The wonders of arbitrage, and the impact of small percentages

Arbitrage is "practice of taking advantage of a price difference between two or more" .... of anything really. It doesnt make a difference unless the price difference is across A LOT of something e.g. 10p price difference per tin of beans, across 10,000 tins of beans (£1,000!), or unless it is done regularly.

Consider £100. It grows by 3% per year (what some people might consider the likely long term growth rate of stocks in the UK). Next year it is £103. The following year it grows again, not to £106 but to £106.09 - and the following year to £109.27. In the 37 years to my retirement it gets to £298.52 - so nearly three times as much. Pretty good, if it wasn't for the impact of inflation (which in late 2011 runs at more than 5%, so my pension pot is actually LOSING value).

But don't worry - there's dividends too. Those are payments that some companies make to their shareholders each year, out of the profits tha company makes. Tesco pays 4.06% in late 2011, British Gas owner Centrica pays 5.09%, and Google ..... well, it pays 0%. Let's say we are about (UK) average (US stocks tend to pay out a lot less), and we get paid a "yield" (i.e. the percentage of the share price) of 2.5% across all the shareholdings we own.

After 1 year our £100 has become £105.50, after two it's £111.30, after 3 it's £117.42 ..... all the way up to £725.01 after 37 years. We are in the money guys, and this is why investing your pension pot in company shares is a great idea.

Except hold on.....I am investing in the market through funds. I have to pay the fund manager. Suddenly that 3% + 2.5% = 5.5% per year needs to be reduced to take account of the fund manager charges. I learned about Total Expense Ratios (TERs) when I was trying to find out how much funds cost. One way of measuring them is the fund's own quoted Annual Management Charge but that seems to be a bit of a con - TERs are generally regarded as more representative. And the UK average TER? According to this Telegraph article it's about 1.6% (the article also says TER is also rubbish, but doesnt give a very acceptable alternative!). In Denmark, the cheapest in Europe, it's 1.49% according to this article.

So how does that affect my £100 over 37 years? Assuming the same growth (3%) and dividend (2.5%), in Denmark my fund manager would give me £428.33 back, and in the UK £411.88. I looked at my Scottish Widows TERs - one of them was 1.77%, so my £100 would only be worth £387.67.

I was looking at these numbers , side by side with this childish portfolio of random stocks recommended in The Week I was running through Google Finance. I was thinking about the guys with public school accents and hangovers. I was thinking, this is a complete joke industry.......

Who else sells you a service that causes you to lose almost half what it delivers you, without in many cases anyone even asking a question.

And the thing that drove me round the bend the most? Quantitative easing - Government-sponsored money printing (which always works) that made my funds worth loads more for about three weeks, then drop back in value again.

I decided that next time the Government announced it was printing loads of money, I was cashing in my chips at this metaphorical joint.....

So what changed?

I was pretty happy with myself at 28 with a pension up and running - plenty of people my age who I know haven't even got one, and that usually because they don't know the first thing about them.

I did hear once, probably from a pension fund manager, that you should contribute half your age when you start a pension, as a percentage of your gross salary, into your pension fund until you retire. By that calculation I should have been putting away 14% - i was doing closer to 25%.

When he'd advised me, Phil had pointed me towards Trustnet as a place I could track the performance of my funds. He'd given me a sensible selection - Fidelity's European and South East Asian funds, Invesco Perpetual's High Income (an investor's classic), Newton's Oriental fund, and Scottish Widows' generic North American fund. I'd added, for a reason I still do not recall, JP Morgan's Emerging Markets fund.

Being into the whole thing, I did what any new investor does and tracked the performance of the funds on almost a daily basis. I wanted to see my next egg grow and grow, and feel safe about my impending retirement (in 37 years time). What I saw was not encouraging - I saw ups and downs running into hundreds of pounds, with profit and loss percentages running in double figures and oscillating wildly. To compound matters, I was running a "virtual share portfolio" in Google Finance to see if I personally would be any good at this investing lark. It didn't oscillate wildly.

I began to look around me, at individual's I knew personally who worked in the pension industry. I started to ask "do i actually want to entrust (and pay) Bloggs to arrange my future?". Bloggs was often knocking off work earlier than me and dealt with more hangovers per month that I had in a year. I had also played with some spreadsheets as part of an arbitrage exercise and began to learn the impact of single figure percentages, compounded over years.

How it all started

In late 2008 my employer, a small consultancy based in London, decided to start offering its employees pensions. We got the business's bank manager down from the north of England to advise each individual on pensions in general, and specifically what the bank could offer.

I learned a good few things about pensions in the hour I spent with the bank manager:

1. Everyone is / was incentivised thousands of pounds to sell you a pension - which makes the selection by the adviser a bit "murky" to say the least
2. Common knowledge is to start early in life invested in shares (high risk, high growth potential), and migrate these across to bond-type investments (low risk with a relatively fixed rate of return) as you get closer to retirement
3. Outside the public sector and big businesses you are limited to cash-based pensions i.e. money goes it, it gets invested, then there's a lump sum at the end to buy an "annuity" (you give them all your cash, they give you a taxable income until you die - basically, its you betting against them). When they talk about "gold plated" public sector pensions, this refers to the fact that there is no risk as to how much you will get
4. Your cash is usually invested into funds i.e. you give it to someone, and then they invest it on your behalf - and in almost all cases it appears that open-ended investment companies (OEICs) are the only way to do this (something I later found out not to be the case). These OEICs are not charities, and you pay them both upfront to buy into their companies (say 5%) and then pay them an annual percentage of your total funds invested with them for the work they do (this varies massively). The OEICs tend to specialise in different areas - say the Far East, large UK companies, etc. - and the level of specialism generally dictates the level of fee. Obviously (OBVIOUSLY!) the performance of the OEIC far exceeds the fee and so you win and the fund manager wins
5. The Government wants you to invest in a pension (so they can cut the state pension down), so they allow you to do it tax free - so, if you put £1 in from your pay packet, they put 25p more in (basic rate tax payer) or 67p more in (higher rate tax payer). Its not all generosity though - they tax the money in 50 years time when it comes back out
6. Pensions MIGHT grow at an average rate of 5%, 7% or 9% before fees. Based on the past. Which is never a guide to the future.

Needless to say, I took the pension offer I was given by the bank manager (who was "tied" i.e. could only sell pensions from one company) to an IFA i knew personally for a second opinion. I got quite frank advice - to summarise, the bank offered me an AEGON Scottish Equitable pension, and it pays the adviser who sells it £3,500 cash for doing so. It was reputedly the highest commmissioned pension on the market at the time. It wasnt a bad pension provided you wanted to make absolutely no changes to the amount you invested per month or the OEICs you chose to invest in. So it was pretty inflexible, and not really suited to a footloose 28 year old in a job with a company that was very heavily influenced by economic conditions!

Great sales job by the IFA I knew - he talked me straight into a Scottish Widows Personal Pension, which paid him about £1,200 for selling it to me (the advisers have to earn a living for this work, so i don't begrudge them the commissions), was flexible about the amount I invested each month, and which OEICs i put money into. Phil, the IFA, even pointed me towards some funds to start me off - 30% US, 30% UK, 25% Europe, 15% Far East and Emerging Markets.

He even got me to opt out of the State Second Pension - so instead of the Government investing my second pension for me, I could do it through Scottish Widows myself. Great stuff - fits well with my anarchist tendencies.

I remember asking "what about a SIPP (Self-Invested Personal Pension)?" - that was something we'd talk about later, once I had a decent amount of cash in my pension which would make it worthwhile.....