Wealth warning: Interest-only mortgages are like power tools – useful in the right hands but capable of chopping them off. If you’re not sure you’ll stay interested in your finances for three decades, avoid! Get a repayment mortgage and keep life simple.

I have an interest-only mortgage. This confession causes some friends – and Monevator readers – to gasp.

Am I not a financial blogger? Don’t I know interest-only mortgages are risky? Weren’t they associated with the financial crisis?

“Are you nuts?”

I have my moments, but I’m mostly a responsible sort. And I believe interest-only mortgages are not as toxic as their off-ish odour suggests. In a couple of ways they’re arguably less risky than repayment mortgages.

Interest-only mortgages do have one big downside. We’ll get to that.

But they also have a couple of advantages.

What is an interest-only mortgage?

A quick refresher, and then on to the concerns.

• With an interest-only mortgage, your monthly debits to your bank only pay the interest due on your loan. You don’t repay any capital – and you needn’t until the end of the mortgage term. At that point the entire debt is due.

• This contrasts with a repayment mortgage, where you make capital repayments as well as interest payments each month. At the end of a repayment mortgage term – typically 25 years – it’s all paid off.

One obvious advantage of an interest-only mortgage is your monthly payments are lower, because you’re only paying interest, rather than capital and interest.

This may be appealing when house prices are high and interest rates are low.

Suppose you took out a £400,000 mortgage over 25 years at a ten-year fixed rate of 2.5%:

• Monthly payments with an interest-only mortgage: £834

• Monthly payments with a repayment mortgage: £1,795

Quite a difference! You’ve nearly £1,000 left in your pocket each month with the interest-only option.

Low rates make interest-only mortgages look like a winner. Here’s the same scenario with 1990s-style 12% interest rates:

• Monthly payments, interest-only: £3,999

• Monthly payments, repayment mortgage: £4,212

With very high interest rates, there’s is little difference between monthly interest-only or repayment payments. Either way most of your initial payments go on interest.

Today’s very low rate environment makes the interest-only option appear attractive when you’re only looking at monthly payments. Because rates are low, there’s little interest to be paid.¹

Screamingly important: It’s not all about monthly payments!

These comparisons tell us about monthly payments – but not about the big picture of buying your home outright.

That’s because the interest-only mortgage is not being paid off.

In my example, with the interest-only mortgage there will be a £400,000 debt due at the end of the 25 years.

This gaping hole will need to be filled, either by selling your property to repay the mortgage – not usually a permitted as a plan for residential owners – or by using capital from elsewhere. (Aha!)

In contrast, the repayment mortgage will be paid off in full after 25 years. And long before then the debt will have dwindled significantly.

What’s more, the total amount you pay to own your home will be higher with an interest-only mortgage.

• As you pay down capital with your repayment mortgage, interest is charged on a shrinking outstanding balance, which reduces the future interest due.

• With an interest-only mortgage you pay interest on the full debt for the life of the mortgage.

I’ll get back to this in a moment.

The repayment mortgage as a piggy bank

We might think of a repayment mortgage as like a ‘forced’ savings account.

True, it’s a strange sort of savings account, because it starts with a massively negative balance – of minus £400,000 in my example – and eventually you ‘save’ back up to breakeven.

But it works the same way.

Every £1 you put into repaying off the outstanding capital increases your net worth by £1, compared to if you’d spent that £1 on sweets or beer, because you’ve now paid off £1 of debt.

If you started with a negative balance of £400,000, you now only owe minus £399,999.

You’re richer!

A repayment mortgage is often even better than a normal savings account, because you don’t pay tax on your ‘interest equivalent’ when reducing your mortgage, but you might pay tax on interest on cash savings. Depending on your total income and tax bracket², this means repaying debt may deliver a higher return than earning interest on savings. (It’s all been made a bit more complicated by the introduction of the savings allowance though. Check out this primer from Martin Lewis if you want to do the sums.)

Of course the downside of this ‘mortgage pseudo-savings account’ is your home could be repossessed if you fail to make your payments. That’s several dozen shades darker than the worst that can happen with a real savings account.

Five perceived problems with interest-only mortgages

Let’s crack on! Let’s look at some arguments people make against interest-only mortgages, and why they aren’t necessarily a concern – and certainly don’t amount to a toxic product – in the right circumstances.

1. An interest-only mortgage is more expensive

This is one of the best arguments against using an interest-only mortgage – or perhaps I should say against misusing it.

Going back to the £400,000 mortgage charged at 2.5% for 25 years:

• The repayment mortgage costs a total of £538,409³

• The interest-only mortgage costs a total of £650,113⁴

The difference is in the interest bill. It is £111,704 higher with the interest-only mortgage. As I wrote earlier, that’s because you’re charged interest on the full £400,000 for the life of the interest-only mortgage.

Now you might be thinking you’ve spotted a gaping hole here in the logic of using an interest-only mortgage.

We’re trying to get richer around, right? Not poorer.

But as mathematician Carl Jacobi’s maxim states⁵ “Invert, always invert.”

With the interest-only mortgage in this example, you are effectively paying £111,704 in additional interest⁶ to rent £400,000 from the bank for 25 years.

After that, money that would have gone into repaying the mortgage can instead go into investments that will probably deliver a higher return overall.

Not a higher return than house price growth – that’s irrelevant here, see point #3 below – but a higher return than the 2.5% interest rate your bank is charging, adjusted for your personal tax situation.

That basically means global equities – shielded from taxes in an ISA or SIPP – which might be expected to deliver annual returns of around 7-8% a year, depending on who you ask and what period they look at. (Remember we can use nominal returns here, because your mortgage interest rate hurdle is also nominal. In real terms the value of your £400,000 debt is being shrunk over time, too.)

If you use an interest-only mortgage and invest, you’re effectively gearing up your portfolio with the mortgage debt. Every pound of debt that’s not repaid is effectively invested into your portfolio instead, for 1-25 years.

If all goes well, you’ll end up richer. After 25 years you’ll pay off your mortgage balance and the excess (we hope) is yours to keep.

Of course it’s not a slam dunk. Investing in equities – even with a lengthy 25-year time horizon – is much riskier than repaying a mortgage, which delivers a known return. There are no guarantees.

Also tax looms large. Compare an after-tax gain on equities with an effectively juiced-up after-tax return from paying down debt, and the potential differential shrinks.

For me this means that while I have headroom in my annual ISA and SIPP allowances, I’m planning to effectively run a larger, leveraged, tax-sheltered investment portfolio, rather than pay down my interest-only mortgage – at least for the next 10-15 years.

If I have spare cash after that (after an emergency fund and so on) I’ll throw it at the mortgage.

This is definitely a personal decision, and I guarantee people will turn up in the comments saying it’s too risky and you should just pay down your mortgage debt.

Notice though that these same people will often be paying into a pension while carrying a repayment mortgage – in some ways a similar proposition, though not one I’d personally argue against for a minute – or perhaps they had a defined benefit pension and were never faced with such decisions. (Certainly anyone who says using an interest-only mortgage while they themselves have a repayment mortgage at the same time as they’re saving into an ISA, let alone a general un-sheltered investment account, is riffing on their cognitive dissonance!)

Remember too that plenty of people have taken out interest-only mortgages without any plans to repay the debt. This is mostly why interest-only mortgages have a stinky reputation. But that is the opposite of what I’m suggesting here! I’m doing this entirely to grow my wealth, a portion of which should one day be used to pay off my outstanding mortgage.

Also note that you have some optionality with the interest-only approach.

My interest-only mortgage T&Cs allow me to repay up to 20% of the outstanding debt off in any particular year.

If markets do much better than I expect at any point over the 25-year term, then I can switch from investing more to repaying the interest-only mortgage before the debt becomes due, or maybe even deploy lump sums liquidated from my ISAs against the mortgage (though it’s hard for me to conceive of doing that and losing some of my precious ISA wrapper…)

Ditto if interest rates rise, and it becomes more expensive to run the interest-only mortgage.

Here’s a couple more articles to read on the topic:

• Pay off the mortgage or invest?

• The dangers of borrowing to invest (Series covers several key points)

• Can you afford NOT to have a big cheap mortgage?

As so often, it’s make your own mind up stuff.

The Accumulator changed his mind in a similar-ish situation and decided to focus on reducing his mortgage debt rather than maximising his investing gains. No shame in that!

2. You’re not reducing the capital you’ll eventually owe

The second – also excellent – argument is that paying off, say, £400,000 is a massive slog for most of us, and you’d be best off starting early.

I agree that for many people this is wise advice.

However even with a repayment mortgage you might not be repaying much capital in the early years, depending on rates.

Sticking with my £400,000/2.5% example (and rounding for ease of reading) in the first year of a repayment mortgage you’d pay £9,860 in interest. You’d only pay off £11,666 of the outstanding capital.

So that’s roughly 45/55 interest to repayment.

The figures do get better over time. By year ten you’re repaying £14,610 a year in capital, with less than £7,000 going on interest. This is because your prior repayments have shrunk the debt that interest is due on.

But a big chunk of your early bills are actually going towards servicing interest, even with a repayment mortgage.

And it’s much worse when rates are ‘normal’.

At a more historically typical mortgage rate of 6%, you’d pay nearly £24,000 in interest in year one on that £400,000 loan, and merely £7,000 of the capital.

That doesn’t seem so much a repayment mortgages as a mostly-interest-mortgage!

Here’s an illustration of the interest/capital split under a 6% regime. Notice how long it takes for capital repayments to outweigh interest payments:

With a 6% interest rate, even a repayment mortgage is mostly paying interest early on.

Of course we don’t currently live in a 6% regime. You could argue that with today’s low rates it’s actually a great time to have a repayment mortgage and to slash your long-term debt, exactly because most of your payments are going on capital.

It’s a coherent argument.

My point is simply that both interest-only and repayment mortgages feature a lot of interest-paying, at least initially.

It’s just a bit disguised, because when a bank rents you money to buy a house, it all gets wrapped up in one monthly bill.

3. You’re not smoothing out your housing exposure

This argument is wrong thinking, but I’ve heard enough people say it that I suspect it’s pretty common.

The (faulty) logic goes:

With a repayment mortgage, you’re gradually increasing your exposure to property as you pay down your debt.

Often they will add something like:

“The stock market looks wobbly, so instead of investing I’m going to make some extra payments towards my mortgage in order to put more into the property market instead. You can’t go wrong with houses!”

I’ve even had a friend suggest to me that repaying his mortgage over time (including with over-payments) is like pound-cost averaging into the stock market.

But while this certainly results in good financial discipline, the theory itself is nonsense.

When you buy a property is when you get your ‘exposure’ to the housing market. Your exposure going forward is the property you bought. The cost of that asset is the price you paid when you bought it.

Everything else is financing.

Most of us take out a mortgage to buy our home. How we choose to pay that off – every month for the life of the mortgage or in one lump sum in 25 years, or something in-between – is about managing debt, not altering our property exposure.

If you make an extra £50,000 repayment towards your mortgage, you haven’t got £50,000 more exposure to the housing market. Your property exposure is still whatever your house is worth.

Rather, you’ve paid off some debt (/done some enforced saving!)

True, it’s debt that is bucketed against the specific asset of your home. But that’s it.

The way to pound-cost average into the residential property market is to buy multiple properties over time, or to invest in a loft extension or similar.⁷

4. What if you can’t make the interest payments – you won’t own your home?

People seem to believe using an interest-only mortgage is more precarious than a repayment mortgage. You often see this insinuated in articles.

There is a feeling that somebody living in a home financed with a mortgage where they’re not paying down debt each month is living on a limb.

But your financial situation is more than just your house and your debt.

It includes your cash savings, your investments, your pension, your monthly income, your liabilities, and more.

When I bought my flat with an interest-only mortgage, I put down a 25% deposit. Since then I’ve repaid almost no capital⁸.

In contrast, my friend P. bought a flat around the same time as me with a 20% deposit and a repayment mortgage. He will have since repaid a couple of percent of his mortgage.

I don’t see that he’s in a more secure position than me, on these bald facts alone.

• Neither of us own our properties outright.

• Both of us could be repossessed if we fail to make our mortgage payments.

• He’s made bigger monthly payments to his bank. I’ve put a higher percentage of my net income into investments.

You could even argue that my interest-only mortgage is less risky, on a month-to-month basis. My monthly payments are lower, and so they would be easier to meet in a pinch. The rest of the time I can – and am – diverting the spare cash into building up my other savings and investments, not spending it.

This actually gives me more of an accessible ‘liquid’ buffer than he has.

With an interest-only mortgage you can also spread your assets more widely than someone who is putting everything into paying down their repayment mortgage ASAP.

Their assets may be very over-weighted towards one single residential property. More of yours will be in global shares and bonds (effectively financed by your mortgage…) in addition to property .

Of course, if you just use your lower interest-only payments to live beyond your means rather than building up your investments then it’s a different story. I’m not arguing for paying lower monthly bills and then moaning to the regulator in 25 years that you didn’t understand you had a debt to repay!

But blame the player in that case, not the game.

5. You don’t ‘really’ own your home, even if you do keep up the payments

My mum said this to me. She seems to believe she always owned her home because she was paying off her mortgage each month, whereas because I’m not she thinks I don’t own mine.

This is all hand-waving stuff.

Some people say the same about homes bought with repayment mortgages, too. They say the bank ‘really’ owns your house. That you’re just renting until you’ve paid off the mortgage. Until then you’re a tenant of the bank, which is the ‘true’ owner.

This is wrong, legally speaking.

When you buy a house you take legal ownership of that property⁹. It’s registered under your name at the Land Registry, and you have various rights and responsibilities that come with ownership.

If you happen to buy it with a mortgage, then you’ve also taken on commitments to the bank that lent you the money.

Because some people don’t repay their debts, banks want some security.

And… you’ve just bought a home… so hey, there’s a big lump of hard-to-move security sitting right there!

Invariably then, when a bank lends you money to buy a property, this loan is secured against that same property. That’s why the bank gets your property valued beforehand. (You didn’t think it was for your benefit, did you?)

There are all kinds of implications from using a mortgage like this, but not owning your home isn’t one of them.

Of course with an interest-only mortgage you do need to repay the debt eventually to stay in your home. Your 25 years of home ownership will come to an end if you have to sell your home to pay off your mortgage.

That’s 100% true.

But it’s not a reason to avoid an interest-only mortgage – it’s a reason to have a plan.

Outstaying your interest

There’s a vogue on this site at the moment to crunch numbers, but at 3,000 words I think this article is weighty enough.

Boiling it down, it’s a pretty simple concept…

Investment returns > extra interest-only mortgage costs = win

Investment returns < extra interest-only mortgage costs = loss

… maybe adjusting your investment returns by a risk factor to reflect the uncertainty of gaining them.

I’ll say it again, to try one last time to stop someone in the comments saying I said something else – for most people, a repayment mortgage is a simple, reliable way to buy a home. It will probably reduce your financial vulnerability over time. It should be the default choice.

But for those of us who like to juggle our finances for fun and profit, an interest-only mortgage is well worth considering.

1. Then again, high rates usually come with high inflation, and that would be eroding the real value of your debt quicker. [↩]
2. And the interaction with your personal savings allowance. [↩]
3. Mortgage debt of £400,000 and interest of £138,409 [↩]
4. Mortgage debt of £400,000 and interest £250,113 [↩]
5. via Charlie Munger. [↩]
6. Of £250,113 in total interest. [↩]
7. Or to buy shares in one of the few listed companies that owns substantial amounts of residential property, such as Mountview Estates. [↩]
8. I made one small ad hoc payment to ensure it worked. [↩]
9. Well, assuming you own the freehold. It’s more complicated with a leasehold property, but let’s save that for another day. [↩]

What caught my eye this week.

Every year the global bull market in equities and bonds continues, it gets harder to convince people that investing isn’t always so breezy.

Sure we had that setback towards the end of 2018. If you squint a bit, it could even be described as a crash. But the whole thing was over in a couple of months!

I read comments in the aftermath of that wobble from younger investors who were pleased they hadn’t sold out in a panic.

Good for them, genuinely.

But as trials go, the 2018 correction was a sprint, not a marathon.

Crash course

A proper prolonged crash will come again. That isn’t a reason not to invest – bear markets are part and parcel of enjoying the gains from shares – but it is a reason to make sure your portfolio is robust to all reasonable scenarios.

This new video created by Robin Powell for financial planner RockWealth provides a good primer for those who don’t know – or have forgotten – what a bear market looks like:

(If you’re reading on email and can’t see the video, please visit the post on Monevator.)

Even I have to remind myself that in the years immediately after I began this website – in the depths of the 2007 to 2009 slump – I was accused of recklessness for suggesting readers continue to put money into shares.

If that’s hard to believe now, think of all those who say today they would never own bonds or REITs or gold – preferring to go all-in on equities.

Sure the expected return from bonds looks lousy (as it has for the past few years).

But if shares lose 30% in a year then you’ll soon hear from others who were delighted they had some money in other assets.

As John Lim – reflecting on the 30-year bear market in Japan – wrote for Humble Dollar this week:

If the Japanese experience teaches us anything, it’s that stocks can be incredibly risky.

A Japanese investor who had some portion of his or her holdings in bonds fared far better than one fully invested in stocks.

If nothing else, it would have allowed him or her to sleep better at night.

Here’s a few more miserable reminders to vaccinate yourself against hubris:

• How scary can investing be? – Monevator

• The day the market crashed [Podcast] – The Motley Fool (US)

• Why I buy in bear markets – Monevator

Don’t be too frightened to invest!

But don’t be too invested to avoid getting frightened…

Have a great weekend.

[continue reading…]

This is part four of a series on how to maximise your ISAs and SIPPs to achieve Financial Independence (FI).

*DEEP VOICE*

Previously, on How To Split Your Pot Between ISAs and Your Pension For Fun and Profit:

• Part one set out the FI problem of retiring early using UK tax shelters.

• Part two explained why the tax advantages of personal pensions make them superior to ISAs later in life.

• Part three laid down a basic plan for judging how much you need in ISAs compared to SIPPs.

*CAMERA PANS DOWN TO A HUNCHED FIGURE DOING MATHS*

*THE ACCUMULATOR LOOKS UP AND BEGINS SPEAKING*

Customising the plan to your own situation relies on knowing what sustainable withdrawal rate (SWR) to use.

Before we get into that, I’ll recap the plan so far:

• We’ll live on our personal pensions from our minimum pension age onwards.¹

• Our ISAs and General Investment Accounts (GIAs) bridge the gap between giving up work and popping the corks on our pensions.

• We won’t bank on our ISAs and GIAs lasting longer than those gap years. That enables us to balance the need to grow our wealth as tax efficiently as possible against retiring early without taking unnecessary risks.

• We’re not rich enough to ignore the risk of low growth or an unfortunate sequence of returns, so we’ll need a strong dose of risky assets (hello equities!) to reach our goal² plus a buffer zone of lower risk assets (we meet again, bonds and cash).

To ensure our FI plan is based on something other than gut instinct, bum-clenching, and the sweet smile of Lady Fortuna, we’ll base our calculations on the best research we can.

As well as having a (very) rough idea of how much annual income we’ll need and how long it should last, we need to know how much wealth we must build before we can celebrate our independence day.

Cue letting off firecrackers in the office, stripping to the waist to the sound of Ride Of The Valkyries, and telling the boss we love the smell of resignation in the morning!

But I digress…

We need a credible sustainable withdrawal rate

SWRs are designed to guard against the disaster of drawing too much, too fast, too soon from our investments, and so running out of money like a gaggle of teenagers running out of gas near an axe-murderers’ convention in a spooky wood.

• Your SWR number is a guide to how much annual income you can sustainably draw from your portfolio given certain sassy parameters (see below).

Knowing your desired income and SWR enables you to calculate how much wealth you must first build to later sustain that annual cashflow at that rate of withdrawal.

See the bonus appendix at the bottom of this post for the maths.

A credible SWR is a good planning tool because…

• …it deals with the fact that we’ll be living off a volatile portfolio of assets that can fork out an unpredictable range of outcomes: good, bad, and indifferent. This is the root of sequence of returns risk – the danger that a bad run of market returns exhausts a deaccumulation portfolio in short order.

• …excellent SWR research is publicly available and relevant to DIY investors relying on their own resources to plan their future.

• …SWR strategies can cope with historically bad investment returns, but aren’t so cautious that we must postpone our financial independence for years trying to guarantee safety.

• …SWR strategies enable you to withdraw a consistent, inflation-adjusted income for the duration of your retirement (subject to all-important caveats that you need to understand).

I understand that some readers prefer an even more cautious approach, or have already accumulated sufficient assets or income streams not to need to worry about SWRs.

That’s all well and good. But not everybody – including me – has that luxury. Safety costs money.

I’ll give you the information you need to use SWRs appropriately while understanding the limitations of the strategy.

From that vantage point, you can then decide if an SWR strategy makes sense to you. Just rest assured I’m not a 4%-rule groupie, or a lifestyle blogger with a course to sell.

For SWR parameters, caveats, terms and conditions, please read:

• SWR pitfalls
• Choosing a conservative SWR to suit your circumstances
• SWR levers you can pull
• An alternative lower risk retirement strategy

Choosing your SWR

I’ll base our SWR numbers on the research of Professor Wade Pfau.

Pfau is widely respected in the field of retirement research. He’s attacked the withdrawal rate conundrum from multiple angles. Also, he has researched SWR rates for time periods lasting from ten to 40 years.

That’s important because many of us will need two SWR numbers:

• The rate at which we can withdraw from our ISA, so that we don’t run out of money before we can access our personal pension.

• The rate at which can we withdraw from our portfolio – combined across all accounts – so we don’t run out of money for the rest of our lives.

Pfau uses historic market returns and Monte Carlo sims to scope the variety of market conditions we may face in the future.

Monte Carlo sims reshuffle returns data to generate many more scenarios than are available from the historic record. They’re alternative history generators, enabling us to stress test our plans against extreme circumstances that didn’t occur. Think Great Depression followed by Great Recession.

Pfau has also produced SWRs curtailed by the high valuation, low interest rate world we face right now.

The weakness of Pfau’s research is that it uses US historic returns that have been relatively benign in comparison to the global investment experience.

Because Monevator readers are mostly non-US investors with globally diversified portfolios, we need to cross-check US research against accessible global data to make sure we’re not unwittingly adopting an SWR that’s too sunny for grey old Blighty.

That’s where Timeline comes in.

Timeline is withdrawal rate strategy software designed for financial planners. It’s excellent, and thanks to its free trial, we can dial up global market returns data in both historic and Monte Carlo flavours. I strongly recommend you try the free Timeline trial and use it to stress test your own plan.

SWRs for ten to 50-year periods

Okay, that’s a lot of preamble to get to the money shot but here it is. Below you’ll find the SWR numbers I’m using to model our ISA / SIPP FI plan.

Because there isn’t one SWR to rule them all – and because we’re trying to get a grip on an uncertain future – I’m going to show you a range of SWRs for each time period. You can then make an informed decision about how conservative you want to be.

There’s a full explanation below of the terms used in the table.

This table could do with some explaining:

Timespan – The maximum period in years that you need your investments to last. For example you need your ISA to bridge a 15-year gap until your minimum pension age, you could choose a 5% SWR by the light of the Low Interest SWR column. If that ISA must last 20 years then choose a 4% SWR from the Low Interest SWR column.

What if you’re an in-betweeny? What if you have a 17 year gap to plug? If you’re an optimist then you’ll round 17 years down to 15 and choose a 5% SWR. If you’re cautious, then round your time horizon up, and choose the 20-year 4% SWR.

Or you could compromise with a 4.5% SWR, knowing that SWR rates are a curve and that a 4.5% SWR is supported by the historical and Monte Carlo results for the 20-year period.

For lifetime spending, most of us are best off choosing a 40-year plus timespan. 

For eight-year periods or less: save enough in cash to cover your spending needs plus an inflation top-up.³ The potential upside of equities isn’t worth the risk of grievous loss with so little time to bounce back.

Historic SWR – Pfau’s research for 15- to 40-year timespans using US historic asset returns (1926-2014). (See table 1 in his research paper).

Pfau provides SWRs for different asset allocations (0% – 100% US equities versus 100% – 0% US government bonds) plus success rates. Our table shows the best SWR for a particular time period and success rate. Click the table 1 link above to see Pfau’s asset allocation findings, and please also refer to our asset allocation section below. Pfau published an updated version of this research in his book How Much Can I Spend In Retirement?⁴

Monte Carlo SWR – Pfau’s Monte Carlo simulation of ten to 40-year timespans using US asset returns data. See table 3. Success rates are converted into failure rates in that linked research paper. Again, click the table 3 link for asset allocation info and see below. An updated version of this research is also available in Pfau’s book How Much Can I Spend In Retirement?⁵

Low Interest SWR – Pfau’s Monte Carlo simulation of 15 to 40-year timespans using US asset returns data anchored to low interest rates. See table 2.

Pfau’s sim is designed to reflect the low interest rate conditions that have hung over the world since the Great Recession. He allows assets to slowly rebound to their historic average returns over time.

Low interest rates reduce the expected returns of equities and bonds, and so this column is especially relevant for anyone retiring in the next ten to 15 years. You can see that the Low Interest SWRs clock in around 1% lower than the historic and Monte Carlo norms.

Global Portfolio SWR – Timeline uses global asset returns data that isn’t publicly available to produce withdrawal rate strategies suitable for UK investors.

I can’t just publish their data, but I’ve used their superb app to sense check Pfau’s work. The Global Portfolio SWR shown in the table is a downbeat take on Timeline results, using both historic and Monte Carlo scenarios.

The Global Portfolio SWR generally lags the US historic and Monte Carlo SWRs but it’s a sight better than the Low Interest SWR. Unfortunately, the Low Interest SWR is only based on US asset returns, albeit crocked by low interest rates, so a Global SWR equivalent could be worse still.

My Timeline results didn’t take into account current market valuations, although it looks like their Monte Carlo sim is flexible enough to do so.

Take heart though – the Global Portfolio SWR does incorporate the drag of 0.5% investment fees⁶ while Pfau’s work skips that problem.

Success rate – This is the percentage of scenarios where the simulated portfolio didn’t run out of money before the end of the timespan. For example, a 6% Historic SWR left you with money in the bank in 99% of scenarios simulating a 15-year retirement. Note, the success rate may actually be 100% but I’ve adopted the Timeline convention of capping out at 99% because failure is always possible.

Any scenario that ends its run with so much as £1 left counts as a success. In reality, a retiree would almost certainly notice their balance plummeting long before and cut back on spending to prevent their portfolio going to zero.

Success rates for the Low Interest SWRs are much worse as you can see in the Success Rate Low Interest column.

Some research deals in failure rates, which are success rates for pessimists. A 95% success rate equals a 5% failure rate.

SWR patterns

The higher your SWR, the less wealth you need to have saved to deliver your desired income.

• SWRs are generally higher for shorter timespans.
• SWRs are lowered by higher success rates.
• Higher equity allocations are generally needed to maintain feasible SWRs over long timespans.

You can offset the negative effect of longer timespans by lowering your success rate and upping your equity allocation to some degree.

I’ve generally erred on the side of 99% success rates for ten to 25-year periods that I think of as the ISA years. You could lower the success rate if you don’t mind going back to work if you cop a nightmare scenario. You can also trim your success rate if you’re prepared to cut your spending by 10% to 20%.

The 30-year plus periods are personal pension territory and so I’ve reduced the success rates to 95% or 90% because you’ll likely have plenty of back-up options. These could include still having money left in your ISA, cutting spending if needed, equity release, using annuities, eventually drawing a State Pension, and/or failing to set a Guinness World Record for life expectancy.

I personally think success rates below 90% are unacceptable. There’s no getting around it in the Success Rate Low Interest column though – Pfau didn’t calculate the success rate for SWRs lower than 3%. You could cut your SWR to 2.5% or even 2%, or rely on the back-up options mentioned above should the worst case materialise in your lifetime.

If your retirement is many decades away then you can console yourself with the thought that historical norms may have reestablished themselves by the time you’re ready to use your SWR for real. I suspect many of us think a ‘new normal’ has descended upon the world, though.

It’s worth dwelling on Pfau’s cautionary note:

Historical withdrawal rates are not random; they tend to be lower when stock market valuations are high and when interest rates are low.

Both of these factors are at work today in a way that has been rarely experienced in the historical record.

If you’d like to know more about how SWRs are constructed and how sensitive they are to variations in volatility, inflation, asset returns, success rates, and the sequence of returns then check out Pfau’s deep dive into the topic.

Meanwhile Timeline enables you to play with the parameters as if you’re sitting at your own financial mixing desk.

The upshot is there’s no point ceaselessly searching for the optimal SWR. It doesn’t exist. I’ve rounded the SWRs in the table to the nearest half point because precision creates a false impression of control.

Similarly there’s no point ceaselessly searching for cast-iron safety. It doesn’t exist. The point of this exercise is to provide a practical platform for planning.

Remember you also need to adjust your SWR to account for the cost of investing. We suggest you deduct 50% of your total expected annual fees from your SWR. (We only deduct half because of the mathematics of a real-world portfolio drawdown).

I’ve assumed total fees of 0.5% (0.25% platform fees and 0.25% average portfolio OCF), so I’d need to chip 0.25% off the SWRs from the table above (except the Global Portfolio SWRs which already include 0.5% in fees). For example, if I choose a Low Interest SWR of 5% then I need to pare it back to 4.75% to account for the impact of fees.

Make sure your retirement income is calculated gross of taxes and you’ll need to reduce your SWR again if you want to leave a legacy. SWRs assume you can use up all your capital in the worst case scenarios.

SWR asset allocations for FI

Hunting for the optimal asset allocation to support your SWR is another fool’s errand. Table 3 in Pfau’s research shows just how much asset allocations can vary and still come within a whisker of the same SWR result.

For example, an equity allocation of anywhere between 33% and 72% lies within 0.1% of the best SWR for a 40-year period with a 90% success rate. That’s good news if you don’t have a sky high risk tolerance.

Still, it’s worth understanding the ballpark asset allocations that supported the Global Portfolio SWRs for each timespan and success rate in our table above:

Surprisingly few equities are required over periods of ten to 20 years to achieve a high success rate. That’s because the volatility of risky equities needs to be balanced by low risk assets over such a short time.

Pfau’s work with US returns shows much the same thing. Equities hover around 20% for portfolios that must survive ten to 20 years with a success rate of 99%.

Cash figures heavily because historical UK government bond returns are generally long bonds that got smashed during high inflation episodes, especially from 1947 to 1974. Pfau uncovers the same pattern in the US; allocations of around 40% cash (or bills) deliver success rates of 99% for ten to 20-year timespans. Cash is an underrated asset that dampens volatility and it does better against unexpected inflation than is commonly assumed.

I found the 70:30 portfolio results could all be improved upon in Timeline by going to an 80:20 equity:bond allocation. Yet beware of torturing the data and ending up with a concentrated portfolio that’s optimised for the past. History rhymes but it doesn’t repeat. Past results can impart useful guiding principles, but shouldn’t lead us to fight the last war by banking everything on a Maginot Line of, say, 100% small cap equities.

Pfau also says that historical data is biased against bonds because the overlapping retirement periods examined by historical sims overweight the middle part of the track record. That period coincides with a savage bear market for bonds.

Monte Carlo sims don’t suffer this problem and tend to show that higher bond allocations can support higher SWRs than assumed by historic data research. Again, see Pfau’s table 3.

I wouldn’t blame anyone for cutting back their bond allocation given the current outlook but you should still hold a substantial slug because diversification is your best defence against an uncertain future.

Caution ahead

The green numbers in my table above are the SWRs I’ll employ in the upcoming and earth-shattering case studies later in the series.

I’ve picked the most conservative SWRs available from the range because they’re likely to protect us from bad outcomes – short of The Four Horsemen defecating on humanity’s doorstep.

Indeed one of the problems with SWRs is that they often leave too much money on the table if you don’t suffer a terrible sequence of returns. Don’t feel pressured to heavily discount the green SWRs in the table if it means you must spend so long building a bomb-proof level of wealth that you will never get to enjoy it.

Ultimately an SWR is our placeholder for an unknown future, and we could debate it until the future arrives.

Nobody should delude themselves that any system can bestow safety or a perfect outcome. Choose your trade-offs, understand your risks, enjoy your independence, adapt as you go. That is what this series is about. 

The plan we’re sketching is not a forecast. It’s just enough to get us off on the right foot. Prepare to take further steps along the way.

Next episode: You’ve probably noticed that choosing a suitable pre-pension SWR relies on knowing how long your ISA / GIA should last. We walk through a straightforward calculation that enables you to work that out and finally get your ISA and pension working in tandem to achieve FI.

Take it steady,

The Accumulator

Bonus appendix: SWR maths is fun!

How much wealth do you need to sustain an inflation-adjusted income?

It works like this:

Divide your required FI income by your SWR.

For example:

£25,000 / 0.05 (5% SWR) = £500,000 stash required to sustain an inflation-adjusted £25,000 for 15 years – according to the Low Interest SWR column of our table above.

How much more would you have to save to increase your income by £1,000?

£1,000 / 0.05 = £20,000

£520,000 is therefore needed to support an inflation-adjusted income of £26,000 for 15 years with a 5% SWR.

How much less could you save if you earned £5,000 part-time a year for those 15 years?

£5,000 / 0.05 = £100,000 less required in stash.

Or, £20,000 / 0.05 = £400,000 stash.

How SWR withdrawals work

Year 1 income:

Multiply your portfolio’s value by your SWR

For example, if your SWR is 5% and your portfolio is worth £500,000:

£500,000 x 0.05 = £25,000 annual income

Year 2 income:

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

£25,000 x 1.03 = £25,750

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

Year 3 income:

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

£25,750 x 1.02 = £26,265

And so on. Every year ye shall live, or have money left.

Like this? Enjoy more maths-for-investors fun with Monevator.

1. The minimum pension age lies between 55 and 60, depending on when you’re born. [↩]
2. The exception is bridging an eight-year or smaller time gap until accessing your personal pensions. It makes sense to rely on cash for periods as short as this. [↩]
3. Or build an index-linked UK government bond ladder. [↩]
4. Exhibit 4.5 page 87. [↩]
5. Exhibit 4.8 page 94. [↩]
6. And 0.5% should easily be enough to cover platform costs and a portfolio of keenly priced index trackers. [↩]