What would you pay?
by Doug Brodie
In this blog:
/1.What’s inside the grey box?
/2. Probable v possible: the cost
/3. Guarantees are contractual, dividends are discretionary
/1. Inside the grey plastic box…
Inside the grey plastic box is a slide rule: hand-held calculators only appeared en masse in UK schools in 1976/7. Prior to that complex calculations were taught on the calculator of the day, a slide rule (note: it never needs a new battery or sunlight to work).
It’s possible to do pretty much all the mathematical calculations you and I will ever need on this slide rule – possible, but very far from probable. Just because we could, that’s no reason at all for us all to rush out and buy slide rules, just in case we might need them.
We have a client whose career was in the insuring of passenger aircraft: it’s technically possible that all the engines could stop working at the same time, however if we believed that then air travel would simply not exist. That doesn’t mean aircraft will not crash, it means that is unlikely.
Widely regarded as one of the world’s most dangerous airports, ringed in red is a pilot’s eye view of the runway at Lukla, the entrance village for Everest.
Having navigated the ridges, wind sheer and other obstacles, the pilot is then confronted with all or nothing;
At the far end of the runway is nothing but mountain, so when the pilot is committed to landing, that’s it, there’s no Plan B.
Just because getting it wrong and smacking the mountain is possible, doesn’t mean it’s probable. Currently around 30,000 people fly into Lukla every year, with between 20 – 30 flights per day in season and with good weather. The last crash there was in 2019 when an empty aircraft hit a stationary helicopter and two guards on the ground were killed. This was a year after five people were killed in the Leicester FC helicopter crash, and we still have around 24,000 helicopter flights over London alone each year. Clearly many people believe that with flying, what’s possible is not actually probable.
/2. Probably v possible: the cost
In the case of the employees being switched out of their guaranteed pension at work, the employer gave an uplift of 25% of base salary as fair compensation. We know this is the right type of compensation because BECTU told us that the BBC final salary scheme cost the BBC as employer roughly 23% of salary.
With an inflation-linked annuity, not only is the cost 100% of your capital, it also cuts your income by around 40%:
A 62 year old, leaving 2/3rds income to a spouse from a £500,000 pension annuity:
With no increases the income is £2,606 per month (6.25%).
With RPI guaranteed increases the income falls by 40% to £1,547 (3.71%).
So do you need the cost of that word ‘guaranteed’? If you have guaranteed RPI-linked expenses then that’s a case of liability matching, and don’t forget you have a guaranteed state pension to cover basic costs (currently inflation linked, but who knows in the future).
What happens if you decide that you can deal with fluctuations in costs by letting your lifestyle expenditure soak up the blows. If retired your fuel cost isn’t for commuting so you can travel less, you can change around your household shopping, go out or drink less, all of which adds up: it’s a lot harder to cut living costs when you’re both working and juggling household bills for a family with growing children. That’s not you, so do you need to pay the enormous cost of to have inflation linking guaranteed?
/3. Guarantees are contractual, dividends are discretionary
A contractual liability is met by securing assets with a matching liability – when an investment guarantees to match RPI the only assets with an embedded certainty of meeting that payment are index linked gilts. These all have different maturity dates so you’ll have to try and guess how long you’ll need one – i.e. when you’re likely to die. If you’re 62 now, let’s pick 95, so that’s 33 years meaning we want a maturity in 2056-ish. You’re in luck, there’s a Treasury 0.125% maturing on 22/11/2056.
What does its label mean?
Both the annual coupon (the 0.125%) and the principal (the capital) are adjusted in line with inflation, RPI.
The current price is £67.17 and the coupon rate today is 0.0625%.
There’s no point doing the maths, purchasing an index linked gilt for an individual is simply not feasible, the base yield is just too low to be a rational decision, even though that income is then guaranteed to keep pace with inflation.
This is why we think guarantees are not necessary.
Possible, but not probable. Regular readers know my normal hobby horse for demonstrations is F&C (1868), so let’s look at Bankers Trust, five years younger starting in just 1888. This shows the dividend from 1993 (30 years ago, the length of a common retirement), which is then increased every year by RPI – i.e. it’s inflation linked.
The orange line is the 1993 dividend inflation linked – the blue line is the actual dividend paid and you can see that RPI linking was not necessary. This was not a one off, our research has shown this is a very common case with well reserved and diversified trusts.
If we then put all thirty of our core trusts together, equally weighted in one portfolio, the picture is this:
To compare to an RPI linked annuity, the annual income above is 55% higher than an RPI-linked and you also have 100% of your capital.
From an advisory perspective it is quite clear to that the price of covering off that ultimate ‘possibility’ is well outpaced by the option of the ‘probability’ – ie guaranteed index linked income is ridiculously expensive and very poor value unless it is absolutely needed.
Doug