Before buying a TV or a toaster, I check out the reviews. Of course I take them with a pinch of salt. But if a few sources give one model a high rating and say another is better used for scrap, that’s meaningful.

In the wacky and weird world of investing, this approach can lead you astray.

A reader asked us:

Good reads from around the Web.

Once I’d finished kicking myself, I allowed myself a wry smile on reading the latest house price survey by UK Value Investor. It brought back a lot of memories.

John entitled his post UK house price forecast: It’s not looking good.

But I was thinking that for me it might have been called A little knowledge is a dangerous thing.

The source of my dark mirth was the following graph. It shows how the average house price moves through bands of apparent over and under-evaluation over time, as defined by a deviation from the longer-term norm of property prices to average earnings:

Source: UK Value Investor / Halifax

When I look at that graph, I’m taken through the story of my adult life.

In the mid-1990s, fresh out of University and already with an eye to a bargain, I was urging friends to buy their own home. I can vividly remember reading an article in The Sunday Times showing how the price-to-earnings ratio for London property had hit an all-time low in the wake of the early 1990s house price crash. (Yes kids. Really).

It’s hard even for me to believe now, but the meme back then was that buying was so over, and that Generation X would usher in an era of renting. (Which has eventually happened with the Millenials, but not exactly out of choice.)

As you can see in the graph, I got ‘anchored’ in 1995, as the behavioural economists say, to very low prices. Unfortunate.

I wanted to buy, but for various reasons I didn’t – I’d only had a job for six months and I knew it was the wrong one, the £5,000 or so I’d saved as a student (!) didn’t go far, and I was greedy and wanted to buy in gentrifying Clapham Old Town, not Brixton where I actually lived.

What was the rush? Nobody wanted to buy. A couple of years of frugal living and hard saving and I’d swoop in like Hetty Green.

When I moved out of London for a couple of years to a new job, I urged my new friends in the provinces to buy there, too, as the infamous ripple rumbled beyond the M25.

Incidentally, these friends have finally stopped thanking me for first putting this idea into their heads, either because they have forgotten, they are too-embarrassed by my ongoing property penury, or they’re too busy going on holiday with all the money they save from paying £200 a month for a four-bed house in the best part of town.

Which is fair enough, obviously, but being remembered as the kindly savant did soften the sting a little…

Trees that grow to the sky

Back in London in the early 2000s – and with a combination of nearly 10 years of savings and access at last to sufficient self-employment records to please the bank manager – I put in an offer on a two-bed in 2003.

And then there was a snag with the paperwork. The mortgage agent suggested, in essence, that I make something up.

I dithered.

Truth is I dithered not only for moral reasons. I was now telling my friends that I thought property was becoming truly over-valued in London, and I was risking ten years of savings from a very ordinary basic rate taxpayer level income in the face of a potential crash.

If my London friends who heeded this terrible call still remember it, they are kind in (generally) not mentioning it. Swings and roundabouts, I suppose.

Look at the graph above and you can see my fears. Prices are moving into the orange zone. My gut call was right. But my crystal ball was murky, and history had other ideas.

Remember, we couldn’t know then what would actually happen next.

Here’s what happened next:

Source: The Guardian

This graph – from The Guardian – shows that average London prices are now more than 14 times earnings, according to the property specialist Hometrack.

The unprecedented eight-times peak that had me quailing back in 2003 looks positively pedestrian.

Non-buyer’s remorse

What a palaver. For the record I did look at a few properties in 2010 (partly as a result of helping a friend who didn’t want to view them on her own) and thought prices now looked a tad more sane.

I wondered if it was time to stop the bleeding.

Alas, that mini-crash lasted about six weeks and my firepower had been smashed to smithereens roughly halved by the financial crash. Which left me feeling guilty as well as keeping me renting.

Some readers have told me over the years to stop complaining, and just move and buy. I am complaining to some extent I suppose, but it’s a sort of rueful self-knowing complaint.

It is what it is, as my younger friends say. But that doesn’t make it “right”. (Substitute rational, fair, sustainable, predictable, a good bet, or whatever other word you like – I’m just using it to cover the waterfront, not to imply a deep moral injustice).

I can buy, even in London, albeit because I’ve basically turned myself into West London’s answer to the early Warren Buffett.

But that doesn’t mean I will, or even should.

Bailed out by the bond bubble and the BOE

I understand anonymous commentators on the Internet are all geniuses. Their property purchases were wise, prescient, and it’s entirely in the proper order of things that their homes now cost 10 times what they paid for them, and that they couldn’t afford a shed at the bottom of their garden if they had to buy today.

That’s nothing – you should see them at the races!

But let’s be honest, if you were told in 2007 that the world was about to face a once in five generations financial crisis, would you honestly have thought London property prices would be trading at more than 14-times earnings some six or seven years later?

I sold most of my bank shares before the worst of the crash hit because I was convinced high debt was part of the problem, although I didn’t in any way understand exactly how in the way we all do now.

It was also part of the reason why I was nervous back in 2003 – I saw ill omens all around, particular with spendthrift friends buying flats via credit cards and parental handouts.

Ho hum. Moral hazard has been on holiday for a decade.

Other people say “of course property prices are very high, bond yields are very low.”

To which I say: Unconvinced. Prices are not at anything like such high levels in the US, which had a bigger crash and for a long-time as low or lower bond yields. Nor the big cities in Germany and Spain where ten-year yields are from time to time negative.

Oh, and anyway I’m not going to condemn myself too harshly for not to have anticipated the property bubble would be bailed out by 5,000-year lows for interest rates.

Brexiteers to the rescue?

Clearly all property markets are local to both time and place, which it took me too long to fully understand. The UK economy – and more particularly London – has been doing very well in a world that’s been doing rather poorly.

The brilliant Brexit may now burst the London property bubble, but then again it may not.

I’ve seen the thing stagger back onto its feet too many times to stomach the confident soundings of a new recruit. I’m more like one of those hardened zombie-fighters that the prettier and younger movie stars find holed-up in the top-floor of a crumbling tower block.

They think the worse is over. I’ve seen it all before.

A little knowledge is a dangerous thing. On the other hand, my experiences (and that housing deposit I never deposited, but instead put into the market) has helped make me the investor I am today. And I’m pretty content with that guy’s record.

Still, I can’t deny it’d be nice to be able to knock a wall down now and then.

[continue reading…]

There is nothing magical about pensions versus ISAs, the UK’s two tax-free savings wrappers, that somehow enables pensions to break the laws of mathematics.

Both pensions and ISAs deliver one-shot tax relief, as well as allowing your savings to grow tax-free.

• Pensions give you the relief upfront, by rebating the tax you’d otherwise pay on your contributions.

• ISAs give you the tax break later, since you pay no tax when you cash in your ISA investments.

You’ll often hear people claim that pensions are better than ISAs because upfront relief is more valuable. “You have more money to compound over the years with a pension,” they say, which they claim gives pensions the edge.

But this is wrong – all things being equal.

Now, all things are rarely equal, and I’ll get to that in a minute.

But first the science bit.

Pension versus ISAs: A quick recap

Pensions

• With a pension, you get tax relief on your contributions.
• If you pay 40% tax, say, then a £1,000 contribution costs just £600 of taxed income.
• You pay tax on the money you take out when you retire.

ISAs

• With an ISA, you get no initial tax relief.
• Instead, you put some of your taxed salary into the ISA.
• However, you do not have to pay tax on the money you withdraw later.

Mathematically speaking, there is no difference between these two situations, provided the tax rate is the same.

Proof that ISAs and pensions are the same, maths wise

Here’s some algebra to prove pensions and ISAs are equivalent – all things being equal.

Consider the variables:

• A lump sum investment of £x
• Tax rate of t%
• Annual growth of i%
• Investment period n years

With an ISA you get no initial tax relief, and you pay no tax on withdrawal.

The formula for how your money compounds over ‘n’ years is therefore simply:

• ISA = x * (1+i)^n

With a pension you get tax relief of t%, but you also pay t% tax when you withdraw the money later.

The formula for how your money compounds over ‘n’ years is:

• Pension = x/(1-t) * (1+i)^n * (1-t)

Now, (l-t)/(l-t) cancels out. This leaves us with:

= x * (1+i)^n

Which is exactly the same as the ISA!

This is why some prefer to use the phrase ‘tax deferment’ rather than ‘tax relief’ when talking about pensions. The relief you get upfront is cancelled by the tax you pay later – all things being equal.

A worked example of tax equivalence

Here’s an example of pensions versus ISAs with real numbers.

Consider a higher-rate taxpayer who:

• Sets aside £1,000 of his gross salary to invest every year
• Pays 40% tax
• Gets 10% a year growth on his investment
• Leaves it to compound for five years
• Draws an income of 5% a year in retirement

With the ISA, he is funding his contributions out of his taxed income.

Higher-rate tax is 40%, so our man’s £1,000 contribution is multiplied by (1-0.4=0.6) to reduce it by 40%, then compounded over five years, and then finally, he takes out 5% (so we multiply by 0.05).

• £1,000×0.6×1.1×1.1×1.1×1.1×1.1x.05 = £48.32

With the pension, our chap can put in the £1,000 from his salary tax-free. However, he must pay 40% tax at the back-end.

This time, we get:

• £1,000×1.1×1.1×1.1×1.1×1.1×0.6×0.05=£48.32

The same!

Important caveat: Things are NOT equal

I’ve shown there’s no difference between an ISA and a pension from a pure maths standpoint.

But I said that was with ‘all things being equal’. And things aren’t equal!

Caveat 1: Lower-rate taxpayer in retirement

Most people pay a lower-rate of tax in retirement (0-20%). This can make a pension a better option than an ISA for higher-rate taxpayers who will be lower-rate taxpayers in retirement, because the rate they pay on withdrawing the money (20%) will be lower than the tax relief they got on when they put the money in (40%, or 45% for additional rate payers1 ).

In my worked example, instead of multiplying by 0.6 to represent the tax on withdrawal, as a lower-rate payer you’d multiply by 0.8, which gives a much higher income of £64.42.

But there’s more! You still have an annual income tax personal allowance as a pensioner. So a good chunk of your pension income may not be taxed at all. (The first £11,000 at the time of writing, presuming no other taxable income streams are complicating matters.)

On the other hand, some of your personal allowance should be used up by (hopefully) a State Pension at some point in your retirement. The State Pension counts as taxable income.

As you can see the marginal tax rate you’ll pay can be very uncertain 15-20 years in advance.

Caveat 2: Tax-free lump sum with a pension

A second important factor is that you can take out a one-off 25% lump sum2 entirely tax-free with a pension.

On this portion of your money you get tax relief going in, and yet can pay no tax on that 25% coming out later – the best of both worlds!

Again, this gives pensions an edge over ISAs.

Caveat 3: Employers pay into pensions, but not ISAs

Employers contribute to pensions, which can be a substantial advantage, and there are National Insurance savings too.

Pensions are also better protected if you lose your job and need to claim benefits.

Pensions versus ISAs: Same but different

In the old days – that is, three or four years ago – we’d now shift gears to talk about the huge and hidden downsides of pensions.

Gloomy organ music would rise up out of nowhere, an unseen wind would shutter the windows and plunge us into darkness, and we’d somberly recount the onerous restrictions on what you could actually do with your money that you’d saved into your pension when you were old enough to need it.

All that changed though with the 2014 Budget’s pension freedoms.

There are still some rules on what you can do with your pension pot – most particularly when you can get access to it. Currently you need to be 55, but that age climbs if you’re younger and many fear it will keep rising.

You do also need to be aware of the tax implications of different withdrawal strategies.

In contrast, with an ISA you can spend your accumulated money how and when you like. It’s always tax-free.

But still, when it comes to how you invest your pension pot once you’ve retired and how you withdraw it, most of the old strictures are gone.

Most dramatically, you’re no longer compelled to buy an annuity. You can instead invest your pension in other assets to create an income that suits you.

Famously, you can even withdraw the money to buy a Lamborghini if that floats your boat.

Our contributor The Greybeard has been covering this brave new world of pensions and deaccumulation. Please do check his articles out.

The changes mean that most people on a fairly normal retirement path will conclude that a low-cost pension based around tracker funds or an ETF portfolio is the best vehicle for retirement savings.

My co-blogger The Accumulator certainly thinks pensions have the edge.

ISAs are still massively valuable for all-purpose savings. They can also back up your pension contributions, and diversify the risk of future governments fiddling with the rules.

And if you want to retire very early, ISAs will probably have to feature heavily in your strategy, given the age restrictions on accessing pensions.3

In an ideal world you’d have both a pension and ISAs. But whatever you do make sure you’re using some sort of shelter to stop tax reducing your investment returns.

Note: Older comments below may pre-date the pension freedoms. Check the dates! Also I’ve not gone into Lifetime ISAs, as there are signs that the government is already having second thoughts about the inherent inconsistencies in this halfway house. If they are implemented we’ll come back to them, so please do subscribe for updates.

1. But beware of reduced annual allowances if you’re a high-earner. [↩]
2. Technically it’s called a Pension Commencement Lump Sum, or PCLS. [↩]
3. If you’re trying to retire in just ten years say, then the annual ISA contribution limits are going to be a snag. Make sure you’re fully up-to-speed on capital gains tax strategies and the like. [↩]