A big week for news. A Spring Budget that shifted the retirement savings goalposts like a giant tossing cabers, alongside a banking crisis still threatening to drag down US – and possibly European – banks, like giants gasping for air.
On pensions, do read the cracking comments to our article on Wednesday. We’re lucky to have informed readers who mostly take the time to flesh out their thinking when they post. You’ll learn as much from that thread as from any media article. Especially when many financial journalists seem confused as to how the Lifetime Allowance really works.
There’s no doubt this ceaseless pension meddling is a pain though – from how the Lifetime Allowance has been reduced over the years to Hunt going back on a pledge made just last autumn to freeze it until 2026 (making this week’s reversal potentially bitter and costly to anyone who had acted accordingly) to Labour’s response that they’ll – you guessed it – reverse the reversal.
I believe the Lifetime Allowance is bad regulation. But changing the pension rules every few years is even worse. Pensions require people to plan for several decades away. Yet we can’t be confident the rules will even outlast an election.
Those who can should probably take advantage of this latest pivot. But do your research carefully – and don’t dawdle!
Here today, gone tomorrow
As for the banking crisis, that story is changing daily. I just deleted a huge bunch of relevant links I collected over the week. Most of them – while admirable takes – have been overtaken by events.
The most interesting of these discussed how the failure of Silicon Valley bank is a sign of a wider shift in the venture capital ecosystem. But that’s pretty esoteric stuff from a mainstream perspective when a European bank like Credit Suisse is listing.
Now money can be moved in seconds online, bank runs seem to be just a Twitter panic away.
Perhaps my main takeaway therefore is US regulators seem to be deciding they can’t risk any deposit losses – because that risk even existing can drive deposit flight – and so they will in time legislate towards either full insurance of deposits or at least limits in the several millions.
Existing insurance schemes work by protecting enough small deposits to satisfy most of a bank’s customers that their money is safe. This gives the larger deposits a sort of free ride.
The theory is that protecting the little guys means a bank run won’t happen. But Silicon Valley Bank’s failure showed that model has limits.
Banks are still not boring enough
If we do see all cash deposits protected that would surely change the business of banking, both in the US and abroad (if only due to regulatory arbitrage).
Banks would become quasi-national utilities if the Government explicitly stood behind their balance sheets. And they’d be regulated as such.
On the other hand smaller banks (of which the US still has thousands, some of whom fail ever year) might get a leg-up. Larger banks wouldn’t benefit from Too Big To Fail status if, thanks to universal insurance and regulatory scrutiny, no bank could fail.
For what it’s worth I still think the drama is containable – not least because it has to be. The authorities can do what it takes, albeit we might be cleaning up the consequences for years to come.
As the Motley Fool said this week in a tongue-in-cheek letter to lawmakers:
[Imagine] how well your sensitive, musical instrument-playing children would fare in post-capitalist Mad Max wasteland.
Then add a zero to every number in your rescue package.
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Genuinely exciting developments today in the typically somnolent world of pensions. Chancellor Jeremy Hunt has announced he’s scrapping the Lifetime Allowance for Pensions.
Hunt is also significantly increasing the pension annual allowances.
The government will remove the Lifetime Allowance charge from 6 April 2023, before fully abolishing the Lifetime Allowance in a future Finance Bill.
The maximum Pension Commencement Lump Sum for those without protections will be retained at its current level of £268,275 and will be frozen thereafter.
The government is also set to increase the Annual Allowance from £40,000 to £60,000 from 6 April 2023. Individuals will continue to be able to carry forward unused Annual Allowances from the three previous tax years.
Finally the Money Purchase Annual Allowance will rise from £4,000 to £10,000 and the minimum Tapered Annual Allowance from £4,000 to £10,000 from 6 April 2023. The adjusted income threshold for the Tapered Annual Allowance will also be increased from £240,000 to £260,000 from 6 April 2023.
Together these are massive changes. Unusually sensible ones, too.
Good riddance to the Lifetime Allowance for Pensions
For anyone who is too young, who doesn’t earn enough – or who has more exciting hobbies to preoccupy them like macramé or reading obituaries – and so hasn’t been paying attention, the Lifetime Allowance for Pensions has long been one of the most complicated, counterintuitive bits of legislation in the whole tax maze.
See this summary of how the Lifetime Allowance works from The Details Man on Monevator. But set an alarm on your iPhone first –just in case you nod off while reading it and forget to come back.
Scrapping the Lifetime Allowance for Pensions on the grounds of tax simplification is good enough.
But the government’s avowed aim is to encourage older and typically higher-earning professionals to remain in the workforce for longer.
The thin end of this particular wedge has been the high-profile case of doctors. They have apparently been leaving the NHS in droves because, they felt, continuing to work no longer paid.
It was always more complicated than that. But suffice to say creating a fix just for medics would have sent an already cumbersome system into meltdown. Great for accountants but crap for the rest of us.
Plus it would hardly have been ‘fair’. Whatever that is taken to mean these days.
So – almost unbelievably after seven years of terrible decisions from the top – the Government has instead ripped the whole sorry thing up.
The Lifetime Allowance for Pensions was clumsy. It penalized investment success. It introduced all kinds of bureaucracy. And it was fully understood by no one.
We are well rid of it.
Less taxing for the moderately wealthy
I was as surprised as anyone to see the Lifetime Allowance for Pensions put to the sword.
But it’s particularly notable given the annual contribution allowance is being hiked by 50% to £60,000, too.
At a stroke, higher-earners can now defer a lot more tax – and for longer – than before.
However you can see these changes as potentially progressive if you squint a bit.
That’s because, as I noted above, the tax-free lump sum (nobody ever calls it the Pension Commencement Lump Sum) has been frozen.
It won’t even increase with inflation.
Presuming these changes remain in place indefinitely (spoiler: they won’t) then over time the 25% tax-free lump sum will become less valuable in real terms.
So higher-earners will be able to put more into their pension. But they will subsequently be taxed on more of it it down the line.
It gets rid of the complexity and edge case silliness of the Lifetime Allowance for Pensions. But freezing the tax-free lump sum means it isn’t all gravy financially.
The freeze of the lump sum allowance at a concrete £268,275 makes the increases in the other allowances more valuable for ordinary pension savers – who are more likely to have a 25% lump sum below that level – than for the very wealthy.
More flexible for today’s high-rollers
Still, this doesn’t make the other changes redundant for very high-earners.
If you’ve got a high but lumpy income, say – perhaps because you’re a freelance or an entrepreneur – or you expect to earn much more later in your career, then the extra headroom should be very helpful.
Tax relief on money going in makes pensions the best way to boost your retirement savings in a hurry. So being able to contribute more in a particular year (perhaps from savings) is a boon.
And while we must always remember that pension income is subject to taxation (unlike income that you take out of an ISA) there are ways to mitigate this.
So these changes do seem to be pro-enterprise. That is, the sort of thing we used to expect from the Conservative party before it was captured by its economically self-defeating lunatic fringe.
I said I was happy to see Hunt and Sunak take the reins after last year’s Mini Meltdown. This sensible suite of pension changes backs up that faith.
What do you think of the changes?
Of course the devil will be in the detail.
It will be interesting to see how the big hike in the Money Purchase Allowance might be put to use by FIRE1 types. Please share your thoughts below.
Also, I was already concerned at the growing stature of pensions as an inheritance tax (IHT) dodging vehicle before these changes were made. That light is now flashing red.
Presumably Labour will do something about it after the next election, and Hunt knows this. So perhaps it makes sense politically to let the opposition carry the can.
(I understand most of your lights flash green on IHT when mine flashes red. I’d rather let people get very rich on their efforts and tax the children who did nothing to earn it. Most of you seem to prefer to tax those who actually earn the money – given we have to tax somebody. Ho hum!)
Should we feel sorry for someone who bit the bullet and made decisions based on the existing system yesterday – or even this morning?
These changes always seem unfair to me on that front. It’s yet another argument for tax simplification – and then stasis, so we can all plan with confidence.
Finally, do you think it will achieve its aim of keeping people in work for longer? Perhaps that depends on how many people get the FIRE bug.
All told, these are the biggest changes to the pension system since the introduction of the pension freedoms a decade ago.
What do you make of them? Let us know in the comments below!
This might be a Mini Budget moment for the US. Its regulators moved yesterday to shut down Silicon Valley Bank and to take control of its deposits. It’s the biggest US bank failure since 2008.
Silicon Valley Bank’s shares had already been pummeled this week as the Californian lender tried to secure extra funding to shore up its balance sheet. But in the face of a bank run, its regulator cited“inadequate liquidity and insolvency” and pulled the plug, taking control of its $175.4bn in deposits.
Financial shares sold off on fears of contagion – even here in London – but this doesn’t look like a ‘Lehman moment’. However that doesn’t mean the failure is not significant.
Silicon Valley Bank was the dominant lender to the US venture capital industry, was the 16th biggest bank in the US, and it was valued at over $44bn at the end of 2021.
It’s failure is probably not systemically disastrous, except in exactly why Silicon Valley Bank got into trouble and what it reveals (again) about the state of the financial system.
Because its failure isn’t really due to troubles in the venture capital ecosystem that it serves – despite the well-documented collapse in tech and start-up valuations over the past 18 months.
No, it has been undone by our old and now clearly not so risk-free friend – fixed income.
On the run
At the height of the post-pandemic growth mania, everyone was throwing money at the venture capital sector.
The biggest VC companies ballooned. Some began to pivot their strategies to become permanent owners of the companies they funded. Meanwhile at the other end of the spectrum, VC newsletter writers and podcasters launched one-man firms and raised real money.
One way or another, much of this froth ended up on deposit at Silicon Valley Bank. As the FT explains, the bank then decided to park $91bn of these deposits into low-risk but – crucially – long-dated assets, such as mortgage-backed securities and US government bonds.
Well we know what happened next. But in case you’re still oblivious to the regime change, central banks around the world hiked interest far faster and further than anyone predicted. This crashed everything from blue sky tech firms to Amazon and Apple to the 40 in your 60/40 portfolio.
It also saw Silicon Valley Bank’s portfolio of safe assets that stood behind its customer deposits fall $15bn underwater.
Which wouldn’t in itself have been a problem – the assets have a positive yield-to-maturity, and will pay out their face value in the long run – unless sufficient depositors got scared and began to demand their money back in droves.
Which is what happened this week.
As economist Noah Smith explains in a comprehensive piece, the US FDIC scheme – the equivalent of our FSCS guarantee – was beefed up after the financial crisis to try to stop this happening:
Because everyone knows the federal government will cover their deposits, they aren’t worried about losing their money in a run, so they’re never in a rush to pull it out. And because they never rush to pull it out, runs can’t even get started.
For a normal bank, about 50% of deposits are FDIC insured.
But there’s a but:
But 93% of SVB’s deposits were not FDIC insured. So SVB was vulnerable to a classic, textbook bank run.
Why did SVB have so many uninsured deposits?
Because most of its deposits were from startups. Startups don’t typically have a lot of revenue — they pay their employees and pay other bills out of the cash they raise by selling equity to VCs. And in the meantime, while they’re waiting to use that cash, they have to stick it somewhere.
And many of them stuck it in accounts at Silicon Valley Bank.
Smith gives an excellent summary of how the run got started. It was down to the usual alchemy of initial lemming-like behaviour transforming into rational action once everyone else is at.
The consensus of opinion this weekend is that Silicon Valley is an outlier that over-served a concentrated customer base. And so that the rest of the financial system isn’t very exposed.
I imagine US regulators are pulling all-nighters to try to ensure that narrative holds over the weekend. Ideally they’d probably want to get the bank’s business shifted into bigger and safer hands by Monday.
However the episode is another example of the rapid ascent from near-zero interest rates leading to a mild calamity. We previously saw it with the Mini Budget-provoked pension crisis here in the UK, and I’d argue with the collapse and bankruptcy of much of the cryptocurrency infrastructure.
The more of these blow-ups we go through without a system-wide meltdown, the more confidence we’ll have that the financial system was sufficiently shored-up following the dramas of 2007-2009.
I mean, just imagine what would have happened to bank balance sheets following the collapse in fixed income asset values last year if they had still been levered-up like in 2007.
On the other hand, the more of these blow-ups we see, the more we might fear that one of them is going to get us eventually. (My best bet would be something connected to the global housing market.)
So let’s hope inflation calms and rates can stop rising soon.
The past year saw interest rates ascend from the murky depths of near-zero. What began as a gentle wobble expanded like some giant emission from the sub-aquatic crust below calm seas to – ahem – belch violently at the surface, causing shockwaves in all directions.
Hmm, my co-blogger The Accumulator makes these metaphors look so easy. Anyway you get my point.
Early last year I warned this regime change could derail early retirement plans by whacking equities and bonds. Mortgage rates would rise, too. Although on a brighter note cash savings would pay more. Albeit not, as things have turned out, by anything like enough to match inflation.
In the UK we eventually even got a government-induced Mini Financial Crisis, when a spike in bond yields threatened to blow-up the pension system and imperil the banks again.
And to my surprise, this shift is still not over. 18 months ago I’d expected inflation to have eased a lot by now. The longer high inflation lasts, the more likely it gets embedded via higher wages.
Policymakers are similarly bemused, if not panicked. They first talked of “transient” inflation. Then they unleashed a rapid succession of hikes. Then they arguably lowered their guard – only to see inflation fears now pick up again.
Bonds and equities have fallen recently as more and longer-lasting US rate rises are back in sight:
Rate expectations
What we are seeing here is the messy sausage-making behind the ugly word ‘normalization’.
We’ve gone back to a world where money is no longer almost free.
As much discussed, the inverted yield curve that has resulted from the rate hikes that got us here seems to predict a recession is coming. (Though the academic behind this signal has doubts).
Most pundits expect a mild slowdown. But I suppose a very deep recession could hammer the outlook for inflation and hence rates. Maybe we can’t entirely dismiss a return to near-zero interest rates – especially if the vast amount of borrowing out there limits how long high rates can endure.
However it looks much likelier to me that we’ve seen the last of policy rates of 0-2% from central banks for a while. That we’re back in a 3-6% market interest rate world.
That has consequences for financial products and services, and for government borrowing and business strategies, too.
Higher borrowing costs will surely inflict a correction on frothy residential property markets. Higher costs will also change how businesses raise money and where and why they invest. Zombie outfits propped up by low rates could finally go bust. There will be other winners and losers.
Banks for instance should do better in a higher rate environment, all things considered. They’ve become masters at finding other ways to make money rather than simply sweating their ‘net interest margin’, which was crushed in the near-zero era. But the alchemy of lending at higher rates and paying savers less is more forgiving at today’s levels. So traditional banking should do markedly better from here. (Barring a true housing crash…)
Elsewhere, any company sitting on a lot of cash will finally have the wind at its back – whereas such prudence was a drag on returns for over a decade.
But these won’t just be conservative companies with strong balance sheets.
We can also expect firms that take a lot of customer cash upfront – and then sit on it for a while – to report higher income from interest earned, too.
Many companies are in this position. It all depends on exactly when they pay their suppliers for whatever they sell their customers. A big delay creates a cash ‘float’ that can generate an income.
Cash in an investment account
However the most interesting winners from the return to higher rates from a Monevator perspective are the investment platforms and brokers.
Stephen Yiu – who manages the sometime market-beating Blue Whale Growth Fund – reminded me of this in a recent interview with the Investor’s Chronicle.
Yiu mentions his fund invested in US broker Charles Schwab explicitly on expectations of higher interest rates. That’s because Schwab earns interest on cash left idle in its customer accounts.
When risk-free rates were very low, this ability was redundant.
But with short-term US rates nearing 5% and Schwab boasting $7.5 trillion in assets under management, it’s almost a superpower.
Not all Schwab’s trillions under management will be in the right kind of assets or accounts. I just pulled up that $7.5 trillion total figure from investor relations. Plenty of assets will be, though.
Consider next that Yiu says 10% of customers’ money on Schwab’s platform is typically held in cash. Depending on what exactly you multiply by what, you can quickly forecast a huge income stream here.
All without any of the risks attendant with banking.
I remember seeing a similar dynamic when studying the results of Hargreaves Lansdown many years ago. Interest on customer cash back then contributed nicely to its profits. But this dwindled to nothingness in the years after the financial crisis.
Hargreaves scrambled for a fix for a while. It even worked up a peer-to-peer savings product, though this was ultimately scrapped. But today’s higher interest rates are a panacea.
Hargreaves’ revenue in its latest half jumped 20% thanks to higher interest income and customers holding more cash, presumably spooked by last year’s turmoil. That’s a nice hedge to the bond and equity downturn for the investment platform.
Indeed from its perspective, the best thing a customer can do is hold cash.
From its recent results:
Overall revenue margin [was] between 50 and 55 basis points, primarily reflecting the higher revenue margin on cash resulting from higher interest rates. The margin for each asset class being:
– Funds 38-39 basis points (no change)
– HL Funds 55-60 basis points (no change)
– Shares 30-35 basis points (no change)
– Cash 160-170 basis points
Notice that cash is by far the most profitable asset class for the broker.
How do you rate them?
Higher rates are good news for Hargreaves Lansdown and its shareholders, then. But what about for you and me?
Well I was dismayed to hear Schwab’s US customers leave 10% of their money un-invested.
Yet a quick glance at where customers keep their money on Hargreaves Lansdown suggests we’re even worse – with just over 11% of investment account assets held in cash.
To be fair, Hargreaves Lansdown does pay interest on this cash. From 1% to 2.4% right now, depending on what kind of account you have the cash in, and how much you have there in total.
As a quick comparison, rates seem a little higher at Interactive Investors. Whereas it appears that AJ Bell pays a little less. This is just my quick impression, you’ll have to break out the calculator and look at your own balances for an accurate comparison. And of course consider the total cost of investing.
We’ve thought about adding interest rates to our broker comparison table, incidentally, but the wide variety of permutations – and the frequent rate shifts – means it’s not really feasible.
Hence you’ll have to do your own research I’m afraid.
Money for nothing
Whatever your broker pays you on cash in an investment account, the point is those rates are likely much far lower than you – and your broker – can earn with the best cash or cash-like options.
Which is exactly why uninvested cash is a profit center for the brokers.
Investment platforms need to make money of course. Even zero commission brokers must get paid to stay in business.
Personally I’d prefer to see higher interest rates at the expense of higher explicit charges, at least with the mainstream platforms. (And lower foreign exchange costs while we’re at it. They’re dreadfully expensive at most platforms.)
However I’m in a minority. As with free banking, we’ve been conditioned to look for cheaper-to-zero explicit costs – and to not think about exactly how we’re the product as well as the customer.
Make any cash in an investment account work for you
The bottom line is that if we’re now back in a permanently higher interest rate world, then you need to have a strategy for what you’re doing with your cash allocation.
We have already seen skirmishes in this battle in the past few months.
For instance, there was the short-lived euphoria over the high interest rate Vanguard was paying – but this has since been reduced.
I suspect the previous charging structure was a legacy of the low-rate era that the investing giant hadn’t got around to updating until customers (and us!) paid attention. See the comments to that article for how things played out there.
My co-blogger is skeptical about these, but I see it a bit differently.
I definitely agree that if you want all the benefits of cash, hold cash. Any funds are riskier, even if those risks are tiny. Both in terms of volatility and risk to capital, but also maybe access in a crunch.
However if you have the bulk of your worth inside investment accounts – and a lot of that is in cash – then the extra income you could get from a money market fund paying you more than 3% versus a broker paying 1.5% could be meaningful.
And given how much we obsess over small fee differences around here, I don’t think we should lightly dismiss the cost of uncompetitive cash holdings. So perhaps putting a portion of whatever you want to hold in cash into a money market fund could make sense for some.
There are also fixed income ETFs that fit the bill. I own a big slug of the iShares Ultrashort Bond ETF. (Ultrashort in terms of duration, not in terms of ‘going short’!) This holds mostly investment grade corporate bonds close to maturity. It is very stable, can be disposed of in moments, and currently boasts a weighted yield-to-maturity of 4.7%, if you believe the iShares factsheet.
A better option though if you want to permanently own cash as part of your investment portfolio – to diversify your ‘bond-ish’ 40% or similar of your 60/40 portfolio, say – would be to start opening cash ISAs again. This way you’d get a tax-free and competitive return on your cash. And that cash would actually behave exactly like cash in a crisis. (That is, it would do precisely nothing.)
Just please don’t leave 11% of your portfolio lying around in your investment account as a generic cash balance on a long-term basis. You’re throwing money away.
Or if you do, then maybe also buy some shares in Hargreaves Lansdown or Schwab. That way you might also benefit from such folly!
