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How to improve your sustainable withdrawal rate

A hamster in a wheel with the caption enough of this already.

Thus far we’ve explored why the 4% rule doesn’t work in the real world, and established a more sustainable withdrawal rate (SWR) for UK / global investors. Please read those articles if you’ve not already done so, in order to get the most out of this piece.

Now for the good bit! We’re going to talk about why you can use a higher SWR if – and only if – you’re prepared to execute a withdrawal plan that’s considerably more sophisticated than the 4% rule.

To raise our SWR we’re continuing to use the layer cake concept advocated by leading retirement researchers William Bengen and Michael Kitces.

The layer cake personalises our SWR by applying a suite of plus and minus factors.

  • The last post was all about the bad stuff. We saw how it forced my SWR down to 3%.
  • Now I’m going to layer on all the positives, and test my approach using global historical data.

Without wanting to ruin the surprise, I was pretty shocked by the results you’re about to see and I think I’ll need to be more cautious than the test suggests when the rubber really hits the road.

Even Kitces is very clear about the layer cake’s limitations:

Although the ‘layer cake’ approach of safe withdrawal rates does allow for planners to adapt a safe withdrawal rate to a client’s specific circumstances, there are several important caveats to be aware of.

The first and most significant is that many of the factors discussed here were evaluated in separate research studies, and it is not necessarily clear whether they are precisely additive.

Okay, so remember my SWR is currently bottomed out at 3%.

Let’s head for the top!

Diversification sweetener

Our baseline SWR assumes we’re invested in a Developed World 50:50 equity / bond portfolio. Yet there’s plenty of evidence that a stronger equity tilt and more diversification increases your SWR, especially over longer time horizons.

The shotgun spread of long-term equity returns means that an equity-heavy portfolio can shoot the lights out sometimes. However it also falls far short of the target on unlucky occasions. Bonds can staunch the bleeding when equities haemorrhage, yet too much bondage may also cripple you over time.

Early Retirement Now (ERN) sums up the dilemma:

Stocks have a lot of short-term risks, but in the long-term stock returns are tied to economic growth and thus, in the very long-term, real returns become less risky due to that.

Bonds have relatively little short-term risk around their trend growth rate, but their trend growth path itself has a lot of risk in stark contrast to stocks.

The answer isn’t to simply load up 80-100% in equities and hang on for dear life. Rather we can aim to alter our asset allocation as we go.

Michael McClung in his brilliant retirement portfolio book, Living Off Your Money, recommends an eve-of-retirement bond allocation of 50% for a 30-year time horizon, or 55%-65% for longer stretches.

The reason for starting retirement with a heavy bond load is that you’re particularly susceptible to sequence of return risk in the closing years of accumulation and the opening decade of deaccumulation. You can protect yourself during this period with high-quality government bonds.

Kitces has shown how an ill-timed stock market crash can setback your retirement plans like an asteroid strike scuppered talking dinosaurs. He also explains how the sequence of returns in the first 10 to 15 years of your retirement can seal your fate for good or bad.

It’s important to have enough bonds to deal with these threats, and to deploy your bonds effectively.

McClung in particular has developed techniques to help you do this – see the ‘dynamic asset allocation’ section below. The trick is that you allow your bond allocation to wax and wane according to market conditions.

More generally, the historical data sampled by Kitces, Bengen, McClung and others tells us that broad diversification beyond bonds works in retirement just like it does during the accumulation phase.

They cite evidence in favour of diversifying your retirement portfolio with:

Kitces offers a diversification bonus of +0.5% SWR for significant multi-asset class diversification. It seems daft not to take it.

The Accumulator’s layer cake SWR:

3% + 0.5% diversification = 3.5%

Dynamic asset allocation

The best way to protect yourself from sequence of return risk? Live off your bonds when equities are down.

Beyond that you can further improve your portfolio’s life expectancy by using a rebalancing method that increases equities exposure when they’re seemingly cheap, and only replenishes bonds when equities have seriously outperformed.

This is dynamic asset allocation. It’s a super-charged version of ‘buy low, sell high.’ You can read about McClung’s version – called ‘Prime Harvesting’ – by downloading a free sample of his book.

Techniques such as dynamic asset allocation will test your risk tolerance because in extreme market conditions you may eat all your bonds and end up 100% in equities. Steer clear if you’re cautious.

Otherwise Kitces awards 0.2% to your SWR for dynamic allocation.

The Accumulator’s layer cake SWR:

3.5% + 0.2% dynamic asset allocation = 3.7%

Flexible spending and dynamic withdrawal rates

Here is the big SWR cherry on top. If you can cut your spending during a downturn then you gain a massive advantage over a constant inflation-adjusted withdrawal plan.

Dynamic withdrawal rates mean you adjust your spending in sympathy with your portfolio’s fortunes. Like managing a forest, being able to conserve your resources when they’re under stress is obviously more sustainable than consuming an ever greater percentage when the rot sets in.

Flexibility is key. Retirement researchers have devised all kinds of rules that allow you to spend more when the market soars, but you must also spend less when there’s trouble at mill.

McClung does a masterful job of analysing various dynamic withdrawal rates in his book, while ERN has written a sobering series exploring how much you might have to cut back using one of the better known spending systems.

In practice, cutting back is what all retirees do if their money runs short. The risk is that extra spending early in retirement may force us to spend less later if the cookie doesn’t crumble our way.

That gamble may be easier to take if you believe that retirees spend less later in life. What do you reckon? The evidence is patchy and may not apply to you. I’ve read research that concludes retirees spend more if they have it, but spend less on average because most end up with less to spend.

Kitces’ flexible spending modifier:

  • +0.5% SWR for modest spending cuts in bear markets and/or plan to decrease spending in later life.
  • +1% SWR for substantial (10%+) spending cuts in bear markets and/or plan to make significant cuts in later life.

I think Mrs Accumulator and I can handle 20% spending cuts so I plan to use Michael McClung’s EM dynamic withdrawal rules. Our State Pensions should meet near 70% of our estimated outgoings later on. I’m gonna claim the full 1% bonus!

The Accumulator’s layer cake SWR:

3.7% + 1% flexibility bonus = 4.7%

My new world portfolio SWR

My personal SWR was creamed by negative factors in the last post. It finished up at just 3%.

Now it stands at 4.7% and I’m stunned.

What does it all add up to in cold hard cash?

Well, we’d like an annual retirement income of £25,000, so our retirement wealth target at 4.7% SWR is:

(1 / 4.7) x 100 x £25,000 = £531,750

In contrast our target at 3% SWR was £833,333, which was 57% higher.

Wow. Just wow.

If I use the ‘4.7% rule’ then we’re FI already!

The sniff test

The big question is does this layer cake business pass mustard?

The research shows that your SWR changes dynamically as you shift the parameters. I can test these moving goalposts using global historical data thanks to the fantastic Timeline app.

Timeline is commercial software created by retirement researcher Abraham Okusanya. It’s aimed at financial planners who want to model portfolio withdrawal plans.

Timeline is very well designed, loaded with great features, and delivers the Holy Grail of global / UK appropriate datasets. I think it’s worth paying an IFA to run your numbers through it if they have access.1

My 4.7% SWR achieved a 99% success rating on Timeline – success means historical me didn’t run out of money in 99% of scenarios.

The bottom 10% of scenarios did require me to cut spending drastically to actually avoid running out of money though. That may not be your idea of success.

On the other hand, every path above the 10th percentile was comfy, and the best case scenario near-tripled my income for years. I used all the layer cake assumptions – good and bad – to get the result but was able to leave our State Pensions in reserve.

However that doesn’t tell me that my 4.7% rule is safe or even sustainable. We live in the future, not the past. I won’t experience the historical data in retirement, though hopefully I won’t face anything worse.

The truth is that a lower SWR is safer no matter how much kung-fu you know, so I’m not actually going to adopt a 4.7% SWR.

4% it is

So after everything we’ve been through I’m going to choose 4%.

Editor: You clutz! You total time-waster! Is this your idea of a joke?

Okay look, it’s thousands of words later and I’m as aghast as anyone, but I’m not using that 4% rule.

  • I’d have to use a 3% SWR to live with naive, constant inflation-adjusted rules.
  • But 4% with all the layer cake trimmings works with McClung’s system and it comfortably performs in Timeline.

In short, I am only happy to choose 4% because it leaves me room for manoeuvre when allied with the withdrawal techniques we’ve touched on in this series.

I also have – and must have – a Plan B.

Maybe my ability to use complex techniques will ebb through my eighties and nineties? Maybe I won’t even make it that far – a big problem given Mrs Accumulator’s interest in dynamic withdrawal rates continues to hover around zero. (“But look, they’re dynamic!”)

Plan B is to switch to a simpler, safer Floor and Upside strategy when our State Pensions kick in and annuity rates tip in our favour.

Aside from that we’ll maintain an emergency fund, there’s always the house to sell or reverse mortgage, and there are side hustles to hustle if we have to.

More than anything, digging into the research has taught me that a SWR is a very personal number. Like inside leg measurement personal. And it’s probably not even a number.

Really, it’s a floating set of coordinates that give you something to aim for. Your final destination can only be known when you arrive.

Take it steady,

The Accumulator

  1. For a fixed fee of course. []

Weekend reading: People forget that people forget

Weekend reading logo

What caught my eye this week.

I debated a Tweet of Morgan Housel’s this week, after that excellent financial writer retweeted President Trump’s suggestion that Boeing should rebrand its 737 MAX after two fatal crashes. Morgan thought this good advice from the President. I wasn’t convinced.1

Here it is as a screenshot (I’m not sure if you can embed conversations from Twitter):

You’ll see Morgan has 132 Likes for his Tweet. And you’ll notice my pithy reply has zero.

Morgan replied to me with the example of Arthur Anderson, the scandal-struck Enron accountancy firm that was ultimately renamed Accenture.

A snappy riposte that eight people Liked – including me!

A couple of people Liked my subsequent comments, but really, I mean literally a couple. On the numbers, Morgan had won.

Here’s the thing though. I am right.

Edgy material

Whenever I wonder what my presumed source of edge is as an investor, ten minutes on Twitter puts me right.

It reminds me people prefer to be outraged. People prefer to be melodramatic. People emphasize the recent and close at hand to an insane degree.

Super well-read Morgan knows all this of course, and he could easily have written my reply to him on another day. But I suspect many of his followers cycle from one 24-hour crisis to another, every day watching the world come apart at the seams. Apparently.

So as I say, I’m right – people forget.

A few examples:

  • In 2015 the US Mexican food chain Chipotle saw its shares crash from around $750 to around $250 in the wake of several E Coli outbreaks. Sales fell because people didn’t want to get poisoned. I heard numerous analysts repeatedly write the stock off as dead money. But last year’s revenues were Chipotle’s highest-ever, and it’s smashing expectations again. People forget.
  • After being revealed to have cheated emissions tests, Volkswagen was condemned as having not just trashed its own brand but also that of German manufacturing writ large. It was a scandal! There’d be boycotts, big fines, maybe a restructuring. Yet 2018 was Volkswagen’s best year for car sales ever. People forget.
  • In 1989 we had the Exxon Valdez oil spill in Alaska – one of the worst in history – which trashed the environment and saw Exxon receive additional criticism for its slow response. Never mind, by 2006 it was the most valuable company in the world. People forget.
  • Or how about the terrible behaviour of all the Wall Street banks in the run up to the financial crisis? So bad it almost brought down the global economy. You remember, that guy wrote that book they made into a film. Never again! The big banks had to be broken up! Even I ranted! But were they subsequently taken apart for their sins – by disgusted customers if not by regulators? Yeah, not so much. The biggest Wall Street banks are far bigger than they were before the crisis. People – boom – forget.

I could go on and on – these are just the examples that first popped into my head.

In fact it’s harder to think of companies that didn’t recover from a public relations scandal!

I know what you’re thinking – there was the Ratner jewelry debacle in the early 1990s, when the CEO Gerald Ratner told a business conference that his products were cheap because they were “total crap”. Hundreds of stores were closed in the aftermath. You won’t find a Ratner-branded shop on the High Street today.

True, but that’s because the company was rebranded Signet in the 1990s. It’s now listed in New York and is valued at well over $1bn. So it didn’t die – but it did feel the need to rebrand. I guess we can chalk this one up as a win for Trumpian thinking.

I’m not saying companies don’t fail. They do, all the time. But in my experience it’s rarely because of a one-time issue. They fail because their products or practices become out of step with their markets.

We have to remember survivorship bias – doubtless I’m forgetting companies that did disappear because they, well, disappeared.

But the general point stands – much of the time people forget. They forget the terrible thing that happened a few years ago. They forget who it happened to. They even forget bull markets follow bear markets, as the Of Dollars and Data blog explained well this week.

They forget that they forget.

There are many things eroding edge in the financial markets, but the collective wisdom of Twitter isn’t one of them.

[continue reading…]

  1. Aside: Wow, how little of that paragraph would have made sense a decade okay? Tweets, retweets, public debates, Boeing having a safety problem, and – yikes – President Trump. []
Image of coins and a cut-out model of a house.

We’ve not one but two of our favourite bloggers guest posting today. What’s more they’re going at each other head-to-head! Roll up, roll up, for a bare knuckle cage fight – personal finance style! Okay, not really, Mr YFG and Fire v London are too polite for that. But we hope you enjoy their gentle jousting nonetheless.

There’s a divisive issue that has been tearing the nation apart forever. Bloggers are at odds over it. Family members squabble over it. Maybe you’ve even put off retiring because of it.

No, we’re not talking about Brexit. This is a far more ancient disagreement than that mere whippersnapper!

We’re thinking of the age-old question as to whether your home is an asset and an investment. And even if it is, whether you should count it as part of ‘the number’ you need in order to declare yourself financially-free and able to retire early, should that float your boat.

Parliament isn’t getting a great rap at the moment, but we see merit in a serious debate. So let’s have at it!

At the end you’ll even get to give your (indicative) vote.

  • Proposing the motion “This house believes it deserves to be included in your net worth” is FIRE v London, who is here to make the argument FOR including your home in your Financial Independence (FI) net worth figure.
  • Opposing the motion is Mr YFG, who will make the argument AGAINST.

And are you sitting down, dear reader? Because there’s a twist…

Warren Buffett’s wise sidekick Charlie Munger once said:

“It’s bad to have an opinion you’re proud of if you can’t state the arguments for the other side better than your opponents.”

We’re going to put this to the test: Each debater is arguing the opposite of what they believe.

Let’s see if we change anybody’s mind. (Maybe even our own?)

We now call upon FIRE v London to get proceedings underway.

FIRE v London: Property should be counted in your net worth

Gentle readers, the argument I am putting forward today is nothing short of simple common sense.

Property is big!

Property is the biggest type of asset out there. In the UK it is 51% of our net worth, dwarfing all other types of asset.

Why would retail investors like us FIRE1 types ignore the biggest asset class?

Of course not all properties are residential properties. And not all residential properties are your home. But what we are discussing in this debate is your primary home – where the FIREr lives – and whether this home, and any associated mortgage, counts in the Net Worth calculation you tend to do for FIRE.

The average home in the UK is worth around £250k. In London it’s more than £480k.

For most people, the savings needed for Financial Independence are around £1m. So in that context, the house you live in is an important number – potentially half of the total assets required.

Why would we possibly exclude the most important asset from the calculation?

Big as an asset but also big as an expense

Of course, property is also the biggest cost for most households. It is around 22% of disposable income in the UK on average, and a lot more for #GenerationRent – who in London pay on average more than £1,600 per month to rent a home.

From the point of view on somebody on the FIRE path, this is important. To be Financially Independent one needs to be able to meet all your living expenses, and this obviously includes housing costs. If you own your own house outright, with no mortgage, you’ll have a significantly lower cost of living.

So, in fact, this house believes not only that your primary home, as an asset, should be included in your net worth, but that your housing costs should be included in your assessment of FIRE. You can no more disentangle your primary home, as an asset, than you can forget about paying for electricity and broadband.

So far, so much common sense.

Rent vs buy? An important side question

In fact once you move beyond common sense, there are good practical arguments for considering both your asset and your housing costs in your FIRE deliberations.

It may even be that – counter-intuitively – renting rather than owning turns out to make FIRE more achievable.

Certainly in parts of London with low rental yields, renting may prove significantly cheaper, especially if you can obtain decent investment returns on the freed up capital.

This house might be better off sold! But you won’t know if you don’t consider it in your net worth.

UK property has important tax benefits

But never mind the size of it, look at the quality. Property is not just a large asset, it is also – especially as your primary home – one of the best assets. Particularly here in the UK.

In the UK property holds a special place in the heart and mind of everybody – not just those Englishmen whose ‘home is their castle’.  In Britain, property investment is ‘safe as houses’. Property is a ‘one way bet’. Stocks and shares? That’s ‘gambling on the stock market’, whereas you can put your trust in ‘bricks and mortar’.

As you can see almost every week in the Sunday Times’ Fame & Fortune column, where successful people make these arguments all the time. And they are successful people, so their arguments must be right, right?

In the UK, the taxman agrees with Fame & Fortune. Property is taxed differently to other types of asset. Crucially, there is no capital gains to pay on your primary home. If you pay off your mortgage, live in your home rent-free, and ultimately have no capital gains to pay, your primary home – the single biggest chunk of wealth for most of us – attracts no tax.

As in most places, here in the UK property is also arguably the key asset that it makes sense to borrow to buy. This means that you can get leveraged returns on it. This means you’d be crazy not to – especially for your own home, where mortgage rates are particularly low.

So, property is different. It is a large and obvious asset for retail investors to buy. In owning it you eliminate rent as a housing cost. There is no tax to pay, and you can leverage up your returns. You’d be foolish not to invest in it.

Let’s hear no more nonsense about excluding it from your net worth. Property is too big to exclude, and too attractive to exclude. That’s why this house believes it deserves to be included in your net worth!

But now I turn to Mr YFG, who is going to oppose the motion.

My YFG: Does my asset look big in this?

Whilst my honourable friend is right to call our home big, the case for it being an asset is less clear.

That’s because our homely abodes don’t generate any income or cash towards our FIRE target.

As Robert Kiyosaki of Rich Dad, Poor Dad fame points out, a home creates a negative cash outflow. For example, a mortgage, maintenance costs, bills and taxes. That makes it a liability!

My friend and rival also correctly points out that whether you should rent versus own your own home is a serious question to ask. This follows from the above. A bigger, more valuable house means you need to hold greater and greater amounts of other assets to balance out the cash outflow.

It also means leaving money on the table. The research shows that in the UK, investing in the stock market has beaten investing in property.  Money in your house is money out of the market. Money out of the market is the lost returns needed to finance FIRE.

Overall, the bigger your house, the harder it is to reach FIRE!

Alternative facts

Putting aside whether a house is an asset or not – can we even claim it’s big?

Valuing a home is very difficult. Unlike shares in an ETF (or FIRE bloggers), no two houses are alike. Sure, we can get a valuation from our local slick-backed-hair estate agent. But the ‘true’ value is only known when you come to sell.

Those mansions in Florida were quite valuable until they weren’t. Likewise the owners of former homes in Dunwich thought little was safer than houses… until the North Sea developed a taste for bricks and mortar.

This means that if you include your own home in your assets column the number is a little bit ‘fake news’.  It’s not a ‘real’ number like the cash in your bank account. It may never be realised.


The main point of our FIRE stash is to fund our living costs. All those craft beers and avocado on toast won’t pay for themselves! And this is very difficult with a house.

As mentioned above, a home generates negative cash flow. But even thinking in capital terms, it’s tricky to realise capital amounts, too.

Unlike stocks and shares, we can’t just sell piecemeal amounts of our own home into the market as needed. Nobody would be interested in buying a quarter of my guest bedroom, and not only because of the mound of bric-a-brac I’ve stored in there.

To realise money from our own house we have to sell it all or else take out big remortgages. That makes your own home a really bad investment for funding living costs.

Mums and their sons

My honourable friend is quite right: An Englishman’s home is his castle. I love my home. And this level of emotion makes it very difficult to stay rational.

My home is the best home. Just like my mum’s son is the best son in the world.

So when it comes to my home, I have a huge blind spot. I’ll always be tempted to bump the value of my home up in a way that I can’t with my index fund investments.

My home is more than a number in a spreadsheet. As a rational accountant I must guard against that, and discount whatever value I magic up for my home.

In summary my case is this: we can’t categorically say a home is an asset as it loses money. Whilst it’s a big expense, it’s hard to put a real number on it. Any number we do conjure up is contingent on a future star-crossed home we’re in love with making it rain in our bank account. And even that number is probably unrealistically high because who doesn’t love their home?

My case rests.

Who is right? You decide

Well, there you have it. Two opposing points of view on a key question facing any ambitious seeker of Financial Independence.

What do you think?  If you rent, is buying your own home part of your financial plan? If you own already, what will your financial independence look like in the future? What arguments are we missing?

Please vote in the poll and expand your thoughts in the comments below!

Should you include your home in your Financial Independence net worth sums?
  1. Financial Independence Retire Early. []

How to get a 14% return from RateSetter

Mixing RateSetter’s £100 bonus offer and high interest rates should deliver a tasty return

Good news! RateSetter has brought back its £100 bonus for investors who put away just £1,000 for a year. To get the bonus, follow my links to RateSetter in this article. I will also be paid a bonus by RateSetter if you sign up via one of these ‘refer a friend’ links to claim your £100 bonus. This doesn’t affect your returns – it is paid by RateSetter.

I won’t cause any readers to fall to their knees screaming “No! How can it be? Why didn’t somebody tell me!” if I say it’s been hard to get a decent interest rate on cash for the past few years.

Even the Bank of England’s rate rises haven’t done much. High Street banks always drag their feet in passing on rate rises.

But in this article I’ll explain how you can effectively get a 14% return on a chunk of your cash by taking advantage of a bonus offer from RateSetter, the peer-to-peer lender.

True, this very attractive potential return does not come without some risk.

In practice, no Ratesetter investor has yet lost a penny. Every lender has received the rate they expected.

Nevertheless, peer-to-peer does not have the same protections as traditional cash deposits, so you should think about it differently to cash in the bank. More on that below.

If you can accept the risk and have the spare cash to hand, I believe this is a pretty safe – though not guaranteed – way to make a good return.

It also exemplifies how being nimble with your money can enable you to achieve higher returns – even in today’s low rate world.

Not a few Monevator readers have taken advantage of this win-win RateSetter offer over the past couple of years!

About RateSetter

RateSetter is one of the new breed of peer-to-peer lenders aiming to cut out the banks by acting as a matchmaker between ordinary savers and borrowers like you and me.

Rates change all the time, but as I write you can get up to 5.4% as a lender with RateSetter by putting your cash into its five-year market.

Since March 2018 you’ve also been able to open a RateSetter ISA, which means you get your income tax-free.

Meanwhile borrowers can get a loan charging less than 4%. RateSetter claims that rate is competitive with the mainstream banks, and says banks are its competition (rather than it simply getting all the bank rejects).

RateSetter charges no lending fees, which is great news for savers like us. Borrowers do pay a fee.

Over £2.5 billion has now been lent through the RateSetter platform. This is no longer a tiddly operation.

And importantly, of the 66,942 investors who’ve lent money with RateSetter not one has yet lost a penny of their investment.

In 2010 RateSetter set-up a ‘Provision Fund’, which is funded by charging all borrowers a risk-adjusted fee.

Money from the Provision Fund is used to repay lenders whose borrowers miss a payment, for as long as there’s money in the fund to do so.

It’s a different model to the initial approach of rivals like Zopa. Back then you were encouraged to spread your loans widely and accept a few would go bad, reducing your return.

The RateSetter approach is different.

But as sensible people of the world, we should understand there’s no magic here.

Downside protection

Some loans will still go bad. And those bad loans will still reduce the returns enjoyed by lenders in aggregate – because the Provision Fund fee levied against borrowers as part of the cost of their loan could otherwise have gone to lenders through a higher interest rate.

However what the Provision Fund does is share those losses between all lenders, reducing everyone’s return a tad.

This makes your returns predictable. Your outcome should be dependent on the interest you receive – rather than being distorted by the poor luck of being personally hit by an unusually high number of bad debts.

Note that the Provision Fund does not provide complete protection against a situation where all the loans made at RateSetter default. Far from it!

Rather the Provision Fund aims to cover the bad debts predicted by RateSetter’s models, with a margin of safety on top.

At the time of writing, Ratesetter says:

In the event that credit losses were to increase significantly, the following things would happen:

  • The Provision Fund would reduce in value as it reimburses investors for missed payments.

  • The Provision Fund is large enough to cover credit losses up to 116% of expected losses. If credit losses rose above this level, the Provision Fund would be depleted and investors would earn less interest than they expected, but their capital would be unaffected.

  • If credit losses rose even further and exceeded 231% of expected loses, investors would start to lose capital, which means that they would get back less money than they put in.

  • In this instance, it may take longer than expected for investors to receive their money back and access to funds may be restricted.

What would happen if losses did exceed the RateSetter projections?

First the Provision Fund would be used up, and ultimately exhausted.

After that interest payments could be redirected to repaying capital. You’d lose on interest payments, but it could cover lenders’ losses on capital unless the default rate got too high.

Finally, in a doomsday scenario with very high default rates, capital could be eroded. I’d expect other investments like equities and corporate bonds would also be taking a pummeling. But cash in the bank would not.

At the end of the day, I believe for most people the Provision Fund approach is preferable to the lottery of individual loans defaulting. But don’t mistake it for a panacea or a guarantee.

You could conceivably lose money if defaults are much worse than expected. More on that below.

How to bag that 14% return from RateSetter

At last, the good bit!

RateSetter is currently offering a £100 bonus to new customers who invest at least £1,000 in any of its markets and keep it there for a year.

This £1,000 minimum investment can be made up of new subscriptions and/or transfers from other ISA providers.1

The £100 bonus is paid once that year is up. It will be deposited into your RateSetter account, after which you can choose to do with it (and the rest of your money) as you please.

Clicking on any of the RateSetter links in this article will take you directly to the sign-up page for the £100 bonus.

For full disclosure, RateSetter will also pay me a £50 bonus if anyone does sign-up via my links, which would obviously be very welcome! My bonus doesn’t affect your returns. It’s paid by RateSetter.

As for your £1,000 investment, you can put it into any RateSetter market, which range from a rolling one-month option to a five-year lock-up. But you must keep it within RateSetter for a year to get your £100 bonus.

To keep things simple, let’s assume you invest your £1,000 in the one-year market, which matches the period required to qualify for the bonus.

The one-year market is paying 4.7% as I type.

So after one year you’d have your 4.7% interest on your £1,000 and you’d also receive your bonus, which works out as a return of 14.7% on your £1,000.

Very nice!

I’ve ignored taxes here because everyone’s tax situation is different.

The good news on taxes is that:

  • You can now open a RateSetter ISA and collect the bonus. You can fund this with a transfer from another ISA provider. In an ISA the income you earn is tax-free.
  • Most people even outside of an ISA will pay no tax on cash interest, thanks to the new-ish Personal Savings Allowance that covers the first £1,000 of interest earned by basic rate taxpayers, and £500 for higher-rate payers.

Is this bonus too good to be true?

A great question.

Clearly it’s not sustainable for RateSetter to lend your money out at, say, 4%, while paying you an effective rate of nearly 15%.

(The cost is even higher to RateSetter if it pays me a bonus, too.)

RateSetter must be hoping this is the start of a multi-year relationship with its new sign-ups, after they become comfortable with its platform.

Once you get over the initial hurdle, peer-to-peer is straightforward. I’ve used these platforms for ten years now.

RateSetter will hope many customers deposit more than £1,000 and ultimately prove profitable in the long-term.

Like all peer-to-peer lenders, RateSetter will be aiming to scale as quickly as possible. Greater size will improve its margins and enable it to continue to meet demand in both the savings and loans market. Scale is a critical factor in virtually all money-handling businesses.

Finally, I expect the cost of this offer is allocated internally to its marketing department.

If 5,000 people sign-up for the bonus that’s clearly a lot of money – but it wouldn’t buy very much TV airtime. At least this way RateSetter can precisely calculate the return on its investment.

I do think it’s a smart question to ask, though, and it neatly brings us back to risk.

A final word on the risks

I have already stated that peer-to-peer lending is not a straight swap for a cash savings account.

The risks are higher.

Firstly and crucially, there’s no Financial Services Compensation Scheme coverage for peer-to-peer lenders. If you lose money, the authorities will not bail you out like they would for up to £85,000 with a High Street bank savings account.

That’s important because even though no savers have yet lost a penny with RateSetter, that’s not a guarantee they will not do so in the future.

The economic situation could change markedly, say, or RateSetter could get its sums wrong on bad debt.

In the most likely (in my opinion) worst-case scenario, the Provision Fund would not be able to cover all the bad debts. This would mean some loss of interest.

  • According to RateSetter, as of August 2018 the loss rate experienced to date is 2.29%.
  • It currently projects this to rise to 3.33%. (Loans take a while to go bad.)
  • If credit losses rose to 127% of expected losses, RateSetter‘s model indicates the Provision Fund would still cover interest.
  • In what RateSetter terms a severe recession, you’d get no interest but it believes you’d get your initial money back.
  • If we saw 400% expected losses, investors might lose 5.6% of their capital.

This illustration is summarized in the following chart:

Provision Fund figures correct as of 1st August 2018. (Click to enlarge)

Source: RateSetter

As for the worst worst-case scenario, like with any business it is possible to imagine catastrophic situations where you’d lose much more.

But to my mind these would probably require fraud or massive incompetence within the company, and/or a far deeper recession than anything we saw in 2008 and 2009. (Probably both at once – as Warren Buffett says you only see who has been swimming naked when the tide goes out.)

Obviously I don’t think that’s at all likely, otherwise I wouldn’t have put any money into RateSetter.

But a hint of what might have gone wrong came in 2017, when the company intervened to restructure several businesses and cover repayments from one via its own funds. This prevented its bad loans from being defaulted to the Provision Fund. This decision to intervene reportedly2 delayed authorization from the FCA. It has subsequently been granted.

RateSetter says: “This intervention was an exception and will not happen again.”

As I understand it, RateSetter has since withdrawn from the wholesale funding operations that produced this situation. (Wholesale funding is when a company lends money to third parties, who then lend those funds on themselves.)

You invests your own money and takes your choice.

Personally, I am happy with the risk/reward here. Not everyone feels the same. My co-blogger, for instance, doesn’t use any peer-to-peer platforms.

As a halfway house to reduce risk one could perhaps only invest in RateSetter’s monthly market, in the hope this would give you more chance of getting money out relatively quickly if say the economy was coming off the rails. The price is a lower interest rate, of course.

I think it’s worth stressing again that nobody has lost money so far with RateSetter. And even if the economy turns very far south, you probably won’t lose more than a small percentage unless something very bad or criminal happens.

That would be a much worse situation than with cash, but not a catastrophe.

However we all know by now that bad things can happen, and every investment can fail you. Do not invest money you cannot afford to lose.

RateSetter and your portfolio

Personally I have always taken a pick-and-mix approach to spread the risk with these sorts of alternative opportunities.

For instance, I have used both RateSetter and Zopa, I’ve invested a little in mini-bonds and retail bonds, I have money with NS&I, and I have taken advantage of high interest rates and cashback offers with accounts like Santander 1-2-3 to boost my returns.

When putting money into the riskier alternative options, I only invest a low single-digit percentage of my net worth with any particular platform. Like this I aim to mitigate the risks of being hit by some sort of systemic or company failure.

I’m not going to labour the point on risk further. Most peer-to-peer articles barely mention it, and I’ve devoted half this piece to it. Consider yourself warned, and read the company’s extensive material if you want to know more.

I think peer-to-peer and other cash alternatives are interesting additions to our arsenal as private investors. But they’re not slam dunk safe bets. I size my exposure accordingly.

Get your £100 while it lasts

So there you have it – a hopefully even-handed assessment of the risk and reward potential of this £100 bonus offer from RateSetter.

From here you’ll have to make your own mind up.

I do hope some of you found this article interesting and enjoy those bonus-boosted returns.

  1. Note: Terms and conditions apply with transfers, so check the small print. The money must be transferred over within a certain time period, which may be down to the ISA provider you’re transferring from. Just setting up a new RateSetter ISA with a fresh £1,000 should be straightforward. []
  2. See this article at Reuters: https://uk.reuters.com/article/uk-interview-ratesetter/ratesetter-recovering-after-asteroid-strike-bad-loan-discovery-idUKKCN1BN1PF []