Good reads from around the Web.

Lots of amateur investors daydream about being the next great stock picker – a contrary-minded Buffett for the 21st Century.

But very few people are wired right (or perhaps that should be wired wrong…)

For most, being a contrarian investor gets no further than reading a magazine article about being a contrarian investor, and then investing in whatever shares or funds it suggests.

And that just isn’t going to cut it over the four or five decades of a lifetime of buccaneering investing.

As Patrick O’Shaughnessy of Millennial Invest wrote this week in a piece on the virtues of cheap yet scary-looking companies:

To buy into a terrifying portfolio, you need to have a contrary mindset.

This mindset is almost sociopathic, because it requires not just ignoring the crowd, but actively trading against it.

Most people can’t do that. They run with a herd even when they think they’re standing apart from it.

That’s surely for the best, given that more than seven billion of us are trying to get along on this little planet.

Gold given the finger

The wannabees come and go.

Remember when any mention of gold brought out dozens of precious metal bugs to call you an idiot, no matter what you wrote?

For all the noise they mostly seemed to think the same thing – that the dollar was about to collapse, and that a Neo-Aztec Kingdom of Gold was set to emerge from spare bedrooms and basement PC dens across the land. Conspiracy theorists who’d buried Krugerrands under their lawns would inherit the earth.

We’re still waiting.

Who knows, things are precarious enough that even I wouldn’t write off the gold bugs’ predictions entirely. But one thing I’m sure of is that the love-in for gold a few years back was as contrary as feeling a bit sad when Robin Williams died.

Look at this graph of the assets amassed at the height of gold mania by the US gold tracking ETF – ticker GLD – as posted by Ben Carlson on A Wealth of Common Sense:

At that peak in summer 2011, GLD became the largest single ETF in terms of assets – bigger than even the mightiest S&P 500 tracker.

But since then, Ben says:

…the fair-weather gold investors have been shaken out, and then some, in the latest drawdown.

Although the GLD fund’s performance is down by a quarter, the total assets invested in GLD are down by 60%.

In other words, GLD’s assets have shrunken far, far faster than the gold price.

Meanwhile the SPY stock market index tracker has returned 60% in gains, and it’s doubled in terms of assets.

Golden brown

This isn’t a post to say that stocks will always beat precious metals, or that you should race out and buy the S&P 500.

(If anything it makes me want to trickle money into a gold ETF!)

It’s more a reminder that like teenage goths who feel they’re uniquely dark snowflakes but all seem to shop at the same branch of Emos ‘R’ Us when you see them outside a Marilyn Manson concert, so any investor who has gone off the beaten-track mob-handed is likely not blazing a trail but heading for a cliff.

This stuff is hard, for all of us.

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Had you’d asked me 15 years ago how I planned to fund my retirement, my answer would have been straightforward.

• A certain proportion of my retirement income would come from a modest defined benefit pension, built up in the 1980s.

• The state pension would make up another modest slug of income

• The balance would come from an annuity, after I’d cashed in my pension savings.

These days, my thinking is a little more nuanced.

In particular I’m a hell of a lot less enamoured of annuities than I used to be. And a hell of a lot more interested in the alternatives.

Poor value annuities

For one thing, in the intervening years annuities have had something of a bad press.

Thousands of Equitable Life ‘With-Profits’ annuitants, for example, got royally shafted. Having exchanged their pension pot in exchange for an income for life, in the early 2000s they saw their incomes effectively halved – or worse — as the board of Equitable Life scrambled to conserve cash. Hardly a just reward for responsible saving.

Around the same time, annuity rates began a headlong plunge from which they’ve yet to recover.

Blame greater longevity, and increasingly derisory bond and gilt yields.

Hence the growing attraction of income drawdown, introduced by the government in 1995 to offer an alternative to annuities.

Income drawdown: Mine, all mine!

Income drawdown provides pension savers with the option of each year ‘drawing down’ a little of their pension pot, gradually consuming the income and eating bit-by-bit into the capital.

So instead of handing over your entire pension pot to an annuity provider in exchange for a guaranteed income, you draw down upon the capital sum that you’ve accumulated – deaccumulating, in today’s jargon.

At all times your pension pot remains yours – because you’re not handing it over to the annuity provider – and, upon death, what’s left can be passed on to your heirs.

Of course there are some downsides to income drawdown:

• There are charges that you don’t get with annuities.

• If you consume your capital too fast, you’ll drain your pot dry.

• Market volatility can mean that capital consumption when markets are down is especially expensive.

The biggie is that an annuity income is nailed-on for life when you buy it – albeit at a pretty poor rate today – which gives you security in exchange for flexibility.

Income from drawdown isn’t secure.

The annuity empire fights back

While miserly annuity rates have attracted a bad press in recent years, income drawdown hasn’t had that good a press, either.

I, for one, was initially put off – no, horrified – by some of the charges being levied by the Independent Financial Advisers and specialist firms offering income drawdown schemes.

Not to put too fine a point on it, some of the same firms that had been offering precipice bonds and zero-coupon bonds now seemed to be offering expensive income drawdown schemes.

Moreover, the traditional annuity providers apparently flooded the finance pages of the weekend press with scare stories. (Cynical? Moi?)

Take this one from the Daily Telegraph in 2012, which began:

Income drawdown: the pension that could leave you penniless

Avoiding annuities could give you more to live on to start with, but your money could soon run out if markets go against you.

The article warned that retired people who took the maximum income from their policies would empty their pensions by the age of 92 – even allowing for a relatively benign investment climate.

Er, yes. But why would you have continued to drawdown at maximum levels if you saw that starting to happen?

Income drawdown limits – imposed by the government explicitly to prevent pensioners from consuming their pots too fast, doubtless prompted by articles like the one just mentioned – also made for grim headlines over the years.

When in 2009 the government cut maximum drawdown from 120% to 100% of the gilt-linked (and already reduced) GAD1 rates, high-drawing pensioners’ incomes duly fell.

In other words, they couldn’t draw down as much as they has previously assumed – and it would be potentially imprudent to do so.

That wasn’t quite the way the Daily Telegraph pitched it, though.

“Our pension was cut by £9,000 a year”, it shrieked, following it up with a dire headline that pensioners faced a 40% income cut.

Recent developments in retirement income

This sort of reporting, while ostensibly balanced, does little to encourage people to weigh up the pros and cons of annuities versus drawdown.

That’s particularly true if such people are reasonably sophisticated investors, who are used to taking decisions about their financial future, and who are perfectly capable of taking an educated view of the relative upsides and downsides of these two contrasting approaches to the deaccumulation phase of our lives.

People like Monevator readers, in other words.

And to my mind three recent-ish developments have tipped the balance even more in favour of income drawdown, and away from annuities.

Development #1: Equity income beats low annuity rates

In March 2009, the Bank of England cut Bank Rate to a historic low of 0.5%, ostensibly for a few months – perhaps a year at most.

Five and half years on, it’s still there.

And whereas the mood music even a couple of months ago was talking about a rate rise in a few months, the prospect of an imminent rate rise now looks slim, what with signs of a slowing economy here in the UK and further trouble in Europe.

In the meantime, annuity rates reflect these persistently low interest rates.

Consider the following annuity rates, sourced from Hargreaves Lansdown, in respect of a single life, investing £100,000 to buy an Retail Price Index-linked (RPI) annuity.

	55	60	65	70	75
Single life, RPI-linked, 5-year guaranteed annuity	£2,249	£2,286	£3,285	£4,265	£5,722

Source: Hargreaves Lansdown, October 2014

Said differently, someone retiring at 55 is going to do so on an index-linked income of 2.25%. At 60, 2.3%. And at 65, 3.3%.

That’s pretty derisory, when you consider that a portfolio of solid income-oriented, dividend-paying shares could deliver double that yield between the ages of 55 and 64 or so.

Even at 70, your annuity will give you less than many decent dividend picks are paying out today – and with the annuity you’re kissing your capital goodbye, too.

Plus those dividends from shares should rise over time, providing a cushion against inflation. To be sure, not in a smooth and consistent way that’s guaranteed to match RPI. But very likely at a greater clip, overall.

In short, for investors prepared to shoulder the burden of picking shares or income funds – and taking on the risks of equity income – then income drawdown currently offers a higher income – potentially without necessitating any capital drawdown at all – and provides a potential capital bequest to boot.

Development #2: Goodbye, income cap

Remember those shrieking headlines about pensions being cut by £9,000 a year and pensioners facing a 40% income cut?

Er, that was then, and this is now.

As of the Chancellor’s most recent budget, the GAD limit was first sharply relaxed2, and then abandoned altogether in respect of drawdown schemes commencing from next April.

As pensions minister Steve Webb famously observed, there will now be nothing to stop pensioners withdrawing the lot, and blowing it on a Lamborghini.

Nothing, that is, except for the fact that – aside from the tax-free lump sum entitlement – such withdrawals would be at an individual’s highest marginal tax rate, calculated by including the withdrawal as part of annual income.

Ouch.

And nothing apart from the fact – as the government hastened to point out, post-Lamborghini foot-in-mouth – that it rather thought that people who’d been sensible enough to spend a lifetime accumulating a pension would probably be sensible enough not to blow it all at once.

Still, all in all your pension has just become one giant piggy bank, with no limits on how you choose to extract money from it.

Quite a contrast to swapping it for an annuity.

Development #3: Goodbye ‘death tax’

Thirdly and finally, the recent party conference season brought a welcome bribe fillip to pension savers who have an eye on passing on the unused part of their pension to their heirs.

Simply put, the old 55% tax hit levied on your pension estate is to be scrapped, proposes the Chancellor.

• If you die before age 75, your pension can be inherited – and money withdrawn from it at will – with no tax to pay at all.

• If you die after age 75, the inherited pension will attract no tax if the funds are left within in it, but any withdrawal will be at an individual’s highest marginal tax rate.

Again, quite a contrast to an annuity.

The inheritance tax benefits are obvious, and already I’ve read press coverage suggesting that such a system would open the doors to multi-generational ‘trust funds’.

Needless to say, you can’t do this with an annuity, either.

Tipping the balance

So there we have it. Do these changes influence your view of income drawdown? Enough to tip the balance over annuities?

As ever, please do share your thoughts in the comment section below.

Please remember that these are difficult decisions with long-term consequences for your retirement and security, and you may need to seek professional financial advice. Our articles are for education and entertainment only, and are not meant to be taken as individual advice.

1. The Government Actuary’s Department provides key data used as part of the income drawdown calculations. [↩]
2. To 150%, having earlier returned to 120% from the short-lived cut to 100% [↩]

The low volatility anomaly has proved incredibly popular in recent years. Investors have moved billions into low volatility funds that dangle a juicy carrot – the potential to earn superior risk adjusted returns.

Historically, low volatility has beaten the market while exposing investors to less risk than the market portfolio.

Yet while other return premiums like value and momentum enjoy widespread support among theorists and empiricists, low volatility has taken the kind of credibility battering that’s normally reserved for the tooth fairy.

The evidence mounts

The major problem is that much of low volatility’s good run may be due to the historical quirk of a relentless 30-year decline in interest rates – a streak that can hardly be counted on in the foreseeable future.

What’s more, the popularity of low volatility funds over the past few years has led to a spike in valuations in the relevant shares – the perfect conditions for a long period of underperformance.

Passive investing champion Larry Swedroe has written extensively on the difficulties that could beset low volatility investors in the future.

He cites evidence that past success has relied upon exposure to large, stable, high-yielding value companies, as well as high concentrations in the utility and non-durable goods sectors.

Such firms are known for loading up on debt. Such debt became cheaper as interest rates fell over the decades, which boosted the performance of those companies and by extension low volatility strategies.

If real interest rates rise though, then these firms may well suffer falls in price in a similar way to long-term bonds.

Over valued

The historical characteristics of low-volatility shares might also suggest that a low volatility tracker could be a good way to gain exposure to the value premium, though such trackers haven’t yet been around long enough for us to tell.

But there’s already evidence that stable, large cap value firms could have lower expected returns than distressed small value companies teetering on the edge of extinction. That could indicate you won’t get similar rewards from low-volatility as you would from a true value fund because you’re not taking the same risks.

Plus if investing in low volatility in practice means betting big on just a couple of sectors (such as utilities and healthcare) then there’s no reason to believe that this will continue to pay off in the future. No one’s ever found a sector premium.

It all suggests to me that if you want a less risky way to pursue the value premium, you’d be better off investing in a value fund combined with a UK Government bond fund to achieve the same result: market-like expected returns at a lower risk.

This way you’d also benefit from the low correlation between equities and government bonds.

Another danger with low volatility strategies has been identified by Erik Knutzen, author of the study, Pursuing the Low Volatility Anomaly.

Knutzen shows that the money flooding into low volatility equities had inflated their prices to a 22% premium by 2012, concluding:

Expensive valuation for low volatility stocks is consistent with their strong recent relative performance and may also indicate an impending period of sustained underperformance.

In fact, in order for the track record of low volatility stocks to become consistent with the expectations we described earlier as reasonable, this category may have to experience a lengthy period of sub-par returns.

Gulp.

Practical difficulties

Meanwhile the authors of the paper The Limits to Arbitrage and the Low-Volatility Anomaly found that the low volatility premium may well persist in the data because it’s exceptionally difficult to capture in practice.

Once they factored in the real-world costs of executing a low volatility strategy (usually neglected by the academics), the authors discovered that most of the theoretical gains were wiped out.

They warn:

In short, our findings cast some doubt on the practical profitability of a low risk trading strategy.

Finally, in his paper Understanding Defensive Equity, Professor Robert Novy-Marx found that low volatility’s edge is explained by its bias against small, unprofitable growth equities, of the sort that have long proven toxic for investors. Novy-Marx demonstrates that the low volatility story does not hold up in other segments of the equity universe.

In other words, the significant outperformance of low volatility is restricted to small cap growth companies, whereas the normal, positive relationship between risk and reward is restored for small value and large cap equities.

Moreover, much of the theoretical success of low volatility strategies may well come from shorting these highly volatile and unprofitable small companies. That is something that is entirely feasible in the frictionless confines of an academic’s back-tested simulation, but which you won’t find on offer from any of the low volatility ETFs that we can actually invest in.

Novy-Marx concludes:

This is not to say that an individual would not have benefited from following a defensive strategy. Investors certainly would have profited from avoiding unprofitable small cap growth firms.

Defensive strategies are, however, an inefficient way to exploit these premia, which are better accessed directly.

Investing in value and profitability/quality funds would be one way to do this.

Take it steady,

The Accumulator