It really is that simple
by Doug Brodie
/1. Guarantee? My bond is my word.
A final salary pension guarantees to pay you a pension every month till you die, with annual increases according to the scheme rules.
These are defined benefit schemes (DB) where the pension benefit is defined.
You’ll note there’s no confusion over the meaning of the word ‘pension’ when talking about DB schemes, yet the income definition gets conveniently lost by the industry when it’s a money purchase scheme.
Rachel Reeves has loudly been trailing her request that UK investment gets bailed out by pension funds. She’s not talking about yours and mine, she’s only talking about the large (HUGE) local authority and similar DB schemes. These have very long-term objectives, running over many decades, and indeed the Yale endowment used to outline its term at 150+ years.
You might wonder how such schemes can invest in long-term assets when they have immediate, current income that they must payout to scheme members who are already retired: simple, they use cash reserves and cash income. They have cash balances, cash producing assets (ring a bell?) and new premiums of cash paid in on behalf of working members. The one thing they do not do is attempt to use total return to pay their income liabilities.
Neither do we.
/2. Everyone’s heard of Warren Buffett – and yet the “Yes but”s.
Citywire published this week a comparison of the annual returns of Berkshire Hathaway, Warren Buffett’s investment vehicle. Its market cap has just gone through $1 trillion – a simply staggering achievement matched by no other investment company. The largest investment company by a.u.m. is Blackrock yet it’s a comparative minnow at a mere $130 billion.
Yes, we can be accused of cherry-picking on timing, however, the point is made that using the correct philosophy, executed with the correct strategy, and then repeating for decades, delivers everything needed. Buffett has always been very simple – use cash producing firms that have strong market presence and use the cash generated to pay back the cost of investment so you can do it again.
And it is very much active beats passive.
We don’t advocate using Berkshire Hathaway for many reasons, not least because it doesn’t pay a dividend; however, we use all these trusts which similarly demonstrate that active managers can beat passive, even with the additional hurdle of fees. Ponder on cost vs value…
For retirement income we’re not rocket scientists or investment gurus, we simply keep it simple and keep entirely focussed on income. As with DB schemes, investment trusts have cash and access to access, and they have continuing inflows from income paid to their investee portfolio – that’s all. And it works – what you see reflected in the table above is that income-paying investee companies tend to produce strong total return gains. Our clients’ own portfolios are simply their own personal DB schemes without the guarantees – isn’t that what every pension should be?
/3. Is it infinity?
Imagine you make a loan to someone, with a simple annual interest on the outstanding amount. Let’s say the loan is £10,000 repayable over ten years with interest at 10% of the outstanding amount. You’d receive £1,000 each year, and the interest you’d receive through the years would be £1,000, £900, £800, £700 ….£200 and £100. At the end of ten years all the money you laid out is back in your pocket, you have no capital at risk at all. Now imagine when you did the deal the terms also included an 11th year interest of £100 – what is the yield of that last interest payment? Yield is calculated as income over capital, and in that case, there is no capital so is the yield infinity?
The reason we ask is because of the table that we run through with our clients, where the cumulative income is calculated and when – normally after 16 years – the income has paid back the cost of purchase of the portfolio, is the ongoing dividend yield infinity?
Image credit: ESA/NASA/JPL-Caltech
/4. It's not just you
One trusts that whatever Ms Reeves decides is necessary with pensions – if indeed anything at all – we won’t see the streets taken over by our senior citizens. If there is ‘an amendment’ to pension benefits we know that that is just the same as most other developed nations, it’s not just us. France is a nation that thinks 62 is waaay too late for retirement, yet we are looking at 66 and 67 here in the UK.
/5. Oregon, Washington, Idaho and Dundee farmers 1888
In the late nineteenth century, several financial entities were established in Dundee to meet the demand from Scottish farmers emigrating to western US states including Oregon, Washington and Idaho. These entities were established to provide mortgages to settlers who used the proceeds to buy land and establish new lives for themselves in the US frontier states.
The three Dundee-based mortgage and land companies – the Dundee Investment Company, the Dundee Mortgage and Trust Investment Company and the Oregon and Washington Trust, merged in 1888 and renamed their investment vehicle the Alliance Trust. The capital in the Alliance Trust was sourced from British investors who were increasingly seeking investment opportunities abroad as the yield on UK government bonds declined in the latter half of the nineteenth century.
Over time the Alliance Trust broadened their investments away from mortgages for agricultural land. The “Dust Bowl” period of the 1930s had a devastating impact in many drought-stricken US states when severe dust storms led to farmers simply deserting their land leading to one of the largest internal migrations in US history. This led to the Alliance Trust owning large tracts of US land, however, shareholders subsequently benefited as it retained mineral rights to these lands whenever possible. Royalties on mineral discoveries amounting to tens of millions have benefited Alliance Trust shareholders in the intervening decades. The Alliance Trust continues to be managed to this day growing over time to become a constituent of the FTSE 250 index.
(with credit to the authors)