There are a few ideas to do with money that are accepted as standard wisdom, that are taken as read and not challenged.
Why Are We So Obsessed With Accumulating Capital?
When we get to that nirvana point of having flexibility over our time, what is it that we want from our money? In order to spend time doing what we want to do we tend to require income, not capital (aside from repayment of mortgage, and even that could come from increasing income to cover payments and not repaying the mortgage – who benefits if you die owning your own home?).
We work for income. When we stop work it is income we need to replace. Slowly we accumulate wealth. Investment portfolios, houses, pension funds.
What do want from these assets? Ultimately, unless it is owned for fun, an asset is only as useful as the income it can provide.
It is income, not capital, that gives us options. Owning assets does not tend to increase financial wellbeing in the long-term. Experiences are the best form of wellbeing, not material things.
Pensions For Income
A pension fund provides us with income when we stop work. We don’t need the capital, access to the fund itself, we need something to live on which will replace that salary.
This was the principle behind the huge company pension schemes (then known as ‘final salary’ schemes, now known as ‘Defined Benefit’). The underlying fund which provided the income was not passed down to the next of kin upon death. There would often be an ongoing (albeit reduced) income for the surviving spouse, but after that, nothing.
Nothing to pass on to the kids. But nobody minded. It was income in retirement we needed.
And then Robert Maxwell fell off his boat and everything changed. His plundering of the Mirror Group pension scheme was uncovered and rules were brought in to protect members of company pension funds.
These new rules were so onerous that most of the larger companies shut down their Defined Benefit pension funds and changed them to Defined Contribution. Public pension provision was massively reduced as a consequence. Almost the only sector where the Defined Benefit pension scheme continues is the Public Sector.
But what have we lost in the process, besides the comfort of fixed income in retirement that so many of the older generation currently enjoy? It is income we need, not capital. For some, perhaps in ill health, being able to access the capital in a pension may be a good thing. For others, taking the whole pension as a lump sum, incurring a tax charge, and then reinvesting for income may not be a sensible move. Specialist advice should be taken by anyone thinking of taking pension benefits in any form.
Income gives options. We believe that pensions should be used to provide a subsistence level of income in retirement. There are other ways of saving and these should be used as well. However always bear in mind that it is predominantly income we need when we retire, not capital.
Investing for Income or Growth?
Where an income is required it is common to seek an investment which pays some sort of regular amount. This could be a property (rent), shares (dividend), perhaps a loan (interest) or maybe gilts (coupon).
An alternative approach, however, could be to take income from cashing in the capital.
Suppose you buy some shares for £100 and that pay a dividend of 5%. This means you get a regular income of £5.
Alternatively you buy a share for £100 that is paying 0% dividend, but the price of the shares rises to £105. You cash in the £5, which gives you your ‘income’.
One advantage of this route can be that you pay less tax. The income route may suffer income tax at your highest rate. Cashing in the growth means you can use your capital gains tax allowance, meaning you might receive the payment tax free.
Obviously this all depends on your circumstances (whether you need your capital gains tax allowance elsewhere, for example). It is also common that companies who distribute their profits to shareholders through dividends are less risky than companies who reinvest their profit for growth and therefore pay low dividends.
Nevertheless, it may be worth challenging the conventional wisdom that income should come from investments that pay income, and consider partial encashments of capital as an alternative.
This would count against investment in property, for example…
Houses Are For Living In
The British are well known for our obsession with owning a house. Where much of Europe is happy to rent, an ‘Englishman’s home is his castle’.
Residential property has produced eye watering returns on capital over the last 25 years or so. As a nation we are so desperate to protect the value of our houses we will do almost anything – after the Credit Crunch of 2007, which saw the collapse of major financial institutions which had placed too much reliance on property values, the housing market actually continued to rise.
This cannot go on forever. Property as an investment has worked very well, and may continue to do so, especially as a source of income. But the value of property can – and will – go down as well as up.
These points are not presented as fact. They are arguable, subjects for discussion. But if we are to focus on using whatever wealth we have to make us happy and not just to make us rich, then it is worth challenging some of the standard assumptions that we hold about money.