that the dogs also only inflicted flesh wounds. 

The majority made a marginal difference to overall returns – for better or worse – so what was the point of them?

What’s the strategy here?  

Big bother

Overall, the portfolio has done well. It’s netted double-digit nominal returns for a decade.

So what am I complaining about?

Well, the snag is this active assortment was comfortably beaten by a world tracker index fund. A simple choice that would have saved money and bother.

(Specific holdings again redacted. It adds to the crypto-fascist theme of today’s post, wouldn’t you agree, citizen?)

I’ve ranked the portfolio’s funds by performance (best to worst) and noted the OCF, too.

We can see that only seven out of the 25 active funds beat the simple MSCI World ETF I used as a benchmark (the green row in the table).

I knew the funds 10-year annualised return in most cases, but where I only had the 5-year return I’ve shaded the cells grey. I’ve rounded the returns and Ongoing Fund Charge (OCF) to the nearest quarter point, except the portfolio’s average OCF. 

A crude projection of this portfolio back ten years sees it lag the MSCI World ETF by a few percentage points annually. It trails by about half that against Vanguard LifeStrategy 100.

I don’t know the trading history of the portfolio – and not all the funds were available 10 years ago – so my estimate is not the realised return. It’s useful only to see whether these active managers together would have added any value versus a passive investing strategy.

Also, I should state this portfolio is over 90% equities. Most of the remaining allocation is in high-yield fixed income.

I’m not saying this portfolio was fated to trail a standard issue index tracker.

What’s the complexity adding?

My question is what is this investor getting for all the cost and risk of holding this motley crew?

It’s not adding diversification compared to a global tracker, that’s for sure.

The portfolio is tilted 60% towards Blighty. It would have made mincemeat of my comparison ETF if UK plc had trounced the US this past decade.

Alas, the opposite happened.

Moreover it’s not blind chance this portfolio under-performed.

Global capital simply wasn’t lining up to back Britain ten years ago. The world market told us that an 8% holding in UK equity was about right back then.

The sub-text read: “Don’t overdo it.”

Today UK stocks weigh in at around 4% of the global benchmarks.

So why is this portfolio stuffed to the gills with British-focused funds?

Perhaps because UK broadsheets and brokers are primarily incentivised by what sells. And that’s typically recent winners and the reassuringly familiar.

Such a pitch – ten years ago – got you a portfolio that banked too much on the UK, and funds vulnerable to a mean-reversion smackdown.

To emphasise the redundancy here, Morningstar’s Instant X-Ray tool found the portfolio’s top ten (underlying) share holdings present in anywhere from four to seven of the portfolio’s constituent funds. 

Feeling all the fees

You may also have noticed that even the cheapest active fund in the mix costs more than three times the fee charged by the ETF.

The most expensive fund charges you more than 11 times the tracker’s fee! Yet it delivered less than half the annualised return over the decade.

For simplicity, imagine this portfolio’s weighted total OCF was 1% (instead of the 1.2% it actually sums to).

Let’s also generously assume returns were the same between the active funds and a global tracker (rather than the case study lagging, like it did in reality).

If the portfolio’s gross annual return was 10% for each of the next 10 years, its 1% charge would consume 10% of the profits.

The index tracker’s 0.15% fees would only eat 1.5% of the profits.

This cost differential makes all the difference when compounded over the years.

Price does not equal quality

Still, those skilled active managers will justify their fees eventually, right?

Well, 18 out of the 25 failed to match a simple tracker, over a meaningful time period, despite their proprietary trading strategies, PhD-bedecked support teams, and glossy brochures.

Worse, the performance ranking above sees the most expensive funds clustered in the bottom half of the table.

Granted, my case study is a random snapshot.

Better evidence comes from the long-running, regularly updated SPIVA analysis that confirms the best performers are not the ones that charge you the highest fees. 

Back in the real world

If all this is true then there’d be an outcry, wouldn’t there? The hard-charging active fund industry would be found out, surely?

Yep, just like ageing women stopped buying expensive anti-wrinkle products years ago.

The evidence has favoured passive investing for even longer than Monevator has been blogging – coming up to 15 years for us – and yet the gravy train rolls on.

At least fit your own oxygen mask first. If your portfolio exhibits traits similar to this case study then I’d urge you to benchmark it against a global tracker using Morningstar’s Portfolio Management and Instant X-Ray tools.

And if that sounds like we’re on some kind of deal for Morningstar endorsement, know we’re not, sadly. I just genuinely think you can learn a lot from using those tools. (A similar analysis of my own portfolio prompted my recent investing mistakes post.)

I don’t pretend passive investing is perfect. Maybe you’ll own some over-bloated winners. Perhaps it encourages hands-off capitalism. Indices stuffed with sin stocks. Pick your poison.

Indeed just like democracy, passive investing is probably the worst strategy – except for all the others you could try instead.

(With grateful thanks to Winston Churchill.)

Take it steady,

The Accumulator

1. Some shares and even an ADR add to the fund fun, if you’re wondering why there are more than 26 holdings. [↩]