How to invest in the UK stock market

So you want to invest some of your pension savings into the UK stock market. This post will show you an averagely clever method of doing this. The method is simple and low-maintenance.

There must be smarter ways of investing but, sadly, I do not know them at the moment.

The simplest way of investing in the stock market is to invest in all traded stocks proportional to the market share of each company.

Following the market is not as silly as it sounds. There research saying that in the long run most managed portfolios under perform the market. I believe this. At the same time I also believe that some investment funds do manage the consistently beat the market. I just do not know which ones they are.

What return is normal?

In the last 40 years, the FTSE All Shares Index increased by a factor of 16 which means 1% annually after correcting for inflation (using PRI inflation index) on average. However, there were years when the index lost more than 25% of its value within a year. These bad times were 1988, 2001-2003 and 2008-2009. The biggest year-to-year drop in FTSE All Shares Index was 43% and it was in October 2008. On the bright side, there were also periods of explosions in stock valuations.

Stock appreciation, which is what indices measure, is one way in which you benefit from owning stocks. The other one are dividends.

So how much return can one expect from dividend payments?

It is surprising hard for find good data on historical UK dividend yields. In the absence of an "official" source of this information, I gathered and cross-checked a number of different sites. We have:

• a Bank of England's paper showing average long term historical yields between 3.5% and 4.5%
• a blog about retiring early shows a similar spread in the last 7 years
• a multi-threaded Guardian article quoting the average dividend yield between 1999 and 2013 at 2.1% (but this estimate is too pessimistic because it uses the maximum index value in the denominator)
• a random website showing average market yield between 2003 and 2013 at 3.8% and a similar number for top 100 companies

So the number ranges from 2.1% to 5%. This is already adjusted for inflation. Perhaps we can assume that the dividends are 3% a year on average.

Therefore, in total we have 1% + 3% = 4% above inflation as the average historical stock market return.

How to do it

You can of course buy all the shares quoted on London Stock Exchange in proportion to each company's share of the market. This is theoretically exactly what we want but the admin and transaction cost of owning hundreds or even dozens of shares makes this option totally impractical.

A more sensible option is to buy units of an index tracker. Trackers follow a market index and pay dividends just like holding the actual stocks would.

Some stock index trackers offered by different providers on the London Stock Exchange are:

• Vanguard FTSE 100 (VUKE)
• iShares FTSE 100 (ISF)
• DB X-trackers FTSE 100 (XUKX)
• SPDR FTSE All Share (FTAL)

(I am not recommending that you buy any of the above, I am not a financial advisor, this is just research I found useful for myself.)

How much it costs

At the moment the cheapest tracker to own is Vanguard FTSE 100 (VUKE). Using VUKE as an example, the cost are:

• admin expenses equal 0.1% of your savings annually
• there is a market sell-buy spread, currently 0.13% which you need count in because you will be buying once and ultimately selling once

So, if you own a fixed amount of VUKE for 30 year this will cost you 0.13% + 30 x 0.1% = 3.13% of your final retirement savings. This is 0.1% annually.

It will cost you approximately half that amount if you are starting from zero and will be regularly buying the tracker over the next 30 years. This is because in this scenario, on average over the 30 years you will own half of your final savings.

Over 3% on admin expenses seems a lot. But most pension funds cost way more. I just checked admin expenses of my old pension plan from work and they are 0.35% annually. This means that if I keep this fund for 30 years, it will cost me at least 30 x 0.35% = 10.5% of my final savings.

How much pension savings do I need?

Once you retire you will not be making money anymore. But you will still need to spend money.

For this to be possible you basically need to accumulate enough savings and entitlements to cover your spending after you retire.

The amount of savings and entitlements you need to accumulate equals the cost of your anticipated lifestyle after retirement multiplied by the time you expect to be retired.

Let's look at this equation in more detail.

How long will you be retired?

The first questions is when you are planning to retire and how long you are likely to live afterwards. It may feels depressing to contemplate this. So let's think about it just once and then write down the estimate and forget the matter.

How long you are going to live after retirement depends on factors like your gender (women live on average longer than men), genetics, health, wealth and lifestyle. There are large differences in life expectancy between people living in different geographic areas.

On average though, in the UK in year 2014, when you retire you can expect to be retired for the number of years summarised below. The reason your retirement will be longer if you are young now is that life expectancy after retirement increases by approx. 2.5 years every decade as the society advances.

	If you reach your desired retirement age soon *		If you reach your desired retirement age in 20-30 years **
When do you want to retire	Male	Female	Male	Female
at 55	26.5 years	29.5 years	34.5 years	38.5 years
at 60	22 years	25 years	28.5 years	32.5 years
at 65	18 years	21 years	23.5 years	27.5 years
at 70	14.5 years	16.5 years	19 years	21.5 years
at 75	11 years	13 years	14.3 years	17 years
*) Office of National Statistics, National Life Tables, United Kingdom for current life tables **) Office of National Statistics, study for projected approx. future increase in life expectancy

For example, I am in my 30s and I will be retiring in about 30 years. I am healthy, male, and some of my ancestor lived until old age. Therefore I feel comfortable assuming that I will stay retired for about 25 years.

If I am lucky, I will live longer than that. I do not worry about the financial impact of such a happy outcome because I can buy an annuity to cover this eventuality.

What will be your cost of living after your retire?

To simplify, let's ignore monetary inflation and contemplate your cost of living after retiring in today's money.

One way to estimate your cost of living after retiring is to use your current cost of living as the starting point. Then you can reduce it for example because:

• if you have a mortgage, you will have paid it off
• if you have children, you will not be financially supporting them anymore
• if you drive now, you be driving less
• you will do less clubbing, diving, kite surfing etc.
• because you will have more time on your hands, you will have figured out cheaper ways to access your local resources
• you will benefit from senior citizen discounts for transportation, TV licence, etc.
• most people's cost of living reduces after they retire simply because they become more frugal out of necessity.

On the other hand, at least periodically, you will pay more for:

• medical treatments and care
• annuity purchase and admin costs

Overall, your cost of living after retiring may probably be between 40% and 80% of your current cost of living. So if you currently spend £3,000 monthly, perhaps you will need at least £1,500 in today's money after you retire.

Another way to estimate your cost of living after retiring is to use today's average salary as a benchmark. It is £2,000 in Britain today after tax. Compared, £1,500 feels comfortable.

How will you be taxed after your retire?

Your future pension income will probably be taxed less than salaries, but it will be taxed. It is impossible to tell what the tax regime will be in the distant future, so let's assume that it will be similar to what it is today.

For a monthly pension of £1,500 a big share of the income is below the personal allowance and hence tax free. A 20% tax rate applies to the rest. National Insurance Contributions do not apply. So perhaps the effective tax rate will be approximately 10%.

Therefore, if you want to spend £1,500 a month when you retire, you might need to receive approximately $1,666 before tax.

Will you have legal entitlements or passive income?

On the bright side, you will probably receive some benefits from the government and perhaps from other sources. You may have a legal entitlement to a defined contribution pension from your employer, a civil service pension or other benefits.

For example, the broadly available State Pension in the UK is £155 a week which amounts to £673 monthly. As of today, you need to have worked 30 years to qualify for the full amount and partial entitlements are available if you have worked at least 25% of the qualifying period.

Perhaps you own a property or shares in a company which generate a passive income. Include them in your calculation if you have any. But do not double count these assets by also including them in your pension savings.

Unfortunately, what you think are your legal entitlements might change in the future in unpredictabel ways. Maybe there will be a financial Armageddon? What if the government goes bankrupt? What if your rental income is confiscated though rent controls? Everything is possible in a long enough horizon. 

There is little we can do about these possibilities when planning finances and the best we can do instead is to make sensible assumptions, embrace the ambiguity and adapt if necessary.

For now, let's assume that the current legal entitlements will still be enforceable when you retire.

What will be your return on investments?

The money you save for retirements and the capital you will draw from after you retire will hopefully generate investment income. The more of this extra help you get the better.

What average investment yield, above inflation, are you likely to achieve in the next decades? 

For example, there is some evidence, that the stock market generates 3%-6% annually in the long term. On the other hand, as of today, you will not find a bank account paying enough interest to even cover inflation.

Perhaps it is reasonable to save to assume 1.5%. If so, then your average saving over 30 years will increase approximately by (1+0.01)^30 - 1 = 34%. Assuming that your average savings will be half of your final savings, you can apply a booster of 17% to your final savings.

Do the math

The table below shows a sample calculation of target pension savings. I encourage you to take a piece of paper and do the math for yourself in the column provided. This will hopefully inspire you to think about your retirement finances in new ways. Do not take this as financial advice though. I am just an random guy on the internet and not a qualified financial advisor. Please use this exercise responsibly.

	Example	You - fill the boxes
Retirement age	@ 65
When will this be	in 30 years
Expected length of retirement	25 years
Anticipated monthly cost of living after retiring	£1,500 monthly in today's money
Required income before tax	£1,500 / (1-10% tax) =  £1,666 monthly in today's money
Legal entitlements and other passive income	£673 of State Pension monthly in today's money
Monthly gap	£1,666 - £673 = £992 monthly in today's money
How much savings you need if investment returns only cover inflation	25 years x 12 months x £992 = £298k in today's money
Anticipated return on investments	1%
Return on investments booster - for the period before retirement	( (1+0.01)^30 - 1 ) / 2 =  17%
Return on investments booster - for the period after retirement	( (1+0.01)^25 - 1 ) / 2 =  14%
How much du you need to pay in, assuming that investment returns will boost your savings	£298k / (1+17%) / (1+14%) = £223k in today's money

So I need to pay in £223k in today's money into my pension plan. Wow! This means that I need to be saving c. £620 a month. 


Reconciliation with someone else's math

Let's check what others think. Money Supermarket says that for annual pension of £10k, a person in mid 30 needs to be saving between $149 and £290 so perhaps their best guess is £220. 

My estimate is 2.8 times higher than theirs. Main reasons are that my target pension is higher, I factored in 10% tax and that I plan to retire 3 years earlier than assumed in the Money Supermarket example. These three explain 2.4 times of the 2.8 times difference. Fairly close.

The remainng differences could due to Money Supermarket possibly hoping for higher investment returns, using different life expectancy tables or the fact that I simplified a lot of calculations by basing everything on averages. Also, it is not clear if Money Supermarket account for the State Pension or not.

So I'll stick to my figures.

Questions for later

How am I going to save £223k? 

Do I need to take my rat race more seriously and beef up my pension plan?

Should I quit my job and become an entrepreneur millionaire? Should I marry rich? Should I join the police?

Am I too young to think about all this and if I stop thinking the problem will go away as I grow older? Will my pension fund's investments boost my savings through the power of compound interest and the genius of stock market managers so I do not need to worry after all?

How is an average British worker, who makes £26k a year, supposed to accumulate 9 times their gross annual income over their 30 years of working life anyway?

Are these questions bothering you too?