Where should an ex-Civil Servant invest their lump-sum?

[Brendan Burgess]

I have been asked this a few times recently and I am answering as follows.

A key principle is to diversify to reduce risk.

As your largest asset is your state pension, you are exposed to two risks which you cannot reduce

• A devaluation of the Irish euro
• A default by the Irish state

State pensions are not funded, so they must be vulnerable to a state default.



I don't expect either to happen, but they are a risk and the consequences for a retired civil servant would be huge, so they must choose an investment strategy which is not exposed to these risks.


Their investments should be invested in a non Irish currency. If they want to retain their money on deposit, they should move it to an account in Germany.


If they are open to shares, they should buy a portfolio of shares which is not overexposed to Irish currency - so a mix of continental european, British and American shares.



However, most Irish shares are well diversified and have only a small portion of their earnings in Irish euro. There is also a suggestion that a devaluation of the Irish euro would lead to an improvement in Irish exports and help Irish companies.

 

[Duke of Marmalade]

Brendan,

I am not sure I agree with this - shades of Jill Kerby!

If for example RCS puts her lump sum in sterling. Now she has real risk. Very good chance indeed of losing 10% or more over a few years.

Seems to me there is indeed a risk that her pension will be reduced because of the Troika but investing in sterling does not diversify that risk and it is difficult to see what would.

Personally I think she should fill her boots with Post Office Savings Certs/Bonds as I do not believe these are at any substantial Ireland Inc. risk.

 

[Brendan Burgess]

Hi Duke

A non-Irish currency would include the German euro. That seems to me to be safer.

I do not expect the state to become insolvent and default on pensions and on the post office. But I think that it is a risk. And it should be diversified against by not having all assets exposed to that risk.

Brendan

 

[Jim2007]

There is no such thing as an Irish or German Euro, consequently you can not reduce FX risk by shipping Euros around Europe, furthermore by moving deposits from banks with high T1 ratios to banks with much lower T1 ratios exposes you to the very real possibility of a default should the bank take a hit! I can not see how moving one's money from a well capitalised bank to a far less well capitalised bank in an unfamiliar environment can be seen as the wise thing to do.

 

[Brendan Burgess]

Hi Jim

If Ireland leaves the euro, it is very likely that deposits in German banks in Germany will retain their value. There is very little valuation downside in this.

Of course, German interest rates are much lower than those available from Irish banks

Brendan

 

[putsch]

Hi Jim

If Ireland leaves the euro, it is very likely that deposits in German banks in Germany will retain their value. There is very little valuation downside in this.

Of course, German interest rates are much lower than those available from Irish banks

Brendan

But in this scenario all bets would be off. How could you be sure that German would not introduce some strange limitations for non-residents seeking to access accounts. It'd be v expensive to litigate there.

Perhaps better the divil you know!

 

[Jim2007]

But in this scenario all bets would be off. How could you be sure that German would not introduce some strange limitations for non-residents seeking to access accounts. It'd be v expensive to litigate there.

Perhaps better the divil you know!

Exactly, in the next say 12 to 18 months or so there is a far greater chance a Europe bank taking a hit as a result of a trading loss or a similar event. We've already seen UBS hit for about €2.5b last quarter and it only managed to walk away because it's T1 is so high! If DB had to take a similar hit it could be a different story.

 

[Duke of Marmalade]

But in this scenario all bets would be off. How could you be sure that German would not introduce some strange limitations for non-residents seeking to access accounts. It'd be v expensive to litigate there.

Perhaps better the divil you know!

Absolutely brilliant and exactly how I read it. As of today there has been a massive transfer of Irish deposits to other Euro destinations, backed by ECB loans to Ireland, backed in turn by loans from the Bundesbank et al. A scenario where Ireland declares it will not back its comitments to the ECB, effectively an act of economic war, Germany may well not honour its comitments to Irish residents.

 

[Brendan Burgess]

As I have pointed out elsewhere, there is no area which is risk-free.

A German bank could collapse or the German state could seize the deposits or Irish residents. A more likely outcome would be that the Irish government would impose a tax on Irish residents' deposits abroad.

Of course, it doesn't have to be German deposits. It could be German shares, which opens up a whole new set of risks. But overall, I think it's better to expose different assets to different risks if at all possible.

Brendan

 

[Gulliver]

Divrsification changes the risk - it does not always reduce it. If I keep ten eggs in one basket, there is a chance that I might drop the basket and break all of the eggs. So I will take great care to choose a good basket. If I put the ten eggs in separate baskets, then there are ten risks that I might drop a basket. And I will have to use some poor baskets. Mathematically, the risks are probably higher on average.

Similarly, with investment, you can choose the best investment opportunity. By the time you have a diversified portfolio, you are likely to be into somewhat higher risks.

 

[Brendan Burgess]

Hi Gulliver

If I put the eggs in separate baskets, there is a higher chance that I will drop one basket and lose one egg. But if they are all in the one basket, there is a chance of a disaster and I lose all eggs.

Say I have two eggs and one of them is in Ireland and I have no choice to put it anywhere else. It is better to put the second egg in Germany. Now if Ireland or Germany goes, one egg will be devalued. It's less likely that both will be devalued. As it happens, I believe that the Germans are better at minding eggs.

Brendan

 

[Marc]

"What gets us into trouble isn't what we don't know, it's what we know for sure that just ain't so". Mark Twain

I understand that many people have concerns about the Euro but positioning ones portfolio as if the collapse of Euro is an absolute certainty and that this is the greatest risk faced by a retired civil servant is going to get a lot of people into trouble.

We don't know for sure what is going to happen but a collapse if the Euro is a huge outside chance compared to the risks posed by inflation, poorly diversified portfolios , loading up on hard assets like gold and diamonds, currency speculation or reckless conservatism from holding cash.

Much of the "advice" touted in the popular press is nothing more than opportunism taking advantage of people's concerns and willingness to follow the recommendations of a "guru".

The hedge against uncertainty is diversification so I agree in principle that the sensible thing to do here is diversify although some ideas about diversification are somewhat hazy.

But the focus should be on the risks faced by a retired civil servant and the portfolio should be tilted to cope with these specific risks.

Their pension looks like an Irish government bond with some inflation linking. You can even work out the relative size of the pension "fund" although in practice there isn't really one there. The revenue use a capitalisation factor of 20 times. So a pension of €50,000pa has a notional value of €1,000,000 in Irish Government debt as a claim against future tax receipts.

In the real commercial world that i live in it would actually cost about 25 to 30 times the pension to actually secure the pension benefits with an investment fund.

So, what are the risks here? Well, we have already seen increased taxation ( a form of confiscation of future benefits) and the effect of this is similar to another form of government confiscation of private wealth namely inflation.

So, Logically the risks faced by a retired civil servant that are most likely to show up are In the form of increased taxation and or inflation reducing the real value of the future stream of income payments.

So, let's assume that our civil servant has a property in Ireland worth a modest €500,000 they have no debt as this is cleared with tax free lump sums on retirement and let's assume that they have €300,000 in cash. These are reasonable assumptions in my experience for a typical retired civil servant.

How does their portfolio look?

Irish property 500k
Irish government debt 1m (I.e the notional value of their pension)
Cash probably in Irish banks or state savings 300k

Does that look diversified? Let me give you a hint. The Irish market represents 0.07% of the world's market capitalisation.

So, we get the 300k out of Ireland as fast as humanly possible and we buy equities with every last bit of it (except for an emergency fund which I'd leave on deposit).

Why this strategy?

Because we need to hedge the current portfolio with real assets (since the pension is simply a claim on future tax receipts) and because 300k out of 1.8m is only 16% of the total asset portfolio. Hardly a high risk strategy.

We certainly DON'T buy Irish equities. We need a global portfolio here. We would typically end up with around 12,000 stocks.

Now to be clear, I have simplified the process to make a point. If retired civil servants properly accounted for the cash equivalent value of their pension and the value of their home, they would naturally want to allocate a much higher proportion of their savings to equities as a hedge against uncertainty.

In any rational asset pricing model, the market portfolio is always a relevant portfolio. So whenever I meet a new client the process I go through is that I am going to put them into a globally diversified portfolio of equities. Now, what is it about this particular client that would make me deviate away from that? When it comes to someone with a state or semi~state pension this logic works well.

No need to worry about euros or Germany or Greece or anything. Diversification achieved. Job done.

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[RedDevil]

If the Euro does not break up
If Ireland does not leave the Euro
If the Irish State continues to pay its debts
The Best Bet for the Lump Sum is
the National Solidarity Bond and you have a choice of 4y or 10y

 

[Marc]

If the Euro does not break up
If Ireland does not leave the Euro
If the Irish State continues to pay its debts
The Best Bet for the Lump Sum is
the National Solidarity Bond and you have a choice of 4y or 10y

Let's assume that the average rate of inflation over the next 10 years is 4%pa and due to increases in taxation a retired civil servant suffers tax charges roughly equal to the inflation increases that they were expecting to be added to their pension. This is not a tax to reduce their current pension just restrict future increases.

Fairly reasonable assumptions I would think most people would agree and easier to sell to the electorate. In effect all I have done is apply a 4% levy to public sector pensions.

I could have expected an annual 50kpa pension to be worth 74kpa with inflation increases but due to the tax hit it is still worth just 50kpa in 10 years time. In effect I would have lost purchasing power of about 50% of my pension.

So, how have my savings done in the national-sold-you a -doubtful-bond to offset this fairly substantial hit in my standard of living?

Well, sadly they have also lost a little purchasing power with inflation averaging more than the interest rate over the period. Oops.

So, under any reasonable set of circumstances this would be a truely terrible recommendation for a retired civil servant.

We don't know this scenario will happen of course but the current liability of all current and future pension liabilities is about 108 Bilion Euro or two Namas.

Some creative accounting is going to be necessary.

 

[Brendan Burgess]

Hi Marc

I agree generally with your analysis. The problem I find is that most people are not prepared to invest in equities. They don't do the correct exercise which you have done and work out that 16% of their assets would be in equities. They think that they have 100% of their assets in equities.

I find people are asking "is Rabo safer than PTSB?" My first step is to "get the 300k out of Ireland as fast as humanly possible ". This is a major step for most people - so getting it out of Irish deposits into German deposits is, to me, a major reduction in risk.

Does that look diversified? Let me give you a hint. The Irish market represents 0.07% of the world's market capitalisation.

I disagree with this reasoning. The Irish market may represent 0.07%, but so what? The most important thing is what markets and what currencies the Irish companies get their earnings from. The location of their quote is not directly relevant. Irish shares represent about 70% of my portfolio. I would guess that around 10% of my portfolio is exposed to the Irish economy. Sure that is out of proportion to the 0.07%, but it's not an excessive imbalance.

When making this argument in the past, I argued that Irish companies were well managed and ethical. But this was wrong certainly in the case of the banks. I am not sure if it's generally true for our large companies such as CRH,Ryanair ,Aryzta, DCC etc. I think it is.

I think it's also more tax efficient to hold Irish shares directly than to hold overseas ETFs. It's certainly a lot cheaper.

So agree with you in principle. Invest the lump-sum in equities. But directly rather than in a fund. And check the ultimate source of the revenue for the companies rather than where they happen to be capitalised.

brendan

 

[tvman]

Divrsification changes the risk - it does not always reduce it. If I keep ten eggs in one basket, there is a chance that I might drop the basket and break all of the eggs. So I will take great care to choose a good basket. If I put the ten eggs in separate baskets, then there are ten risks that I might drop a basket. And I will have to use some poor baskets. Mathematically, the risks are probably higher on average.

Similarly, with investment, you can choose the best investment opportunity. By the time you have a diversified portfolio, you are likely to be into somewhat higher risks.

That is incorrect. It can be demonstrated fairly easily that by investing in multiple assets, whose returns are not perfectly positively correlated, the total risk of the portfolio (i.e. the volatility of its returns) is less than the weighted average risk of the component assets whereas the expected return is the weighted average expected return of the component assets.

 

[Duke of Marmalade]

That is incorrect. It can be demonstrated fairly easily that by investing in multiple assets, whose returns are not perfectly positively correlated, the total risk of the portfolio (i.e. the volatility of its returns) is less than the weighted average risk of the component assets whereas the expected return is the weighted average expected return of the component assets.

Gulliver has a point, tvman. I am sure that you are mathematically correct but try telling a RCS that her risk is measured by average volatility. That's how French banks thought back in 2004. They thought why not spread my euro sovereign risks amongst a few countries, like maybe Greece. Okay, they reduced the risk of complete wipe out from a French sovereign default but they increased the risk of some default.

Returning to our RCS and the Jill Kerby advice to put as much as you can in gold. Yes she has bought a hedge against some calamitous fall in the currency but she has taken on a substantial extra risk - gold has a very good chance of falling in value.

 

[Sunny]

That is incorrect. It can be demonstrated fairly easily that by investing in multiple assets, whose returns are not perfectly positively correlated, the total risk of the portfolio (i.e. the volatility of its returns) is less than the weighted average risk of the component assets whereas the expected return is the weighted average expected return of the component assets.

Ah these arguments bring me back to the good old days of investment banks when the mention of the word correlation and other buzz words such as Beta, alpha, standard deviation etc etc was enough to make bankers orgasm. Of course then they realised that assumptions about correlation were wrong and tail risk events were not as unlikely as first thought.....

Having said that, diversification is a good thing.

 

[Marc]

Brendan

The argument that some of the revenues of irish shares are earnt overseas is substantially missing the point.

The expected return on any stock is a function of the cost of capital to the firm not where it is listed as you correctly point out.

But investors do not need to subject themselves to an irrational home bias they can diversify their portfolios and reduce ideosyncratic risks. To suggest otherwise is frankly irresponsible from an investment perspective.

Be that as it maybe let's consider the old chestnut about tax efficiency.

What's the marginal rate of tax for domestic dividend income? It's got to be on the order of 55% currently. Whereas a distributing fund is subject to tax at 30%.

So if we have a stock with a dividend yield of 4%pa the marginal tax on the dividend directly equates to 2.2%pa.

Whereas in a fund this is just 1.2%pa.

That 1%pa difference easily covers the TER on a global equity fund with room to spare.

Also Irish stocks are subject to 1% stamp duty on purchase so I can cover dilution levies on purchase too.

So I can give you a fund with over 10,000 stocks more tax efficiently than you can buy CRH and of course CRH is going to be in the portfolio anyway.

One last tax point that is often used as a justification for poor diversification is the argument that there is no capital gains tax on death. My answer to that is simple; try explaining that to someone with Anglo shares.

I cover the subject of investing in Ireland in my latest market insight newsletter

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[davep]

I was reading the above thread with great interest until I came to this comment "So, let's assume that our civil servant has a property in Ireland worth a modest €500,000 they have no debt as this is cleared with tax free lump sums on retirement and let's assume that they have €300,000 in cash. These are reasonable assumptions in my experience for a typical retired civil servant." What an amazing assumption!!! I am a teacher and am thinking that after 35 years in teaching of taking retirement. The figures assumed in this thread are crazy! An average normal house at €500k ??????? €200k would be far more realistic however even trying to get that would be difficult in the present circumstances. However the assumption that one would have €300k in savings is totally detached from the reality of any person I know in the public service.