The curse of the defined benefit pension

Trapped in the world of pensions

I went to a very interesting finance seminar today. I work in public sector finance and the seminar was focused on defined benefit pensions the public sector and I tell you…the discussion left me perplexed.

For those that are not aware, a defined benefit (DB) pension is a workplace pension very common in the public sector (and historically available at large private sector companies but less-so now) where your employer guarantees you a pension income in retirement based on a predetermined calculation. Most schemes, mine included, also include life insurance as part of the deal. Here is an example (and this is a completely made-up scheme but loosely based on my current scheme):

  • You contribute 8% of your gross salary to the scheme
  • Your employer contributes 10% of your gross salary to the scheme
  • You work for 20 years under these conditions
  • Your accrual rate is 1/60th
  • Your gross salary at retirement is £60,000
  • In this example, you would be guaranteed to receive an annual pension at retirement of 20 years x 1/60th x £60,000 = £20,000, which is usually linked to inflation.
The typical reaction to pension calculations

So on the surface, this seems like a great deal right? As an employee you have a guaranteed income in retirement linked to inflation. You will have a stress-free retirement in exchange for a long and successful career in the public sector. Simple.

But here is the thing which became clear to me as I listened to the seminar: in a defined benefit pension scheme you will contribute an amount from your salary during your employment which has absolutely no direct link to the pension income you will receive. This is risky and means you have little control over when and how you you receive your pension.

Furthermore, in the current economic environment, the total contributions made into DB schemes are normally not enough to fund the scheme. With interest rates low and people living longer, the schemes are becoming riskier and the deficits higher. Eventually, the scheme trustees will have to either: (1) reduce pension benefits; (2) take on more risk; (3) require higher contributions into the scheme; or (4) CLOSE THE SCHEME. The problem is employers can’t increase their contributions infinitely and employees will start opting out of the scheme if employee contributions are too high. Employers then have to plug their pension deficits even more. It is a vicious downward spiral and the reason many private defined benefit pension schemes have closed.

Personally as an employee in the public sector, now that I have contributed to the scheme for a few years, I feel a bit stuck. I can obtain a valuation of my pension and transfer it to a personal plan, but then would lose out on the guaranteed pension in the future and the life insurance benefit I am currently receiving. In fact, the UK Money Advice Service states:

“Any potential advantages of transferring from a defined benefit pension scheme to a defined contribution one are often outweighed by the costs, risks and loss of benefits involved”

I am also worried about the possibility that the pension I think I am going to get when I retire is actually nowhere near the pension I will actually get because it simply isn’t affordable.

As I walked back to my car from the seminar, I reflected on my journey to financial independence and my hopes to retire earlier than the standard pension age. A specific part of the presentation stuck with me. The presenter spoke about the lack of freedom that one has in a defined benefit scheme.  He had a slide which depicted the three typical phases of retirement:

  • The first phase is the ‘ACTIVE PHASE’ –> this is the phase in retirement where the retiree is still active, traveling the world, visiting friends and family.  Spend in this phase is high.
  • The second phase is the ‘WIND-DOWN PHASE’ –> in this phase the retiree is less active and takes fewer trips as mobility starts to decrease. The retiree is still relatively healthy but less able to travel and therefore spend is modest.
  • The third and final phase is the ‘CARE PHASE’ –> this is where the retiree is elderly and requires increasing amounts of care, possibly in a care home. Mobility is close to zero and spend is very high (but likely funded through assets).

Looking at these phases, clearly retirees will want income to be geared towards the start of their retirement. This is when retirees will have high expenses that they do not want to fund through assets. However, inflation-linked defined benefit pension schemes provide the majority of their value towards the back-end of retirement. Only around a third of the value is realised in the first 10 years. And if I want to retire at say, 50 or 55, then my ACTIVE PHASE will be even longer than most. So does this mean my ‘gold-plated’ defined benefit pension scheme is less valuable then I thought? Perhaps.

Above all, the thing I have taken away from today’s presentation is the realisation that I must continue on my journey towards financial independence and debt reduction on my own terms. This does not mean I am considering withdrawing from my workplace pension scheme. To replicate in a personal pension the pension I would get through my workplace scheme I would have to invest around 40 to 45% of my gross salary (rather than the 8% I currently contribute) and even then it wouldn’t be guaranteed!  So I will continue contributing, but when running early retirement forecasts, I will reduce any dependence on workplace pensions and focus on robust post-tax investments to fund the majority of our early retirement years.

Five recent frugal victories

Screen Shot 2017-05-13 at 19.34.28

Since starting this blog a few weeks ago, I have become extremely focused on the actions we take as a family and how they affect our debt pay-off plan. In the past, we would spend throughout the month hoping we were within our budget, often getting to the end of the month, tallying the figures, and saying “oops, we overspent again”. Now, through the help of this blog, my whole outlook has shifted. I think about every transaction. And I now want to celebrate every small frugal victory in the knowledge that each small saving is a step towards financial freedom. Inspired by the #5frugalthings meme, here are five frugal victories for our family this week, big and small:

  1. I normally pay £2 per day to park at my work car park. On Thursday, I drove into work 45 minutes earlier than normal. I was so early that the car park attendant had not yet arrived (he arrives at 7.30am) and I got into the car park for free!
  2. I made a huge batch of vegetable soup last Sunday with leftover vegetables.  It was enough to feed me and Mr Small lunch for 3 days.
  3. I was picking up my son from a friend’s house and noticed his friend’s twin bed. I mentioned to the other boy’s mother that my son was still in a cot bed but we are planning to get a twin bed for him soon. She said she had a spare twin bed frame in her garage that she was going to donate and asked if I wanted it. “Yes please!” I shouted – perhaps a bit too excitedly. We will pick it up next week. 
  4. I completed a survey for a University research project and received a £5 Amazon voucher for participating.
  5. Not really a frugal thing, but I worked out the amount of SIPP contributions needed to push Mr Small under the higher-rate tax threshold and then set up a direct debit to transfer this amount to a SIPP fund each month.

I’m linking up with Cass, Emma and Becky in this week’s ‘Five Fabulously Frugal things I’ve done this week’ linky.

 

Our savings strategy

oli-dale-139169.jpgNow that I have declared our ambitious plans to pay off our debt and mortgage in 10 years, I suppose it is about time that I set out exactly how we might be able to do this.

It will not be easy, especially since we have debt from fertility treatments,  MBA tuition fees, and a house move. So yeah, it’s a going to be a long journey. Here is how I think we can do it:

  • Firstly, and this is absolutely fundamental to our plan, we are now living well within our means. Our monthly income is more than enough to cover our expenditure. Here is what our typical monthly income and expenditure looks like, including regular transfers to investment/saving accounts:Screen Shot 2017-05-12 at 20.01.25So even after £800 transferred to savings and investment accounts, we have £1,632 left over. Over the next year, this surplus will be earmarked to pay for the final year of my MBA course. We will hold it in our main bank account (we get 2% interest in there up to £5k) until the fees are due.
  • My MBA will be paid for in July 2018. At this point, assuming only minimum debt repayments have been made, our unsecured debt will total around £16,500. We will start to over-pay our highest interest (3.4%) debt by £1,000 per month. The £632 remaining will be kept in our main bank account for annual family trips and other non-emergency yearly costs.
  • Following this plan, our highest interest debt will be paid for by March 2019 and our next highest by June 2019. We will then only have our mortgage outstanding.
  • We plan to then snowball our debt towards the mortgage, plowing £1,416 into a  stocks and shares ISA on the premise that our mortgage interest is less than 2% whereas annual returns on stocks will be much higher than this. We will also divert our SIPP investments to the ISA so that it is not locked away for when we want to pay off the mortgage.
  • Finally, assuming all goes to plan (fingers crossed!) we will have saved the value of our mortgage in an ISA by April 2027 and exactly 10 years from now we will pay the mortgage off all in one go!

Here is my net worth forecast (excluding the value of our house and any emergency funds held in cash) at the end of December for the next 10 years if all the above goes to plan:

Screen Shot 2017-05-12 at 21.10.16

I have made some assumptions in working out these figures. They are:

  • We will receive an average of 5% annual return on investments in stocks.
  • Salary increases will not be invested, but kept for annual cost of living increases.
  • The ISA allowance will increase to £21k by 2020.
  • We will not incur any penalty to pay the mortgage off early.

I would be more than happy to receive any comments on if our plan could be improved in any way.

After the mortgage is fully paid, we will then work on retiring within 3 years from that. Using those dates, I will be 49 and Mr Small will be 55, at which point he can cash in his work final salary pension and SIPP. This may not seem like early retirement, at least compared to the extreme early retirees out there, but for us it will be less than 15 years after we start our financial independence plan and we would be absolutely thrilled with that result.

 

 

On the costs of conceiving a family

viktor-forgacs-140601.jpg

I have to let you into a secret that not many people know about me…

I am infertile.

Those three words are severe and harrowing for me to write down. In fact, I spend a fair amount of energy keeping my infertility hidden from nearly everyone. But it is the truth. And in an attempt to overcome this infertility, my husband and I have spent a stupid amount of money on medical bills over the past 9 years.

The brief backstory

After 4 years of marriage, my husband and I were having no luck in the baby-making department, so went to see our GP. Luckily we live in a part of the UK where the National Health Service (NHS) will fund fertility treatments if neither partner has another child. After 3 years and 13 free treatments, we had a successful IVF cycle and ended up with our loving, magnificent, cheeky 4-year old son, born in 2012.

Once he was around 2 years old we felt the strong urge to provide him with a sibling but we were no longer eligible for state funding so we decided to self-fund one more round of IVF.  We took out a £5,000 personal loan, went through the pain and stress of the cycle, and had nothing to show for it.  At this point, my husband and I were cognisant of our debt and knew that logically we should stop and enjoy our perfect family of 3. But when it came to family and emotions and thoughts of what ‘should be’, logic got clouded. At our follow up appointment at the fertility clinic, we were passed a leaflet.  In large letters next to a staged photo of a smiling chubby baby (of course!) was: “IVF plan with a money back guarantee. Finance available”.

In a what feels like a blink, and clearly under the haze of fuzzy logic, we signed up to a 3-cycle money-back guarantee plan. We paid £12,000 cash upfront for it and if after 3 cycles we do not have a baby, we will get 70% of this cost refunded.

Where we are now

We have now completed 2 out of our 3 cycles. We were nearly successful in the last cycle, but it ended in a miscarriage at 6 weeks. We are due to have our final treatment next month and today we went to the pharmacy to spend the usual £400+ on the first tranche of drugs.

I am ready for this to be over. I am ready to come to terms with our family size, whatever it may be and to stop fretting over what-ifs and uncertainties and possibilities. I am ready to focus on my family for what it is right now and to be grateful for it in its entirety.

The cost of creating our family has been financial and emotional. We are paying off a debt for a child we never had. With our new focus on financial freedom and simple living (and in the clarity of hindsight) it becomes obvious to me: society’s message that one child is not enough has led me to this point.  Society is wrong.  My son is definitely enough.

As we approach this last cycle I have had time to reflect on our journey to get here. If I had known then what I know now, things might have gone differently. During my soul-searching I have written a list of things I wish I realised before going into infertility debt.

Five things I wish I realised before going into infertility debt:

  1. The infertility industry is a business that profits on couples during a time of desperation. If you have failed in a previous cycle, they will try and sell add-on treatments, most of which have no empirical evidence to prove they will increase your chance of conception. But of course, the fact that an additional option is out there leaves you thinking: “maybe I just need that one extra thing and it will work”.
  2. Only children are completely and utterly fine and well-balanced and lovely. Research has backed this up. There is no requirement for a sibling and the bond between a parent and an only-child can be so strong and so beautiful.
  3. Having more than one child does not guarantee they will be friends as adults. I hear many people say that they want their children “to be there for each other once they are gone” or to “share the burden” of caring for them in old age. My husband and I are planning our financial independence now so that our child does not have to care for us in old age. Hundreds of thousands of people enter old age without any children and rely on alternative care without a problem. I have also come to realise, based on recent experience, that in many cases there is one adult sibling who ends up doing the vast majority of care for old-aged parents. This is a sweeping generalisation but I have seen it happen in my family a few times now.
  4. Some people know how many kids they want (if any) but some people will never know; it is okay to not know. I have a friend who has 3 children and feels a great deal of sorrow for the 4th child she wants but her husband doesn’t. I also have a friend who absolutely knows that 1 child is all she wants and is content to stop. If I were to have a 2nd child there will not necessarily be an internal switch that says ‘enough’. I could have a sibling for my son and still feel unfulfilled. My life is as full and satisfying as I make it.
  5. Going into debt for a child that does not exist yet is all too easy to do. Companies exist solely to finance fertility treatments and are charging up to 15% interest for loans to fund treatments. Their websites are polished and professional and filled with beautiful babies, but remember these are profitable businesses. Getting sucked into these deals during a time of desperation is hard to resist.

If we are successful in our upcoming cycle we will rejoice I am sure. If we are not we will look forward to a special, fulfilling life as a family of 3. All family sizes, from a single person on their own to a large family, are wonderful in their own way.

Importantly, whatever happens next month, we will not abandon our financial plans to pay off ALL our debt in 10 years. Paying off our debt is a gift to our future family, whatever size it may be, and we deserve it.

Net worth update: April 2017

Screen Shot 2017-05-01 at 08.44.27

Our net worth increased this month by £2,044 or 5.7%. This is a good increase for us. On average over the past year we have been increasing our net worth at a rate of only 2.5% so I am pleased with the increase, but also know there is still room for significant improvement.

The main driver for the increase was a boost to our savings accounts as we try and focus on building an emergency fund before tackling our short-term debts.  I cashed out £342 of matched betting profits in April and the stock and shares ISA also performed well.  I  opened up a savings account at our bank which has a 12-month bonus interest rate of 3%. I plan to put £400 per month in there over the 12 months.

The short- and long-term debt payments are the standard amounts, i.e. without any over payments.

 

 

Small successes: refinancing and cost cutting

green-chameleon-21532

It has been about two weeks since we have embarked on our ambitious plans to become completely debt-free in 10 years. I have been daunted (and haunted!) by this task and to be honest after crunching and re-crunching numbers am not convinced it is achievable just yet. That being said, we have had some successes in getting us closer to our goal and I am trying to focus on these rather than our debt mountain.

Financial successes this month:

  • Student loan – This loan bugged me, so after some reader advice, I went straight to the internet and found a better deal. I was quickly approved for a £7,500 loan through M&S bank at 3% over 5 years. I estimate this will save me around £1,400 in interest plus the monthly payments have decreased by £26/month. 10 minutes of research for a £1,400 savings – I’ll take it!
  • TV, Phone and Internet – Our monthly expenditure on TV, Phone and Internet was £102 per month, split as £44/month with Sky and £58/month with BT. After reviewing our bills I was convinced this could be improved, so Mr Small called Sky, threatened to leave, and they offered a combined package of TV, Phone and Internet for £55.20/month. That’s a savings of £46.80/month or £561.60 per year. I’ll take that! Note: I understand that Cable TV is a luxury and could be cancelled completely; however we enjoy watching family movies and TV shows and see it as a good alternative to going out and spending even more.
  • Shopping deliveries – We were paying £9.99/month with Ocado on their Smart Pass. This allows us to get unlimited home shopping deliveries. I am looking at our grocery spending and considering changing stores so I called Ocado and asked to cancel the Smart Pass. Lo and behold, they then offered the same exact product for £2.99/month with the first 3 months free. I took the offer.  I will now have 3 months  to look at alternatives without paying a penny for deliveries.  So the savings will be £9.99/month for 3 months and then £7/month thereafter if we stay with Ocado.

In summary, over the past 2 weeks we have saved £82.79 per month in regular outgoings. This is not life-changing savings by any means, but we can put that savings directly into our emergency fund. It also means that all our debt is at a 3% interest rate or less. After a useful reader comment, I have now decided to focus on our emergency fund rather than debt overpayments to try to build it to £10,000. We have 2 old cars and need both of them for work, so I want to make sure our emergency fund will at least cover the cost of 2 new (old) cars. A decent used car can be purchased for £5,000, a price which also falls comfortably within Financial Samurai’s one-tenth rule.

Note: I am not affiliated with any of the above products and do not endorse them in any way. The savings realized above are based on my personal circumstances only. 

 

 

Breaking it down: My family’s balance sheet

After my very first post where I declared my family’s mission to pay £285,000 of debt in 10 years, I think the next step, as scary as it is, has to be full disclosure of our assets and liabilities.

Family balance sheet the end of March 2017

LIABILITIES: £284,868

Mortgage = £262,913 (1.89% interest rate)

Yikes, that is high – but it is not as bad as it seems! Even though we have such a large mortgage, it is secured against our house and the UK housing market has done really well over the past 3 years. We purchase our house in December 2013 for £307,500 and the value is now estimated at around £370,000. That equates roughly to a 6% compound annual growth rate. Considering our interest rate is currently only 1.89%, this means we have been increasing the equity in our property year on year. We are due to re-mortgage our 2-year fixed rate deal later this year and will post more about this on a future post.

Unsecured bank loan = £14,590 (3.40% interest rate)

This bank loan has been in place since October 2013 and we have added to it over time. We initially borrowed £12,000 for moving costs when we bought our house in December 2013 (see above). Since then we borrowed an additional £3,500 in 2014 for an emergency car repair, £5,000 in 2015 for medical costs (more on this in another post), and £8,120 in 2016 for MBA tuition fees. Each time we borrowed we lowered the interest rate and have ended up here. We have paid off the balance aggressively at various points, but always in short spurts before something else came up. So in total, we have borrowed £28,620 and have about half of this left outstanding. I want to tackle this debt as soon as possible but not until we tackle the student loan.

Student loan = £7,365 (8.00% interest rate)

This debt annoys me because the interest rate is ridiculously high. I took it out from a private student loan company at the end of 2015 to pay for the first year of my MBA which started in January 2016. At the time, the loan seemed perfect because the repayments are only £40 a month. I foolishly overlooked the high interest rate, telling myself I would just make large over-payments and wouldn’t end up paying much interest. Of course, something else came up (like the second year of my MBA!) and here I am with this debt 18 months later. We are currently overpaying an additional £120 per month to this loan and we have it in our sights as the very first victim of our debt repayment mission! I am currently researching my options to refinance this debt.

ASSETS: £320,821

Home = £307,500

This is the purchase price of our property in December 2013. I do not like to revalue our home to its market value, which is estimated at £370,000 because this is unpredictable. The first home my husband and I bought in 2006 sold for the same price we bought it for 7 years later (bad timing!). There is no way to predict that the UK housing market will not crash again. We also have other assets in our home, such as cars, televisions, computers, but I do not value these for the purpose of looking at our net worth as they are depreciating assets.

Cash = £7,045

We get a decent interest rate in our bank account so we keep a fair amount in there for liquidity. We have this cash earmarked for the final year of my MBA so have no plans to invest it.

Investments = £6,276

We have a regular deposit being invested in equities via an ISA, a UK tax-efficient savings scheme. I have found a great investment product that has super low management fees. I will talk more about this another day. This full fund is earmarked for our son. We want to put money aside for him for when he is older. However, having researched more about personal finance, I am not sure at the moment how important this fund is. There is part of me that thinks my son should earn his own money and that this balance would be better used for debt repayment or as an emergency fund. I’m a still dwelling on this fact, but for now will continue to deposit £100 per month to this investment pot.

Pensions = ???

I do not know what to put down for this figure. My husband has £25,500 in a Self-invested Private Pension (SIPP) but he cannot access it until he is 55 at the earliest, 13 years away. My husband and I also both work in the public sector which means we have defined-benefit pensions. We contribute a percentage of our salary (around 8% each) to a large fund that our employers top-up. For this contribution, our employers promise that we will receive a pension payment on retirement based on our average salary during employment multiplied by a percentage based on the number of years we worked there. This makes it very difficult to calculate a pension asset value because (i) we do not know how long we will be at our employers, (ii) the pension plan formulas could change, and (iii) whatever annual benefit we receive lasts until our death. So at the moment I am leaving all pension assets out of my net worth calculations, though I am certain they would be quite valuable.

So there it is, laid out plain and simple. Our first task must be to pay off that horrible student loan. To do this, I am going to be looking at our income and expenditure budgets very closely over the next few months and try to increase the rate at which we can overpay that loan. In conjunction, I  want to look into refinancing the loan. I think we can easily pay the loan off by the end of 2018, but I want to see if we can do it by the end of 2017! I will delve into our monthly income and expenditure in the next post.