6 Vital Questions You Should Ask About Any SIPP Or SSAS Investment BEFORE You Part With Your Money
Which SIPP Or SSAS Investment: 6 Vital Questions
Question 1: Does This Particular Investment Fit With My General Strategy?
Question 2: Do You Understand Your Potential Investment Thoroughly, Or Are You Willing To Learn?
Question 3: How Much Of Your Time Does This Investment Require?
Question 4: Do Your SIPP Investments Benefit Your Non-Pension Income Or Taxes?
Question 5: Do You Have A Due Diligence Plan?
Question 6: Do I Need Advisors For Any Portion Of This Investment?
Question 1: Does This Particular Investment Fit With My General Strategy?
Before looking at any specific investment, you should know what you want your investment to do. I personally would like an investment that has:
My Ideal Criteria
- High current (cash) yield
- High potential for increased capital gains
- No chance of loss of capital
- Favourable tax treatment
- Flexibility to draw out the money whenever I want to
- Almost no time requirement from me to manage it, and...
- I would like to make the world a better place whilst doing it
This would be ideal. Unfortunately, no single investment meets all of these requirements. There are trade-offs to be made. I have to scale back my expectations, just as everyone does.
If all of my ideal criteria could be met by each and every investment, there would be no need to decide what your pension is doing. We would have it all. However, since the perfect investment does not exist, we must make trade-offs, and that means prioritising what is important to you. That means making an investment strategy.
Government bonds may be guaranteed and can be sold easily for cash, but the yields are low, and the sale value might be less than you paid if interest rates have risen since purchase.
Real estate might yield higher returns both in current cash flow and in potential for growth, but it is neither easy nor quick to sell. It may lose value and requires time to manage. There are tax advantages.
A technology venture might have a potential for high capital gains, but there are no interim cash flows, no guarantee, the time of getting your investment back is uncertain, and there is a chance that you could lose all of your investment.
Listed shares take no time to buy, but a lot to analyse. There is no guarantee against losses, though there is a high potential for gain.
I think you get the idea.
Let’s look in more detail at a few of my ideal criteria, and some other criteria. Which ones are crucial and which ones are less so?
To start, if you are investing via a SIPP, you probably do not need a favourable tax treatment. You already have that due to the fact that you are using a tax benefited SIPP.
Timing Of Returns:
If you still have time before retirement, then you do not need cash flexibility. The SIPP, just like any other pension, prohibits taking out returns until retirement. You can go for higher returns with less liquidity at least until your retirement time. Even after retirement, you do not need to take all your money out at once. You can leave well yielding investments in the pension during retirement to generate on-going returns. There is a possibility of getting 25% of your investments out tax free at the moment of retirement, but the remainder can still be in less liquid instruments. Before retirement, you can probably be indifferent to whether the investment has high current yield in cash or through capital gains, at least until your retirement day, probably even after that with a portion of your portfolio.
If you have decided to have a SIPP, you have already decided to spend time doing it yourself. How much time is that? Perhaps you are looking over your stocks once a month. Alternatively, you might be rushing through a flurry of initial activity to look for a private company, followed by a time of inactivity waiting for the returns to materialize. Perhaps you will be managing rental property, requiring time for the initial search and purchase, followed by periodic maintenance and the occasional arranging of a new renter after one leaves.
Does the time that your strategy requires actually match the time you can commit to running your pension and the time you want to commit? I have seen many self-directed investors have difficulties because they did not accurately estimate how much time they could or would put in. Either money was left un-invested for long periods, or was invested without sufficient care and this led to losses.
Size Of Each Investment:
Technically, this is called “Money Management” but that term may be confusing. It sounds like “cash management” which it is not. The issue here is how large each individual investment should be relative to your overall portfolio. If your largest investment went bust, how badly would this hurt you?
To put this in perspective, professional traders risk no more than 2 or 3% of total assets on one trade. A real “gunslinger” (risk taker) might risk 5% at a time. In general this is good advice. There is a complicated mathematical formula to optimise the size of the ideal investment given expected return and potential loss, but in general, you should not risk more than 5% in one investment relative to your entire pension.
Do not worry if you have invested more than 5% in a particular asset, for example 20% in one property. It is not the investment amount that should be limited, but the risk. If your property is insured, your risk versus damage is limited to the deductible on your insurance policy. This could be £500 or £1000 for most people, which is a smaller amount than what was invested. Estimating the potential loss from a property’s fall in value is trickier and depends on whether or not you can hold the asset through a down turn and whether or not it is currently yielding well. The point here is that the risk of an investment can be lower than the invested amount, depending on how you manage the asset. “Manage” can mean a lot of things, such as insuring a house, having enough rent to cover a mortgage, regular maintenance and so forth.
In some cases, the risk is the entire amount invested, as would be the case in most private companies. Some assets can even have higher risk than the amount invested. For example, with spread betting and trading on margin, your losses may exceed your investment and the broker has the right to get the excess losses from you. I am not recommending these investments. I am only using them to illustrate that amount invested and amount at risk can be quite different.
Interestingly, it is possible with real estate to lose more than you invested. If you buy a property using a mortgage in the UK and the property loses a lot of value, the bank can take the house and still come after you for any difference. It appears the risk of a market downturn in prices might be a bigger risk than the risk of damage to a property.
One way to manage this risk is to have a high cash return on the property. As long as you are able to cover the mortgage, there is no reason the bank would foreclose on you. You could wait out any downturn in prices. Of course, if rents drop at the same time, this strategy might have difficulty.
Furthermore, if you are still some time away from retirement, the amount you invest could be a larger portion of your portfolio, larger than say 5%. This is not conflicting with the 5% rule of thumb when you consider future investments. For example, a 30 year old might put the entire pension fund in one attractive investment. Even if this investment made a considerable loss, perhaps losing all the money, the 30 year old would have time to recover before retirement. Future contributions to the pension fund would be invested further. Although the investment was a larger portion of the current portfolio, it was a much smaller portion of the current portfolio plus future contributions and future earnings in the pension. This is why I earlier underlined the phrase relative to your entire pension. Of course, a person one day away from retirement, or already in retirement, might be better served keeping more strictly to the 5% rule.
Mark Twain’s One Basket
Mark Twain once turned on its head the phrase “Don’t put all your eggs in one basket,” by quipping, “Put all your eggs in one basket and watch that basket really well.”
The point about size above makes the point to keep risks for each individual investment low. In the extreme, this might suggest that a portfolio with a thousand investments is better than one with only four. However, how can one individual (which is often the case for SIPP investors) understand 1000 investments? If you have too many investments, you are taking a different type of risk, the risk that you do not understand those assets. This leads to Question 2. Before I go into that, however, let me discuss a couple of basic strategies.
The following are basic strategies that anyone can use. Even if you do not use them, you should know them. They form a type of basic target. By comparing any strategy with the following, you will be able to identify good and risky portions of the strategy. Comparing strategies is a good practice.
Start making Sample Strategies
The above discusses that you need to make a strategy, but not how do you do that. The best way is to make a strategy and see if you like it. Let me show a few strategies.
Insurance companies sell annuities, which is a fancy word for a stream of cash flows. You give a lump of money to the insurer and they pay you a stream of cash flows. The cash flows may be delayed, or grow over time, or get indexed to inflation or a host of other options. Usually the stream of cash flows will pay you for the rest of your life, though it is possible to buy annuities for a fixed term.
I will not buy annuities. This is a personal choice and you should not take this absolute advice. The primarily reason for me is the low returns. Rates vary all the time, but at the moment, pay-out rates for a male retiring at age 65 are about 5%. This means that for every £100,000 I pay at age 65, I receive £5,000 for each and every year for the rest of my life. Don’t get pay-out rate confused with yield or return. The return on this investment is much lower than 5% because I never get the £100,000 back. A bond with a 5% return pays back the principle at maturity. Annuities have no maturity and they never return principle. If I got the principal back at some time, for example if it went to my heirs on my death, then the return would be 5%. However without the return of principle, the return is more like 1% or 2%, depending on how long I live. Some could even have negative returns.
How do annuities score with the criteria I listed earlier? It is guaranteed. Also, it takes very little time to buy and no time to manage. Other than these two positives, annuities score poorly. The return is low. There is no chance of capital gains. I am sure to lose my capital which is worse than merely a chance of losing it. There is no real chance of getting the cash back if you need it. There is no tax advantage. And I certainly do not feel I have improved the world by investing in an insurance company.
Like I said, I will not invest in annuities. This does not mean it is bad for you, and certainly this is not my advice. This is only my personal conclusion.
Another reason that I do not use annuities is that I could do better with governmental bonds, which leads me to my next strategy.
I could invest in governmental bonds. At the current time, UK 10-year bonds (gilts in the investment parlance) yield about 2%. With longer date bonds you might get 3%. This is a lower pay-out rate than annuities, but I do get my principle back. If I really needed £5,000 per year for every £100,000, I could dip into the principal a bit. I would still be having most of my principal come back, so this situation is better than annuities.
How do governmental bonds score on my list of ideal criteria? They are also guaranteed and take little time to buy and virtually nothing to manage. They do return principal, which I think counts for a lot. Even if I die, the principle will be left for my heirs. Furthermore, if you need the cash, you can sell them to get your money back. The amount might be less if interest rates have risen. The amount might be more if interest rates have fallen, which I suppose counts as a potential capital gain, albeit a limited one. Other than that, there is no tax advantage. I am mixed on the question about this investment making the world a better place.
Like annuities, the low return probably decides my opinion for governmental bonds. I will not use governmental bonds as my long range strategy.
However, I might use them as an interim strategy while I am figuring out my eventual strategy. The ability to sell them to get my money means they are a reasonable place to park my money while working on a strategy, or while looking for specific investments for my long range strategy.
By the way, governmental bonds do occasionally default, as we have learned in recent years. The UK has not defaulted for a long time, but it is worth mentioning that any “guarantee” is only as good as the guarantor that promises it.
Other Strategies Focus On Higher Yields (And Get No Guarantees):
Annuities and governmental bonds may not be the right investment for you in the same way that it is not the right one for many others, namely the yield is too low. By looking at those strategies, we can see one important element in our requirements: higher yields.
How high should your investment yield targets be? That is like asking, “How long is a piece of string?” There is no real answer. Higher than governmental bonds is a good place to start. However, while you are looking for higher yields, probably the first thing you will give up is a guarantee. So, do not let stated yields fool you. One investment which promises 8% and is backed by real estate might be more attractive than a technology company promising to triple your money. The supposedly higher yield may be less certain, and probably is unlikely to pay out.
Once you have left the arena of guaranteed yields, you begin to take risks. The reason you will make more money is because of the time you put into understanding the risks, limiting the risks and having a strategy. The higher yield is a payoff for your time and consideration.
How will you decide your long range strategy? One of the best ways to make a strategy is to look at individual deals. By learning each intimately, you will get better at analysing deals. Eventually, you will find a style of deal that you will feel comfortable doing repeatedly. It could be rental properties, or security trading, or solar panels, or technology companies, or ... something else.
But before you make a portfolio of good deals you have to start with one. So, start with one that you are interested in.
About Dr Matt Modisett
With more than 25 years’ experience, Dr Matt Modisett PhD FIA ASA MMA has spent his career in investments and insurance. He's worked in the USA, Japan, The Netherlands, Spain, Belgium, Hungary, Australia, and the UK. He was formerly a Chief Investment Officer for an insurer, Asset-Liability Manager for three insurers, and has consulted for many years, all for top tier institutions. He has served as Professor of Actuarial Science and also as Professor of Finance.
He holds a PhD in Mathematics, is a Fellow of both the UK Institute and Faculty of Actuaries and the Hungarian Society of Actuaries, and is also an Associate of the USA Society of Actuaries. He has numerous publications to his credit.
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