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Weekend reading: Oops, bonds did it again

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What caught my eye this week.

The 10-year UK government bond yield has fallen back to barely 1%. Indeed yields are down again everywhere, as Bloomberg reports:

Bond yields around the world are tumbling to multi-year lows as the global shift by central banks to a more accommodative stance has put the kibosh on the oft-predicted but still-unrealized end of the long bull run in government debt.

Among the superlatives hit this week:

– Japan’s 10-year yield slid to its lowest since 2016 on Friday
– New Zealand’s equivalent slipped below 2 percent for the first time earlier in the day
– Yields on benchmark Treasuries have dropped this week to the lowest in more than a year
– Those in Australia are just three basis points from a record low
– The global stock of negative-yielding debt hit the highest since mid-2017

A quick way to be called a moron by people who know more than they understand over the past 5-10 years has been to suggest that bonds still have a place in most portfolios. A wealth-destroying crash was “obviously” imminent, you see.

But markets often move in the way that surprises commonplace assumptions, and that’s certainly been true of bonds.

(Click to enlarge)

Source: Bloomberg

This low yield era almost certainly won’t last forever. However a bit of humility is in order from all of us (including me!) about the timing of any long-lasting reversal.

Of course this is exactly why most people are best off investing passively and getting on with other things in life. (If you want to try to outsmart the unthinkable, there’s always Brexit.)

Have a great weekend! (Hope to see some of you on the march. 🙂 ) [continue reading…]

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Why the 4% rule doesn’t work

The 4% rule is about as safe as a bomb, a lightning strike, a virus, a rocketThe 4% rule went viral because it was billed as simple and safe (*coughs a noise that rhymes with bullwhip*).

Unfortunately, the 4% rule is not safe.

Nor is it simple, once you put the nuance back.

The story is seductive – that you can withdraw 4% a year from your portfolio and never run out of money.

This is often known as a safe withdrawal rate (SWR). Unfortunately the 4% version is about as reliable as that other withdrawal method you’ve heard of.

Got a portfolio of £1 million? The 4% rule claims you can safely withdraw £40,000 in year one, adjust that amount by inflation in year two, and so on, every year until the happy hereafter.

The 4% rule also gives us the rule of 25. Want to live the life of Reilly on £40,000 a year?

£40,000 x 25 = £1 million

That’s the sum you need to amass before you can hit the beach.

Simple as that. At a stroke of the calculator anyone grappling with a defined contribution pension can treat it like it’s one of those turnkey defined benefit, gold-plated jobs!

If only.

The 4% rule: the things they forgot to tell you

Where to begin?

The 4% rule doesn’t include taxes. The £40,000 figure above is gross income. You’ll need to live on less after tax.

Worse: the investment growth assumptions that underwrite the rule assume no capital gains, dividend or interest taxes. If your investments aren’t completely shielded from tax then you’ll need to lower your SWR.

The 4% rule doesn’t include investment costs. Fund charges and platform fees chip away at your annual returns and leech the SWR. Financial planner and researcher Michael Kitces explains that the answer isn’t as simple as deducting your portfolio’s total OCF from the SWR either.

(Another thing to note: the 4% rule reinvests dividends. If yours are spent or taxed then fuhgeddaboudit.)

The 4% rule applies to 30-year retirements. If you live longer than 30 years then the failure rate creeps up unless your SWR goes down.

Financial planner William Bengen, who coined the 4% rule, recommended a 3% SWR to see you through 50 years or more.

The 4% rule uses US historical returns. Bengen’s original portfolio comprised:

  • 50% US equities
  • 50% US intermediate government bonds.

Bengen then used historical annual returns from 1926 onwards to discover that an initial withdrawal of 4% would have enabled retirees to live out the next 30 years on a constant, inflation-adjusted income, without running out of money, come hell or Great Depression.

That’s nice, but remember the US enjoyed super-powered investment returns during the period studied. Other developed countries did not fair so well. Retirement researcher Wade Pfau calculates:

  • The UK’s SWR as 3.36%
  • Germany’s as 1.01%
  • Japan’s as 0.27%.
  • Even the global portfolio only made 3.45%

Apply the 4% rule to Japan and your money ran out one third of the time. In the worst case, your money evaporated in just three years!

Pfau and others even doubt that Americans can rely on future returns being so kind.

Known safe withdrawal rates will fall if a future sequence of returns is worse than anything currently stinking up the historical record.

What can you do with that information? Well, some researchers have worked on the link between current asset valuations and SWR. You’re advised to choose a more conservative SWR when valuations are high, while you can live a little when valuations are low.

Incidentally, the 4% rule even fails in the US when you use a different dataset. Many retirement researchers argue that the sample sizes are too small anyway.

The 4% rule applies to a specific asset allocation. Change the 50-50 US equities and intermediate government bonds split and you’re playing a different game. Bond heavy portfolios (say over 65% bonds) have historically sustained lower SWRs, especially over longer time horizons.

Sticking with allocation, UK investors shouldn’t use US SWRs – but you should appreciate that UK SWRs aren’t appropriate either if you’ve got a globally diversified portfolio.

Bengen and others have shown that diversifying into certain risk factors can improve your SWR. What about other assets such as REITs or gold? Will they improve your chances? The future is uncertain.

The 4% rule’s definition of success is probably not yours. Some SWR studies apply a sneaky ‘success’ rate. They count a SWR as sustainable if it only failed 5% or 10% of the time. The famed Trinity study did this. I think this is acceptable, but you may not. Either way it’s not ‘safe’.

Failure itself is defined as people running out of money before they run out of time. You spent your last dollar as you expired on the final stroke of midnight, December 31st, on the 30th year of your retirement? You’re a success baby!

This definition of failure keeps things simple but it’s not realistic. Most people aren’t oblivious to plummeting portfolios. They won’t fling themselves off the cliff edge like an Olympic lemming. Many will slow down their spending before it becomes unsustainable. People also cut spending in scenarios where the situation looks dire but hindsight tells us things ultimately worked out just fine.

Sadly, you don’t know which it is at the time. People cutback early because they can’t predict if they are history in the making, or whether they’re living through just another close shave for the 4% rule. In other words, living the rule can be pretty scary without a Plan B.

The 4% rule is inflexible. What if you need to spend more than your SWR allows? I don’t mean you have the occasional bad year. I mean something changes that proves your original income estimate to be off-base. Maybe you have unforeseen health costs, or a newly dependent family member. Perhaps there’s no obvious lifestyle creep but your personal inflation rate constantly outstrips headline inflation. Within five to ten years you’re spending way more than planned.

A high SWR like 4% gives you little room for manoeuvre when high spending meets poor returns. Everybody needs a more flexible plan than the basic 4% package suggests.

What if you spend too little? The selling point of a SWR is that it’s supposed to survive the nightmare scenarios. If life turns out better for you – and most of the time it does – then you could have spent more before you were gonged off. All the other caveats notwithstanding, Kitces shows that the 4% rule typically does leave large sums of spare lolly on the table.

Now that’s a good problem to have, especially for your heirs. Whereas, if you definitely want to leave something for your heirs, well, that’s not the 4% rule’s bag. It assumes capital depletion is A-OK. If it’s not then you’re into the expensive world of capital preservation.

So, you can spend too much or too little! Which is it? Well, naive application of the 4% rule can lead to either. It’s a rule of thumb not a strategy.

None of this is meant to impugn Bengen’s original research. It was groundbreaking and he clearly flagged his assumptions back in 1994. The 4% rule has taken on a life of its own, whereas Bengen’s work was only meant to be part of the puzzle. What’s often missed is the advances made in retirement research since.

You can devise a strategy from the wider body of knowledge – we’ll have more on this in the future, but see McClung for starters.

Step one is understanding that living off your money is as much art as science. And step two is knowing that the 4% rule does not work as popularly advertised.

Take it steady,

The Accumulator

Bonus appendix: 4% rule maths

Year 1 income: Withdraw 4% of your starting portfolio value.

500,000 x 0.04 = £20,000 annual income

Year 2 income: Adjust last year’s income by year 1’s inflation rate (e.g. 3%):

£20,000 x 1.03 = £20,600

The 4% SWR only applies to your first withdrawal. Every year after you withdraw the same income as year 1, adjusted for inflation, regardless of the percentage that removes from your portfolio.

Year 3 income: Adjust last year’s income by year 2’s inflation rate (e.g. 2%):

£20,600 x 1.02 = £21,012

And so on. Until the end. Which this is. At least it feels like it.

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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 []
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Weekend reading: Thicker than The Thick of It

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Warning: Brexit before the links. As ever, please feel free to skip if it’ll make you cross.

What happens when a farce turns into farce? Is there a negation, and then rationality reigns?

If so we’re not there yet with Brexit.

Government ministers voting and whipping against their own motions – and still losing. Brexiteers in Parliament voting down Brexit, while those outside deny the contradictions of their own marketing that make it impossible for MPs to “deliver what the people voted for”.

See this tweet for a taste of the antics.

Meanwhile we have Labour sitting on its hands for an (admittedly ill-timed) vote calling for a second referendum – a referendum that is supposedly Labour party policy.

As Theresa May’s undead deal returns for a third showing next week, the leader of the opposition – who has been screwing with us for two and a half years – is now doing the same to a corpse.

I visited College Green in Westminister this week to hang out with the hardcore Leavers and Remainers. It felt like history in the making. Thing is, when history is still being made you don’t know where it’s going.

Were all our national meltdowns – 1066, Henry VIII, Cromwell, Dunkirk, Suez – quite so lunatic? History repeats itself – first as farce, and later as Monty Python. Or perhaps the Tour De France.

I’m reminded of an addict who can’t quit. You watch through your fingers as they are confronted again and again by their terrible life choices. Everyone outside can see the thrill is gone, grim reality reigns, and that they’re just making themselves sick. But given a chance to make a new choice, they spurn it and stumble on.

Brexit. Just say no, kids.

The investing angle? See my previous table. Hard no-deal Brexit has become less likely, but so has a second referendum and no Brexit. We’re coalescing around a middle, which is probably where we should be given the result of the referendum.

Everyone’s not a winner!

[continue reading…]

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