The plan is to be financially independent in a decade. I can see now that it can be done. And I can see how it will be done.

The thought of it is making me tingle. This will be the biggest and most rewarding challenge of my life.

In my case, becoming financially independent (FI) requires all the things the gurus said:

• A stupendous saving rate: 67% of after-tax income.

• A moderate annual expenditure: £20,000 for the two of us.

• A final ‘retirement’ pot that can sustain a 3% withdrawal rate (the standard 4% is too risky in my view, for many reasons).

• A decent spurt of growth from my portfolio over the next decade: A 4% real return a year will do it.

The growth rate is out of my control, so let’s not worry about it here. The final pot is negotiable, which leaves the savings rate and annual expenditure target as the twin keystones of the plan.

Hitting a 67% savings rate without pauperising ourselves means the near removal of Ms Accumulator and I from the tax system.

Tax ghosts

Part one of going off the tax grid is to stick to that £20,000 annual income figure.

From next year, the income tax-free personal allowance is £10,000 each, updated annually in line with inflation.

Split between the two of us that means our entire year’s worth of spending ducks the taxman’s net. £1 of spending over that line actually costs us £1.25 – once you deduct 20% income tax.

Going tax dark part two means stuffing every spare penny we have into our pensions.

Famously, pension savings are taxed at your marginal income tax rate when you withdraw. In other words, if we each spend £10,000 a year from our pensions (in today’s terms) then we will pay 0% tax.

But the beauty is that every penny we save attracts 20% tax relief at the basic rate and 40% at the higher earner’s rate.1

That means every £1 saved is actually worth £1.25, or even £1.67 at the higher rate.

Which means that £10,000 saved is actually worth £12,500 or £16,700 and is returned to us un-gouged by HMRC, if we live within our personal allowances.2

I can’t emphasise this enough. We get an instant return of 20% or 40% from saving into our pensions (not including company matches) and, if we’re careful, it’s never taken back because we’ve danced clear of income tax.

An ISA can’t compete with that

It should take us 10 years to hit financial independence (FI) using company pension schemes and SIPPS. It would take over 13 years if we maxed out our ISAs instead.

If I was trying to hit FI in my 30s or 40s then, yes I’d be all over my ISAs. But that boat has sailed for me.

We’re in our early 40s, so we’ll be within sniffing distance of our pensions by the time the 10 years are up.

If progress is slower than I hope, then we could easily be 55 – the age at which you can begin to make withdrawals from a pension – by the time we hit our FI bullseye. In that scenario there won’t be any hanging around.

Sure, if things go spectacularly well, and I hit my numbers early, then I could be like a pirate becalmed off treasure island – so close to his booty but unable to touch it.

I’m fine with that. I intend to work on for a couple of years anyway to build up a juicy tax-free lump sum. This will be slipped into ISAs to create an emergency fund / extra tax-free income generator / travel-the-world slush fund, depending on the mood at the time.

Final thoughts

It took being able to smash my mortgage before I was able to think clearly about FI. (If you can cope with two things at once then you won’t have this problem…)

You can add even more tax relief gas if your company pension scheme supports salary sacrifice. That will spare you another 12% in National Insurance Contributions (or 2% for higher raters).

At some point in these discussions, somebody will always say:

“The Government can change the pension rules, spanner your personal allowances, or even confiscate your pension.”

To which I say: Yes, you’re right to point out the risks.3

That risk is one of many I’m taking to achieve something big in my life. I’m also entrusting my wealth to assets scarier than cash, believing I have a long and happy life ahead of me, counting on the UK not to suddenly turn into Argentina, and so on.

By all means be aware of the risks, but don’t be paralysed by them. Play the game in front of you.

There’s a good chance that any adverse pension rule changes:

• Will happen early enough for me to change course.

• Will happen late enough that I’ll be exempt.

• Won’t happen as foretold.

My chances of being left high and dry are small.

When all is said and done, the key is being able to live happily on £20,000 or less.

My prescription: Fall in love, maximise your tax allowances!

Take it steady,

The Accumulator

1. I’m not too worried about the 45% rate. Are you? [↩]
2. i.e. Save no more than our annual salary into a pension scheme, or our pension annual / lifetime allowance, and withdraw no more than our personal allowance in any given year of retirement. [↩]
3. Only last week Ed Balls gave notice of his intention to end 40% tax relief on pensions if Labour are elected. Though most will be better off if reports of a new 30% flat rate relief for all are to be believed. [↩]

Good reads from around the Web.

One of the hardest things to explain to a new investor is the benefit of rebalancing asset allocations.

Until you’ve had the “aha!” moment, it can seem like madness to reduce your holdings of investments that are doing well, to buy stuff that’s losing you money.

And then, once you’ve had the “aha!” moment – well, then it’s hard to remember what it was like before you “aha!”-ed, making anyone who doesn’t yet get rebalancing seem a bit like a child who doesn’t yet get why they need to eat.

Enter Larry Swedroe, and his short article that proves again how the magic of rebalancing works. Swedroe cites numbers from an author I’ve never heard of, Jaques Lussier, and his book Successful Investing is a Process. Here’s rebalancing in action (US data, but it’s the same principle in the UK):

An investor begins in 1973 with a portfolio that is 50 percent stocks and 50 percent bonds. For the period ending in 2010, stocks outperformed bonds as they returned 9.8 percent versus 7.7 percent for bonds.

If the portfolio was never rebalanced, the ending portfolio would have had an allocation of 68 percent stocks and the annualized (compound) return would have been 8.9 percent.

Knowing that stocks beat bonds by 2.1 percent a year was the investor who never rebalanced better off?

My own experience tells me that most people would assume you would have been better off not rebalancing due to the much higher return of stocks. Yet, a rebalanced portfolio would have returned 9.5 percent, and done so with less volatility.

In other words, the diversification benefit was sufficient to overcome the 2.1 percent disadvantage in returns. During this period the annual correlation of stocks to bonds was close to zero (0.1).

Rebalancing feels bad in the short-term, but it works over the long-term.

[continue reading…]

Question: What’s worse than putting your money into an active fund that charges high fees?

Answer: Putting your money into an active fund that charges high fees, but that to a large extent holds the same shares as its benchmark index.

Such funds are known as closet indexers, and a new report by wealth manager SCM Private claims that the UK is amok with these clone funds, compared to both the US and to investor expectations.

SCM’s research found 40% of the holdings of the average UK fund matched the underlying index, versus 25% in the US:

Attack of the clones: The typical UK active fund is 40% an index tracker.

It says that nearly half of UK equity funds fall into this closet indexing category, compared to just 10% in the US:

SCM’s research brings clone indexers out of the closet.

Now given that most active funds fail to beat the market, you might cynically think the more of them who copy the index, the better.

But closet indexing is a poor deal for many reasons.

Firstly, if your fund largely mirrors an index, you’ve got even less chance of beating it.1

True, we have abundant evidence that the majority of active funds will fail to beat the market long-term, anyway. But closet indexers are even less likely to outperform. Presumably if you’re putting money into an active fund then that’s what you’re trying to do – so you want to pick a fund with the best shot at doing so.

Secondly, you’re paying a lot of money for less active management than you thought you were getting.

If you’re paying, say, a 2% management fee to a fund manager, but half of the fund is effectively an index tracker, that means at least 1.5% of your fee is effectively paying for the actively managed portion of the fund – which means you’re actually paying 3% for their active efforts! That’s a very high hurdle for their picks to get over every year before they can beat a cheap index tracker.

Thirdly, SCM says there may be miss-selling implications.

I think this is a stretch – if fund managers are allowed to implore you to put your money with them to beat the market even though so few do, it seems anything goes – but in the post-PPI climate, maybe they’re onto something.

Why do closet index trackers exist?

As you might have guessed from my pretty mild outrage, I’m not particularly aghast to learn that so many UK funds are closet index funds.

Perhaps that’s because I’ve known about the tendency for while, or maybe it’s because after so many years of financial scandal and drama, this one seems a village green sort of scam – more Bertie Wooster than Bernie Madoff.

SCM’s boffins worked out that under-performing closet index funds have cost investors £1.9 billion in fees in the past five years, which is admittedly quite a sum. And I do have sympathy for newbies to investing, to whom index tracking seems utterly illogical, whereas paying an expert to manage their money seems most prudent. They are being sold a pup.

But the great mass of the closet indexing money will be in the hands of experienced investors who’ve had plenty of time to wise up. Monevator alone has been making the case for cheap tracker funds for six or seven years!

Indeed, a big reason closet indexing exists is due to the unreasonable demands of investors.

I’m not defending the financial services industry, but it’s worth noting:

Investors are unrealistic. They want market beating funds, but they don’t buy into funds that have had a bad year. Perhaps they even pull their money out of them. This means under-performing the index – even for a short time – is a big risk for the typical fund.

Now beating the market over the long-term is extremely hard, but beating the market every year is impossible. Not even Warren Buffett has done that – he has lagged the index plenty of times. The odd losing year is the minimum price of trying to beat the market.

Of course the fund management industry encourages us to believe otherwise – provided we invest with their people who work harder, smarter, later, or more photogenically. So no tears for the industry. But it does explain closet indexing to a large degree.

Fund management companies have little incentive to risk failure. For massive firms it makes much more sense to try to keep investors broadly content in order to collect those hefty fees, than it does to try to shoot the lights out and risk an exodus of money if you fail.

Career risk is another reason for closet indexing. Even if a fund provider wants its managers to really try to beat the index, it will probably fire someone who lags the market by 5% quicker than someone who lags it by 2%, let alone a manager who delivers 1% either side for a few years. If you’re a well-paid fund manager, wouldn’t you play safe?

The rise of computers and modelling has made it simple to determine variables such as tracking error. This data may be used by sophisticated investment committees and trustees to determine where their money goes. A fund naturally wants its numbers to look good.

Finally, active managers aren’t stupid. On the contrary, they are smart. They have read the same stuff you and I have read about the difficulty of beating the market, and while they may have some behavioural quirks that allow them to feel they’re special, they’re not utterly deluded.

The fear that they are being asked to do the impossible must gnaw away at fund managers sometimes.

Do they really dare shun HSBC, when it makes up nearly 10% of the index? Do they dare ditch BP, or GlaxoSmithKline? Look at all the controversy Neil Woodford has gotten into for refusing to hold oil companies in his much-lauded income fund – and he’s a deity among UK investors.

Can you imagine a 28-year old fund manager in a big institution who is managing a large cap UK fund being able to justify an eclectic pick-and-mix approach to the FTSE 350? Maybe avoiding all banks and oil companies, but going heavy on smaller industrial firms? And justifying it not just to her own boss, but to repeated rounds of big investors?

They’ll say it can happen, but the evidence suggests otherwise.

Don’t be a clone drone

The bottom line is if you want a shot at returns from funds that are sustainably different from the index, you will need to dig deeper into each fund’s holdings to see what it’s invested in.

In an ideal world, funds would clearly publish their active share in the fund literature, so you could identify a closet indexer at a glance. But for now you’ll need to check with sites like Morningstar, or else work it out for yourself.

Of course the bottom BOTTOM line is you shouldn’t go down this road at all. Investing passively into tracker funds is simpler, cheaper, and more likely to deliver better returns over the long-term.

1. See H K.J. Martijn Cremers and Antti Petajisto of the Yale School of Management’s working paper: How Active Is Your Fund Manager? A New Measure That Predicts Performance. [↩]