There’s a tipping point in your investment life when you realise you’ve got a lot of portfolio to protect. Going to the moon is yesterday’s game. Derisking your portfolio is the order of the day.
It’s not purely a rational shift – like reaching a certain number on a spreadsheet. There’s an emotional phase change, too.
You’re no longer that carefree youngster who could cheerfully stomach 100% stocks. You can no longer easily makeup for losses with fresh contributions. You don’t have decades of investing ahead of you anymore.
You might have less than ten years until retirement, say. If you play your cards right.
The question is: how do you play your cards right? What asset allocation glide path should you take that keeps your portfolio powering towards the finish line? While also reducing the risk of blowing up the engine before you cruise home?
A number of readers have asked about this tricky problem recently. And though I’ve been through it myself, I see now it’s quite a dark area on the DIY investment map.
Your mileage may vary
There are lots of rules-of-thumb you can follow – and also contradictory viewpoints aplenty. It’s hard to find a comprehensive guide that clearly discusses the many levers you can pull.
Late-stage accumulation is almost as difficult as the thorny subject of decumulation because:
- There are lots of moving parts.
- You’re exposed to many of the same risks as a retiree.
- There are trade-offs to make, and the ones you choose will likely depend on both your financial situation and your unique (read ‘utterly freaky’) psychology.
- There isn’t a single, optimal, battle-tested strategy to suit everyone.
It’s hard! So I’ve decided to write another 500 words on the magic of compound interest instead.
Not really. The world doesn’t need that! What the world needs – surely – is a Monevator mini-series on derisking your portfolio before retirement.
This first instalment will be a bit groundworky. We’ll survey the landscape so you can place yourself on it.
Then later, when we walk-through the strategies you might adopt in forthcoming episodes, you’ll hopefully then have a clearer idea of whether this or that one is for you.
Let’s roll up our sleeves and get into it.
The central dilemma
Late-stage accumulation presents wannabe retirees with a predicament: the larger your portfolio, the more investment losses (and gains) affect the pound value of your retirement pot.
Say your financial independence target is £600,000 and your portfolio balance stands at £500,000.
In the retirement game of Snakes and Ladders, a 20% gain sends you shooting up the ladder to the final square!
Now you can declare victory! Direct ‘Loser’ signs at your boss. Enjoy a template email thanking you for your many years of service, whoever you are [insert name here].
Not so fast…! What if a 20% loss sends you slithering back down to the £400,000 square?
AAARGH!
In this way gains and losses can dwarf your annual contributions in the final years of accumulation, adding or subtracting years from your journey on a roll of the market dice.
The limits to the old slice and dice
The existence of sequence of returns risk helps explain why optimal glide paths don’t really exist.
Firstly, your path to glory is incredibly sensitive to late-stage market returns – in other words, you’re in the sequence of return risk zone-of-much peril. Equities are so volatile over short periods that it becomes meaningless to run the numbers and apply the law of averages to your situation.
Your returns – in the final handful of years that count the most towards your end result – are unlikely to be average. (As investment writer Ben Carlson has noted, few years are.)
It just doesn’t make any sense to me to take comfort in the mean result generated by 5,000 spins of a Monte Carlo simulation or even one hundred years of historical data. Though I will link you towards the research that’s out there in case you disagree.
Secondly, our individual attitudes to risk vary almost as wildly as stock market returns. What’s more, there’s reason to believe that disparities in risk tolerance not only exist between people but also between different versions of our discrete self.
As in, I know for a fact that the older me is more risk averse than the younger model. Not just financially but athletically, too. I also drive more slowly than I used to and no longer accept Dolly Mixtures from strangers.
Moreover, I’ve read articles suggesting people are more risk tolerant during bull markets than bears. That’s the investing equivalent of: “You only sing when you’re winning!”
And, well, that’s no great surprise, is it?
If you’re concerned for your portfolio now, then how would you feel when the market is 42% down? When you are two years out from retirement?
What’s that Mike Tyson quote again?
Would you like to play a game of Risk?
The problem with the standard rules of thumb is they take a simplistic view of risk.
By their lights, the only risk is a hoofing great stock market reversal – and the answer is a featherbed of bonds and cash.
But this ignores the fact that 2022 showed us that bonds can be hit hard by rising interest rates and inflation.
Cash is highly susceptible to inflation too, though that’s often overlooked.
Hence a well thought-through derisking strategy must also address interest rate risk and inflation risk.
Beyond that, there’s a panoply of risk modifiers that turn on your ability to handle setbacks. In short, the greater your flexibility, the more risk you can afford to take.
The more risk you’re willing to bear, the more equities you can hold in a bid for a faster retirement check-out – or fatter cheque.
But it’s no good just saying “give me more risk then” and making like Indiana Jones in a dash for the exit.
You have to be able to carry that risk – and to sleep at night.
This is not only about sucking down a red day on the stock market. Handling risk also reflects your capacity to cope if the dice do go against you and your retirement is indeed set back – whether by delaying its start or in the living standards you enjoy.
Retirement date
If you can delay your F.U. day by a few years then you can take more risk because you can wait for the market to recover should it cut-up rough.
Additionally, working on reduces the length of your retirement (because, alas, mortality is real) and so the overall amount of pension you need.
Pension contributions
If you have a high savings rate (or your contributions are high relative to your portfolio size) then you’re less reliant on investment growth to hit your target. You can shoulder more risk because – like a younger investor – you can better fill the holes opened up by portfolio losses.
Intriguingly, you could also view this as a reason to take less risk. If you just want to be done with it all, and are less concerned with pushing your pot beyond your number, then you could let your cash money contributions do the work.
In other words you don’t need to max out on equities. So trim back to lower the impact of a stock market bomb that would otherwise blow-up your plans.
Retirement income
It’s one of life’s ironies that the less you need money, the more risk you can accept in pursuit of the stuff. Should the risk fail to pay off – and you still want to retire on time – then no biggie. You can just take less from your portfolio.
You still get the cake. Just not the icing or the cherry you were hoping for.
This option is also super-powerful if you’re happy to work part-time for a spell in retirement. You’re far less reliant on a market outcome delivering to your schedule.
Risk aversion
The more galled you are by market knock backs, the more seriously you should consider the fact that equities could deal you a sickening blow.
Potentially this is the one factor to rule them all. The size of your portfolio contributions doesn’t matter much if a 30% market drop feels like agony to you. The only solution to that is to reduce the risk of it happening.
Watch out for signs that your risk tolerance is in decline. If you’re sweating over small dips or bubble talk then turn down the heat on your portfolio.
Valuations
Stock market valuation signals are like motorway overhead signs advising us to reduce speed.
Sometimes you wonder what that was all about as the hazard fails to materialise. But other times danger genuinely lies ahead.
Currently, the US CAPE and World CAPE valuation metrics are very high. High CAPE ratios tend to correlate with lower ten-year returns, though the signal is noisy.
Meanwhile, expected returns for typically lower-volatility government bonds aren’t much lower than for global equities. So if diversification is the only free lunch in investing then right now it’s coming with a complimentary bag of crisps.
Job and health
The more secure your employment – and the longer you can keep going like the Duracell bunny – the more risk you can take.
I mention these two for completeness. But personally I wouldn’t pay much heed to them, because your situation can change in an instant.
Strategic objective
Your endgame matters. If you want to hit a certain number, by a certain day, then you need to reduce uncertainty in your portfolio.
But the less certainty you need, the more you can venture on achieving a better outcome by loading up on equities.
To that end, the risk modifiers I’ve outlined are additive in some cases. If you’re prepared to compromise on your set retirement date, income, and portfolio contributions then you can make less drastic adjustments to all three if required.
On derisking your portfolio with bonds
It’s important to realise that cash and short government bonds are a recommended part of the risk-off package because they can lower portfolio volatility. Not because they’re expected to contribute much to its growth.
By reducing volatility these assets narrow the range of potential outcomes (good and bad) that could befall your portfolio by retirement day.
If you were burned by longer duration bonds in 2022 then it’s worth knowing that on the risk spectrum:
- Short duration government bonds are more cash-like. Long duration bonds are more equity-like (though not as rewarding over the long term.)
- Hence long duration bonds don’t have much of a role to play for late-stage accumulators.
The exception is if your retirement strategy involves annuities or a liability-driven floor-and-upside approach.
We’ll look at that and more in later instalments in the series. Part two of the series: When to derisk before retirement is available from all good blogs now.
Take it steady,
The Accumulator
If you want to retire at (say), you’ve got maybe 35/40 years of retirement. Why on earth would you be de-risking, when you KNOW that equities will outperform over that period? Buy and hold dividend paying equities and spend the natural income. Job done.
Having a 100% equity portfolio in accumulation is ok and possibly sensible while you are still working and have income from a job -recovery from a stockmarket drop is feasible
A retiree on the other hand has no way back to the workplace and his retirement income must also be 100% successful -that’s a totally different situation
Most retirees have not saved enough to tolerate a 40 % + drop in the equity side of the stockmarket without their retirement income being severely compromised -stockmarket equity drops of this magnitude are not uncommon
A retirees nightmare is a drop of this level occurring just at retiral-having to start drawing from investments in this scenario could so damage the retirement portfolio that it might never recover
Just using dividends for retirement income works but your portfolio has to be proportionally much greater than a portfolio generating income by total return ie selling fund units as required -so it’s not an available option for many retirees
Personally I have used a large % of bonds in my pre retirement and retirement portfolio to reduce volatility,preserve wealth and grow a little-2022 shows however no policy is 100% safe
Investing is not an easy ride -annuities are another option for the risk averse
xxd09
The other factor to consider in derisking is tax. For example, if your equities have hundreds of thousands of unrealised capital gains, selling them down guarantees a loss (in Australia at least). For that reason I haven’t sold down but nor have I been adding to equities over the past year. I have been using new savings and dividends received to build up cash and bond buckets and gradually change the portfolio allocation that way.
“… What’s that Mike Tyson quote again..?”.
Everyone has a plan till they get punched in the face ?
I’m rubbing my hands for this series, so thank you TA. I probably have somewhere between 5 and 7 years to go before FIREing and, although my pot is not very big, I have been moved to de-risk it somewhat by diversifying out of USA/Mag7 over the last couple of months. But that was more gut driven than based on hard headed logic. I’d like to diversify further with some gold, but my hand is hovering over the buy button there given it is hitting all time highs.
I’m hoping this series will be educational (as most articles here are) and very pertinent to me (which they sometimes aren’t, although I read them religiously anyway).
I have 9 years to go to my “target” retirement age (just FIR not FIRE sadly ) so I’m very much here for this! Well done TA for tackling this thorny subject – with the whole sequence risk thing I think it’s even trickier than decumulation personally.
Some markers I used……..
A £100000 in 60/40 portfolio asset allocation should generate £3000 pa before tax -hopefully more if stockmarket does well
Try to work out the retirement income you will need -start keeping records long as possible before retirement -I had and still use Quicken 2004
We seem to spend the same in retirement as when we worked-more leisure time to fill,travelling etc
Your age minus 10 in bonds is a rough guide
Asset Allocations of 70/30 right through to 30/70 do the job over the long term of a retirement -depends on how good you are at handling volatility and how much you have saved where you set your personal Asset Allocation
Get as much in tax free wrappers as possible-ISAs and SIPPs
Keep costs as low as possible-use 2 or 3 global index trackers only-cheap,easy to manage and understand on an appropriate inexpensive platform (see Monevator comparison page)
Living frugally is a great help
xxd09
A timely piece. Interesting to see how series develops. Will it be keeping an increasing share in an AWP type sleeve, or just going for plain short duration Gilts and/or DM Gov Bonds hedged to £Stg?
Perfect timing so thank you in advance! A couple of years until I hit my FI number and know I need to be rebalancing and de risking from an equity heavy portfolio but into what is the question! Will read with interest.
@Matt #1
I don’t think you understood the piece.
But let’s look at what you said. The running yield on vwrl is currently circa 1.5% which may vary, especially in real terms. If you’re wealthy enough to absorb that SWR then congratulations. Mere mortals will be runing at higher SWRs however. Hence the need for the consideration that was well articulated in the article.
Less than one year to retirement and discovered that pension platforms matter. My one work pension only offers annuities. My one SIPP only offers limited drawdown options and the fees change when drawdown starts. I need to do two transfers to get the flexibility that I want, which also means going fully to cash yet having no liquidity.
Would you consider expanding your platforms tool to include SIPP retirement options and suitability?
@Matt/@VM
I’ve recently re-read “Safe Have – Mark Spitznagel” and “Deep risk – BernStein”.
Both are excellent and the key point we usually miss is that wealth is a result of your CAGR(geometric average) – balls deep in the highest expected arithmetic average investment isn’t likely to be the best answer.
To summarise – you only get one investment path, take a bit of time and effort to “manage” its variability. A bottom 10% outcome of potential lifetime paths may be unpleasant.
There’s some great numerical examples in the book that I found embarrassing to read, and wished I’d understood better at 25 not 55.
8 years into early retirement with my personal plan largely based on reading Monevator.
Lucky to have blend of final salary pension and SIPP / ISAS and hence slightly less worried about fixed income component of the plan as baseline costs are about covered.
Spoke to my father who is 93 regarding uncle Harold who still on his running machine at 103. Reminded me that anyone planning early retirement at say 55 could need to be inflation proofed for many years. Another personal reason for looking at fixed income / equity ratio and how that copes with severe inflation over that period.. My father’s retirement has largely been entirely low inflation throughout- not sure this will be the same for me.
I read a lot about market corrections of 20% or more – if one assumes global markets grow at 7% it seems to me, possibly incorrectly, that after 2-3 years markets will generally recover ( with accepted edge cases like japan ). Hence over a 40/50 period I’m relatively sanguine about going a bit larger on diversified equities although I recognise I might also be a bit of an edge case or plain just got it wrong!
I also completely agree that the approach undertaken by xxd09 for DC only plans and or shorter durations makes for easier sleeping.
My other learning is the value of side hustles as a fixed income proxy. Some people want to travel the world in retirement and so not relevant for everyone. I’m local with family, play in a band, walk the dog etc etc. means I have time to help ex neighbour with his business. I find like music, it keeps my brain active ( especially google AdWords! ) and means get to have a bit of fun chatting about the world of luxury London bathroom fitting.
I did experience duration risk with VGOV recently and for that reason am using individual gilts a bit more Plain lack of understanding and desire to keep it simple and no desire to get into bond ladders etc.
There seem to be many ways of undertaking the journey – my overarching plan is essentially to never be a distressed seller – and register your power of attorney before it’s too late!
For anyone who has found Monevator by accident today – I would encourage you to read as much as you can. I found it by accident and it has singularly helped me more than anything in making my plan!
Look forward to next article in this series.
@Matt (#1)
While a natural yield approach is one way, there are a number of limitations, e.g., inflation adjusted income will fluctuate from year to year (e.g., see https://finalytiq.co.uk/natural-yield-totally-bonkers-retirement-income-strategy/) necessitating a good floor of guaranteed income (i.e., state pension, DB pension, annuity, inflation linked gilt ladder) to limit the overall fluctuation in income.
A number of supporter of the natural yield strategy advocate the use of various income oriented investment trusts. AFAIK, there has been little (no?) historical backtesting of how well these cope during severe market tests (e.g., 1937 or 1972-74 for the UK, e.g., see https://monevator.com/the-uks-worst-stock-market-crash-1972-1974/).
I also note that TR49 (1 7/8% coupon) might form a useful inflation linked floor for a natural yield approach (at least for the next two decades).
@TA Agree with others that this is a very useful topic.
Re #14, natural yield back test (@Alan S): it would be hugely useful and greatly appreciated if (maybe as an @TA Maven article, or even as a @TI & @TA collaboration Mogul piece), at some point, there could be a deep dive historical stress test of a natural yield approach to retirement (SIPP) drawdown.
Obviously, not one for this series (as this is glide path to retirement, not as such a drawdown/SWR resilience in retirement), but perhaps at some point in the next few years??
If it was a Moguls piece (either by @TI, or by both @TA and @TI in collaboration) then it could use as its basis @TI’s excellent UK IT focussed natural yield drawdown portfolio, which he premièred in Moguls earlier this year (updated as necessary, should the post appear a little into the future).
That would be super useful to have, not least because natural yield is my overwhelming preference to buying an annuity when I do retire (don’t want to surrender the capital value I’ve worked so long to build up).
Many thanks in advance on this one 🙂
Re: bond duration
You might be interested in two working papers I’ve written on the effect of bond fund duration on retirement planning (the effect on UK SWR is at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4742456 and the effect on UK and US income from variable withdrawals at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4827947)
The results show that while during some historical rolling periods short durations (however that is defined) ) did best and in others long durations did best, overall intermediate durations gave the most consistent results since they were usually neither best nor worst. It is noteworthy that the range of maturities that fall into the ‘intermediate’ category were different for the US and UK.
In general, in periods where yields tended to rise (e.g., 1940-1980), short duration fixed income did better than long and vice versa in periods where yields tended to fall (e.g., from 1980 to 2020 – the primary reason why bond heavy retirements in the last 30-40 years have done so well).
Of course, at the start of retirement it is pretty difficult (i.e., impossible) to predict whether yields will rise, fall, or stay the same.
Sorry for the two posts – I was going to add this to my previous one, but had to go and walk the dog (the travails of retirement!)
@xxd09 #7
> We seem to spend the same in retirement as when we worked-more leisure time to fill,travelling etc
Possibly worth noting that the makeup of that spending is different in retirement.
I don’t know about your case, but in mine there are no work-related travelling costs, although I do contribute to a pension it is at a low level. No mortgage. So although the amount of spending may be of a similar order, it is much more elective, shifted towards the nice-to-haves rather than the must-haves.
Which could help with dealing with the variability of investment-based income/drawdown mentioned here. You can dial down nice-to-haves, must-haves not so much.
@ Matt #1 I understand the Platonic purity of natural yield, but it’s a harsh taskmaster now.
Natural yield is much more attractive/doable when valuations are low. More believable post-GFC than now, where you need a lot of capital for a given income. Worth noting that in the Covid shock some dividends were stopped, so a natural yield fan still needs say three years’ running costs in cash to forestall becoming a forced seller.
This is not financial advice but the permanent portfolio has an outstanding track record of producing annual (even the monthly drawdowns don’t seem too bad) positive returns with very low drawdowns. There are the odd negative years of course but the consistency of the portfolio over 150 years is incredible – https://www.lazyportfolioetf.com/allocation/harry-browne-permanent/. It is easy to implement by any private investor using ETFs. You can set it and forget it and rebalance once a year.
I sometimes wonder why all global macro hedge funds don’t just switch to the permanent portfolio and go on holiday!
Re: Natural yield, while it’s on-topic it’s also likely to derail conversation about TA’s investigations, as to simplify he’s skeptical about the approach unless you have so much wealth that it doesn’t really matter if it underperforms significantly versus a capital drawdown method. Which I would say is a very valid point of view.
I will be updating my Living is Yieldy natural yield portfolio on Moguls anon, but currently thinking only annually. (I actually still need to choose my tracking method, but I’ve noted down all the purchase prices at the time it was assembled, fear not!)
There are some studies I’ve seen over the years that hand-wave about UK equity income trusts. Chancery Lane puts one out (I think) every year. It’s a good read if you’re of my bent but IMHO survivorship bias looms large.
It also (rightly in my view, for their perspective and aims) isn’t much concerned with whether using equity income trusts is ‘better’ than drawing down capital. Their policy is “you need pretty reliable and long-term inflation protected income without worrying too much about 50% capital drawdowns and this approach has delivered it” without being very concerned if holding a global portfolio and a cash/bond buffer would have done better performance wise, long-term.
IIRC they mostly advocate 100% equity income trusts portfolios too (no buffer) presumably on the grounds that the trust structure and income-focus does the job of ‘laundering’ the volatility for the holders.
Anyway as I say a discussion better placed on another thread most likely so I’ll leave it there.
@Peter – Good point on tax. So if stored capital gains means you’re overweighed on equities then my instinctive reaction is you’d counter with the least volatile asset available in tax shelters e.g. cash or liability matched bond ladder where relevant. I don’t know if bond ladders are doable in Australia?
@Trufflehunt – that’s the one! Brilliant quote.
@Kamae, c-strong & KTB – I’m very glad this is coming at the right time. Looking back, I rode my luck.
@DH & Why not – I have never seen a well-researched piece investigating how well low vol portfolios like the Permanent Portfolio and All-Weather work for this purpose. But they should work really well, so let’s investigate that 🙂
@London Sardine – that’s a very interesting suggestion. What kind of features are you looking for?
Flexi-drawdown?
Not having to sell to cash?
Good range of income options?
Who is your SIPP with out of interest?
@Boltt – “you only get one investment path.” I think this is so important. Historical data shows that 100% equities delivers the best outcome for most paths. But as you point out each of us only gets one shot.
So as I came into land, I didn’t care about maximising my number and I couldn’t bank on a V-shaped recovery if it all went south. The vision that haunted me was Financial Crisis scale loss and a U or L shape recovery that set me back years.
@Ex Moorgate – Thank you for sharing! Found myself nodding along. “My other learning is the value of side hustles as a fixed income proxy”- me too!
re: bear markets – we moved this info into the next installment but the average US bear market recovery period is 4 years and 4 months in inflation-adjusted terms. Obvs that masks some absolute shockers too.
@DH – I have yield info for UK market going back to 1860s. It’s not high yield specific but we could at least show the variability in income you’d have to cope with. Would that be useful do you think?
@all — Apols, I just misclicked while moderating spam and it’s *possible* I deleted a comment held in moderation. If that was you and you have the time please do repost, nothing personal! (I don’t know that I did. I just didn’t see the last page of candidate comments).
The quote on “you only get one path” is apposite and also applies to life expectancy. Most lay people look at the life expectancy of a population and mentally attach to it, whilst not realising that they have no claim to it. The mean life expectancy is a single descriptive statistic that belongs to the population, not the individual. The individual is a single draw from that population and it’s highly exposed to variance and that statistic is probably worth more attention. I ran enough stochastic models at work to see randomness at play and it takes a lot of paths to see the mean emerge. We are all individually only one of those paths. Don’t assume you’re the mean.
@why not indeed #18
> all global macro hedge funds don’t just switch to the permanent portfolio and go on holiday!
I am a fan of the PP but the worm in the ointment is you can only really switch to the PP when you have made your fortune. So it’s technically relevant to this post, as long as you have reached cruising altitude. The performance of the PP is so pedestrian that it is a wealth-preserving strategy rather than wealth-creation, and specifically better targeted to those who don’t have a desire to featherbed their kids against the vicissitudes of life after thay are gone.
Optimised portfolio has the comparison.
It exchanges much potential performance to protect against drawdowns. That is a valid appraoch to take, but it does sacrifice speed of accumulation for comfort against suckouts. TANSTAAFL
Ermine-agreed-the choice of spending or not in retirement is very much in the retirees hands so down turns can be dealt with by pulling in horns and vice versa
For want of a better metric I used pre retirement spending levels as the aim for retirement spending too-it has fortuitously -turned out that way -so far
xxd09
@TA #20 (2nd reply to me therein): that would be great for HY.
I think that HY *might* do rather better now onwards (but only*if* bond yields fall in the intermediate to long term), at least as compared to the rather woeful HY portfolio underperformance both a). coming out of Covid and then b). immediately thereafter in the bond and bond proxy carnage of 2022.
At the moment HY shares and income ITs and funds (and, likewise, Corporate Bonds) don’t seem appealing when the supposedly ‘risk free’ (nothing is) Gilt yield has a 4 handle.
But if we go down to 2% in the next decade (maybe off of the back of fiscal repression/ QE #whatever now) then earning 5% divis is a different proposition.
@various comments above: On the permanent portfolio, I love that it’s not data mined (HB came up with it in around c. 1970 from a Bible passage, IIRC!) The AWP and risk parity, contrastingly, worked in a particular time and context. PP is designed to be, well… permanent…
You all knew it was coming!!!
JPG* has been annually tracking 4%SWR with several real life portfolios (inc. Harry Browne aka Permanent Portfolio) since 1994 (ie for some 30 years now). All the data is US sourced but from things you could/can actually hold/buy (such as Vanguard Index funds). IMO, this is an endlessly useful resource, see his latest update at: https://retireearlyhomepage.com/reallife25.html
If you dig around there is a link to the underlying data in Excel and a separate section for retiring at the start of 2000.
*John P. Greaney is a bit of a forgotten FIRE legend – look him up
Without derailing into this natural yield talk too much, ermine said “Natural yield is much more attractive/doable when valuations are low. More believable post-GFC than now”. Not so sure, I think the dividend-y type equities are more fairly valued compared to growth stocks and tech. Plus bonds yielding much higher now, so – steering back on topic – derisking into a 60/40, 50/50, or even 40/60 portfolio is going to throw off way more natural yield than during the ZIRP era.
I agree with wanting to hold a couple of years in cash/near cash to weather against any mass dividend cuts, even with a natural yield portfolio. This is to smooth income even if you shouldn’t need to as much compared to a total return approach where crash protection to guard against sequence of returns risk is more critical.
I likely have a year or two to go before stopping work or semi-retiring. I just signed up to a new work pension last month, immediately dropped their default fund (too risky given my existing asset allocation elsewhere) and have switched to one of their low risk cash-like funds. According to the factsheet a blend of sub 5 year gilts, T bills, moneymarket and other liquid short bonds.
I will be making some pretty hefty contributions using salary sacrifice, that combined with any dividend cash rolling up in my SIPP should automatically provide enough derisking without having to consciously sell down anything/rearrange portfolio.
Getting 4% at least means there is less drag on holding cash now.
Target asset allocation for retirement is looking like 50% equity income (a whole bunch of ETFs and investment trusts), 40% mixed bonds, and 10% cash/short bonds.
Derisking has to fit with the mechanics of creating your retirement income
I pay all my bills with Visa as much as possible-a months credit available if required (plus insurance cover for purchases)
I pay the Visa bill twice a month from current account by a bank transfer
I keep topping up current account as required -often once or twice a month from the 2 years living expenses cash accounts (Instant Access Cash ISAs)
I top up 2 year living expenses cash account once a year from the investment portfolio by selling required number of fund units
On retirement I took my maximum 25% cash free lump sum from my SIPP and lived off this pot while I adjusted to retirement-left the investment portfolio alone for 2-3 years to grow before then starting drawdowns
Means 6% only of investment portfolio is ever in cash but even this is in instant access cash ISAs -tax free -currently 4% interest
However there are many roads to Dublin-this one is mine
xxd09
Will even Harry Browne’s Permanent Portfolio protect us from the West’s onrushing demographic disaster, as described here for the particular case of Germany?
https://www.eugyppius.com/p/germanys-looming-pension-apocalypse
@dearieme Your name is worrying appropriate for that link.
Nothing we don’t already know in one sense, like watching a car crash unfold in slow motion all the same.
At what point is the state pension replaced with some form of seed investment at birth in a standardised portfolio with the clear message that you have to pay your own way in retirement – but here’s 65 years of compound interest to give you a floor. On the same day all public sector pensions are converted to DC I hope.
Definitely relevant to the article series as every day brings more reasons to take control of your own affairs and avoid unpleasantness striking just when you think the hard yards are over. I look forward to the next installment.
“If you can delay your F.U. day by a few years then you can take more risk because you can wait for the market to recover should it cut-up rough.”
Unfortunately, that’s the same as saying “if you can afford to throw away the several best years of your retirement, …”
@JtE #31: agreed, but it’s even worse than that. Given that with (enterprise level premium tier paid licence) AI at work I can now literally output 3x more complex professional work per day/week than without it, at the same or better quality, it’s surely only a matter of time before (most?) white collar jobs disappear. That means the option of working on for a few more years before finally retiring to make up for portfolio disappointment may not exist for much longer. (BTW God knows what soon to be graduates etc are meant to do if their career prospects just disappear). I’m probably alright, as I was only planning on working 5 more years before retirement. But for the next generations……. 🙁
@Delta Hedge #32 > I can now literally output 3x more complex professional work per day/week than without it,
I could have said the same about the personal computer coming in in the 1980s or the availability of SPICE circuit simulation on a VAX computer. We survived somehow and from what I read in the IET magazine Britain still seems to have a requirement for engineers even at entry level.
Some of the same sorts of problems appeared too, it was all to possible to believe in the simulations until the real world on the bench reminded you that not all that was designable in theory was makeable in practice, abstraction needed to be tempered by experience. I am sure that all this AI output will have some variant of that pathology too.
Hi @TA, do you plan to comment on derisking your portfolio across ISAs and SIPPs, and how you balance the two? E.g., might it be counterproductive to derisk too much in the ISAs relative to the SIPPs, in the sense that it would most likely result in less growth in this entirely tax-free wrapper, and potentially expose you to paying more tax when withdrawing from the SIPPs? The calculus for derisking across tax-advantaged wrappers would also change depending on how far off accessing the SIPPs you are. I think it would be an interesting and useful topic to cover.
@Wodger — The article below introduces some of that, see the links in the last paragraph for pointers to the next in the series:
https://monevator.com/how-to-maximise-your-isas-and-sipps-to-reach-financial-independence/
https://monevator.com/how-pensions-will-help-you-reach-financial-independence-quicker-than-isas-alone/
https://monevator.com/how-much-wealth-do-i-need-in-my-isa-versus-my-sipp-to-achieve-financial-independence/
https://monevator.com/how-to-choose-an-swr-for-your-isa-and-your-pension-to-hit-financial-independence-fast/
@TI – thanks for sharing, but as far as I can see those articles are more focussed on how to balance contributions across ISAs and SIPPs, what your asset allocation should be for different SWRs, and whether or not you should use cash for your ISA bridge? So it’s related to my question, but doesn’t directly address it.
Say you wanted a 60:40 asset allocation for a portfolio spread across ISAs and SIPPs, and you were ~5 years away from being FI but maybe 15-20 years away from accessing the SIPPs. Would you derisk by switching to bonds in the ISAs only, leaving the SIPPs to be equities only, since they would have plenty of time to recover from a crash anyway? So it’s about maintaining an overall asset allocation but spreading risk unevenly across tax wrappers.
@Wodger #36 You’ll be running on that ISA for 15 years, so while there’s an argument for the next five years in something safer I wouldn’t put all of it in bonds.
You can’t beat the time honoured spreadsheet with years in the columns and the various asset classes in the rows, as time passes you gradually convert some of the equities year by year to retain the roughly five years in conservative assets. This can also show later revenues coming on stream like your SIPP and eventually the SP
This worked for me in specifying the long term strategy and how I planned draw down.
It’s certainly unlikely to look like ISA=all one asset class and SIPP another, though you are right in that the longer term assets will be equity heavy. But the longer term includes more than half your ISA. The broad rule of thumb of don’t hold anything in the stock market you know you will call on in the next five years is a good place to start.
No plan survives contact with the enemy. You also have to develop this strategy yourself – only that way will you understand it, and most importantly, own it 😉
@ermine – thanks for your thoughts. I currently have a 50/50 ISA asset allocation and a 100% equity allocation in the SIPP, for a 70/30 allocation overall. I’m probably five years away from being FI, so this allocation might be too adventurous (though not if you believe Big Ern).
I’m quite drawn to the plan in Michael McClung’s Living Off Your Money, which starts with a 50/50 asset allocation and then follows a slightly complicated rule-based withdrawal strategy. So my current 50/50 ISA asset allocation is probably in the right ballpark.
I don’t entirely follow your spreadsheet structure – do you have a worked example anywhere?
I started the journey late forties and retired at 52, so I had some time gap to be able to use a SIPP and expected to draw a DB pension at 60
I don’t have a public example. The spreadsheet had one year in each column, so col C is 2025, col D 2026 and so on (up to when you are 100)
Cols A and B were descriptions on the asset in that row, so say cash savings, ISA, SIPP, an then a long way off the DB pension and then the SP
That way I could see the later income streams visually, the capital and the streams were in the rows, I grouped the income streams lower down. DB was a straight income, and I represented the capital in the upper rows and derived a notional income from the capital into the lower income rows.
The aim was to rough out the flows, I burned down my SIPP from 55 to the DB pension. Before then I burned down some savings, at the same time investing into my ISA, the spreadsheet let me see that spread out across the years
Most of my initial assumptions were wrong, but the spreadsheet approach let me track the difference between theory and practice and keep the whole thing on track.
There are inherently different phases for early retirees before 55, because you draw on firstly unwrapped cash savings, then an ISA up to 55, then start to shift the load to the SIPP, and you may start to reaccumulate the ISA, and you may front load drawing on your SIPP ahead of the SP and also because some studies show people spend more in the early stages of retirement.
You need some way of representing these variables against time in a 2D matrix and a spreadsheet is as good a way as any other.
There is always a messy dynamic tension between stock and flow, deriving an income from capital is a black art. That’s why I grouped capital in one horizontal band and the income derived into a lower band. Within the capital group I had a band for risky stuff and a band for cash holdings.
That’s just one way to do it. But it is important to note that the multiple time phases complicate the journey and preclude being able to simply say one asset class in the ISA and another in the SIPP. The plan also has to factor in the complexity of your resources, for instance I had a redundancy payment and a decent amount of sharesave, so I happened to still be a net investor early in my RE journey even though I had hardly any earnings.
@Wodger I’ve got a spreadsheet very similar to Ermine’s, but with income at the top, capital flows at the bottom, and expenditure in between. That allows me to plan for occasional capital items eg vehicle replacement. Each column is sub-divided into budget and actual, so I can track progress. Values are in today’s money throughout, although I do allow for small real terms growth in investments. You can automate it as much as you like/are able (Google AI is useful if you want to know what formulas to use), and play around with different colours, highlights etc to your heart’s content! Like Ermine, I find it really useful to have a visual representation of when different income streams begin and end, or particular savings pots run out.
@ermine and @Martin T — how do you model changes through time in each asset class? Do you apply median expected returns and then subtract expected liabilities on top of that?
@Wodger #41
> Do you apply median expected returns and then subtract expected liabilities on top of that?
roughly that 😉 Anybody planning FI/RE has to have some idea of their essential spend and elective spend. I personally didn’t model expected market returns though it would have been easy enough to do. You update the sheet at the end of each year with the actuals. Because I started after the GFC I was generally updating capital as an apparent uplift (the marked to market amount) and I could track the run down of cash. I do not use bonds at all because I regarded my future DB pension scaled by 16 as enough bond holdings.
Which is a nod to your philosophy and I got away with it because there were no big drawdowns against which bonds are supposed to protect you. This is luck and starting at low valuations, which does not apply now. One should have at least some notion of a response to severe equity drawdowns in the first few years at this time, DYOR etc etc. I should have had this protection. In support of my foolhardy younger self I started with a fair amount of unwrapped cash (redundancy, and a foolish failure to not transfer part of a lucrative Sharesave into an ISA direct, but to liquidate and buy the ISA). In the short term (~5 years) cash is a perfectly reasonable alternative to bonds. I held about three years’ essential spend as cash. Note the ISA allowance was much smaller a decade and a bit ago.
As you update the actuals you see if you are overspending relative to your estimate, and how your equity + bond capital is faring. This gives you useful feedback on your path through the sequence of returns, plus the validity of your modelling.
It’s worth noting for each year the retrospective inflation rate, I used September to September. It is then possible to deflate the current capital by the cumulative inflation rate (or alternative to inflate the earlier sums to show everything in current real terms). I wasted much effort in micromanaging this, and only after I gave up on the sheet after it had faithfully carried me up to drawing my DB pension at nearly the design age did I realise this was pointless, although it soothed the overthinking nerd-brain.
The important information was am I living my principles? Not overspending, or if I am is this rational? You run some assets down in the early periods, if you are doing this intentionally knowing you have an answer to what happens when the balance falls to zero that’s just fine.
It’s the direction of travel relative to planning that matters. Apparently there is some sort of formalised plan do study act philosophy which I was probably exposed to at work, though I came up with the idea for tracking the early retirement process using siloed resources this way on my own.
You’re doing well if you get within 20% of the target, but as long as errors are in your favour great, if not at least you get early warning and roughly how much you are drifting off track. The value is not so much in the modelling – you will waste a prodigious amount of mentation and hopium on that. The value is in highlighting some of these cliff-edges (access to SIPP at 55/56/57) and formulating a response – if you are running an ISA down is is much less stressful if you can see why you doing that as a rational response to the design of Britain’s pension system to favour those following a normal path of retiring in your mid/late-sixties, which doesn’t favour you.
@Wodger I must confess I don’t plot asset allocation on this SS (I use a different one for that!!). I’m 10 years off SPA, and still working p/t. My sheet essentially plots expenditure vs income for each year, and highlights alterations to capital (ISAs, savings and SIPPs) – reductions when we start drawing, increases/movements as we’re still contributing atm. I’ve simply factored in a pretty modest 2% pa real terms growth in capital pots. Wherever possible I’ve automated things, so that I can play around with the effects of altering plans.
@Jonathan the Evil – that’s the nature of risk, surely? If the risk pays off, you can retire even earlier. If the risk materialises then you face delay.
But then again you may be able to make up the lost ground by pulling another level e.g. retire on less, increase contributions, work part time for a while in semi-retirement…
@Wodger – You make a really good point. We need a couple of contrasting hypotheticals, I think e.g. very early retirement as per your scenario (10-15 years before SIPP access) and late-early retirement – more like my personal experience (six years before SIPP access).
My overriding priority would be to ensure the ISA bridging portfolio can pay my expenses for however long it needs to last.
Overall long-term tax efficiency as an objective can be thought of like any other portfolio goal – it relies on assumptions about future expected returns and asset class behaviours. It entails risk.
Speaking purely for myself, I wouldn’t allow the risk of being a little tax inefficient to interfere unduly with my priority of having enough to live on.
I personally FIRE’d six years before I could access my SIPP. Everything I had in ISAs at that point was in cash or linkers (index-linked saving certs at the time, index-linked gilts now).
Six years was too short a timeframe for me to contemplate taking equity risk in that part of the portfolio. Especially because there was very little wiggle room.
I could have taken some equity risk if my ISA portfolio had been larger or I had more time to play with.
As it turns out I was too conservative in my estimation. Primarily because I was / am able to earn some income doing things that contribute positively to my wellbeing in retirement.
But I’ve never seen that earning capacity as a bond. I wouldn’t seek to replace that income if it ended tomorrow so I’m happy with my original cautious ISA portfolio approach. It’s not been optimal for my net worth, but good enough for my net happiness.
Happy to kick around ideas with you to flesh this out some more. If not, then thank you for the inspiration. I think tax-shelter juggling should be part of the series.
@TA with the Budget looming, also worth pointing out that policy decisions can affect plans with little time to amend. I was originally positioning to run down ISAs first, because SIPPs were outside IHT. Now looking to transfer maximum PCLS to ISAs in order to avoid possible double taxation on anything left behind
@TA — many thanks for your thoughts. I think you’re right that ensuring the ISA bridge lasts the distance is the main goal. Previously I thought that it was sensible to treat the entire portfolio as a single pool of assets when considering risky/defensive allocation. But now I think that if there’s a big time gap between when you plan to draw from the ISAs versus the SIPP, then you have to consider them separately. So when derisking, you’d need to progressively dial down risk in the ISAs to achieve whatever asset allocation is needed for the duration of the bridge period by the time you start drawing on it. This asset allocation will vary depending on the bridge duration. And for the SIPPs, you’d need to do the same, but on a separate timescale—so if you’re still 15 years off drawing on them, you might as well be very equity-heavy (if not 100% equities?) to begin with, and progressively dial that down as the access date approaches.
One other thought, though: if cash and index-linked bond ladders are preferable for shorter bridge durations, does that not logically mean that should you progressively switch into that asset allocation as you approach the end of the bridge period (i.e., as the date of the SIPP being accessible draws nearer)?
@Wodger – agreed, thinking about bridging ISAs and SIPPs as two portfolios with separate goals and asset allocations is likely very helpful.
“One other thought, though: if cash and index-linked bond ladders are preferable for shorter bridge durations, does that not logically mean that should you progressively switch into that asset allocation as you approach the end of the bridge period”
Do you mean as the ISA ladder runs down, should you progressively build a new ladder / other low risk portfolio in your SIPP as its D-Day approaches?
@Martin T – deffo. There’s a good paper on retirement tax strategy diversification here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2799288
I’ve summarised it and translated it into the language of ISAs and SIPPs here: https://monevator.com/sipps-vs-isas-best-pension-vehicle/
The considerations are different, of course, for those of us expecting to retire on/after SIPP access age. Here it is better to keep the higher expected return asset (shares) in the ISA as all gains can be withdrawn tax free. Or at least that’s what I’ve done, always open to feedback!
Just to be clear this is a distinct issue from (i) overall asset allocation (decided on the usual principles) and (ii) which tax wrappers you should pay contributions into (admirably covered in the article linked in TA’s previous post). This is for someone who already has a mix of SIPP and ISA assets for whatever reason – in my case I contributed to an ISA for flexibility in case I want or need the assets prior to age 57 (plus I was concerned about LTA risk back when that was a thing).
@ ermine 23
Yes of course the PP is more of a wealth preservation strategy but that is what we were discussing I believe?
It is worth, however, considering the psychological difficulty of having an all equities portfolio and sitting through several 50% plus drawdowns – the temptation to change strategy at just the wrong time can be quite strong for a lot of people.
When you know the odds of you having an up year are close to 85% and the lowest intra year drawdown is 16 % over the last thirty years, it certainly helps you to maintain composure and keep adding contributions to the portfoli0.
The PP is also fundamentally designed to cope with any type of economic environment and is robustly constructed with a simple asset allocation of 25 % to each of the four asset classes, which I believe, in robust statistics is the best way to weight asset classes?
Again, I am not advising anyone to necessarily go full PP but it is interesting to examine its benefits. I am personally heavily weighted towards equities but I have a longer time horizon and am very, very well diversified across all types of assets and factor – small cap, large cap, value, growth, momentum, EM, DM etc.
I also have a decent allocation to gold, silver, commodities and alternatives -ie hedge funds, long short equity, trend followers etc.
@TA — in response to “Do you mean as the ISA ladder runs down, should you progressively build a new ladder / other low risk portfolio in your SIPP as its D-Day approaches?” Yes, because what happened in the past should be irrelevant, shouldn’t it? So even if you started with a reasonable slug of equities for a long bridge period, by the time the bridge period gets down to 5–6 years, you should presumably opt for cash and linkers in the same way that you would have if you’d pulled the trigger with that bridge duration in the first place?
Yes, as the ladder in the ISA runs down, I’d construct a new one in the SIPP ahead of time. That would probably be an incremental switch – though I could imagine circumstances in which it was not.
This assumes I intend to use a ladder in the latter phase of retirement, which isn’t a given, though I do like it as a strategy.
@Martin T (#45),
Re: “Now looking to transfer maximum PCLS to ISAs in order to avoid possible double taxation on anything left behind”
I have been trying to flatten my SIPP (at no more than BRT) [ultimately] into ISA’s since I turned 55*. AIUI this is a variation of your revised plan. I initially set this up to minimise tax paid and fill one years ISA contribution per year – as it all seemingly fitted nicely with my plan to commence my DB. Turns out this was probably a mistake, and I should have gone for maximum drawdowns (from the SIPP) at BR from the outset**.
Lastly, the whole thing has become far more complex than I envisaged it ever could. Eight years down the line I am still not through and it will not be done for a few more years yet (as the rate of progress achievable has slowed to a trickle). Might turn out that the original objective is not actually possible!
Just my take though.
*a somewhat niche practice at the time
**I did change tack towards that approach after a few years, but …
@TA #51 — I was thinking more of shifting the asset allocation in the ISA, since you have a defined end-point (date at which SIPP becomes accessible) and need the ISA to last until then. I suppose it depends on how close to the wind you’re sailing during the ISA bridge period. Continuous modelling of expected outcomes might help.
@ Al Cam – do you have any links to papers / good articles on hedging annuity rate risk with long gilts / linkers? That is, if I’m an investor who intends to buy an annuity in the future and want to hedge against the risk of annuity rates falling in the meantime.
@ Wodger – Ah OK. In that case, much depends on your strategy e.g.
– SWR
– Income bucket
– Floor and upside
– Pure liability-driven cash / linker ladder
Risk is handled differently as per the mechanics of your chosen strategy. But, this is a decumulation problem rather than accumulation. At least if you’re still accumulating then you’re not a forced seller and you can solve a miscalculation by increasing contribs / delaying retirement.
In decumulation, options are: live on less, go back to work, rob a bank.
@TA (#54):
Nothing springs immediately to mind, sorry. There is a school of thought that says we are back to more normal interest rates, etc. So the Annuity rate risk you highlight may be smaller than you fear. Also, gilts/linkers are really only a proxy for Annuity pricing. OTOH, ….
What I guess you may be after is a deferred annuity* – which yourself, @Alan S, myself and others chatted about at Monevator before. IIRC, we concluded it was not clear if such things are actually available to buy in the UK. Perhaps @Alan S or others can add some more?
*ideally with some form of deferred/stepped payment too
@TA:
IIRC, Shankar 2009 is the ‘classic’ TIPS plus deferred annuity paper. There has been at least one person who has had a go at revising that paper – but the details escape me for the time being.
@A1Cam/Martin
Agree with the approach. I turned 55 this tax year and will take £50k pa to make full use of the generous 20% band.
There isn’t enough tax years to drain before the DB kicks in at 60, so my current plan is to defer until 63. This gives me 3 more tax years to reduce the SIPP and a higher PCLS and higher DB pension – hopefully I don’t die early.
ISA are currently the best thing ever – given the readership affluence I’d move heaven and earth to max the ISA every year and let the SIPP go first.
The “no more subs once you hit £200k” rule is coming soon. As is the lifetime tax relief on DC at £200k. Perhaps IoM is the place to be, low taxes and they honour ISA tax free status, even though they don’t need to.
Fingers crossed for tomorrow. I can’t believe they’ll remove the 2 child cap…
For the benefit of readers less steeped in the ins and outs of micro-budget predictions who might be casually reading these comments:
…those are not confirmed as definitely coming!
It is just speculation on @Boltts’ part that such changes could come in the next few years. Not irrational speculation, but to be clear the government has no plans currently in train for either.
(Let’s see what tomorrow actually brings!)
@ TI
Agree just speculation, it’s just my negativity about the direction of travel for the gov to retain more tax income v current position
@Boltt — Yep, a reasonable position to hold. My only quibble is the lack of “I think that…” or similar. (Appreciate it lacks the rhetorical force!)
Cheers for the discussion!
@Boltt (#57):
I assume you are going to use max PCLS followed by flexible drawdown. FWIW, that was the path I chose. Some prefer UFPLS which should mean a higher annual d/down still at BRT.
Go well – if my experience is anything to go by – you will face lots of twists and turns to actually make it happen.
To somewhat mangle @Bills analogy: trying to empty a bucket through a hole that is reducing in size is tricky enough which just gets even more difficult if the bucket is also being filled up! A temporary reversal in valuations may help.
By my calcs, best case: I will need to go round the buoy twice more to empty out the last few percent at no more than BRT as my headroom to HRT is now small*.
Let’s see what tomorrow brings!
*probably not really worth the effort, but …
@Al Cam – No worries, thanks all the same. I thought if anyone knew there’s a fair chance it would have been you 🙂
I’m not thinking about a deferred annuity – I did check recently but there’s still no sign they’re available in the UK. I’m thinking about someone who wants to annuitise in the future and wants the best hedge against a drop in interest rates in the meantime. Long linkers and long gilts fit the bill – though imperfect they may be the best we can do.
I appreciate that worrying about plunging interest rates may be preparing to fight the last war 🙂 Then again ZIRP and QE weren’t on the agenda until the Credit Crunch hit.
Hi,
Thanks for this article, but I disagree.
If your financial planning includes your children and grandchildren* (it should), then the “long term” extends beyond your own death and that of your spouse. The perceived short-term sequence of returns risk isn’t a risk at all, because it will all even out over the next 100+ years. I’m 100% stocks forever, and so are my kids, and their kids, and their kids after them.
Matt (retired early, and giving it away early)
*or other person/organisation/body toward whom you choose to bestow financial security.
@Al Cam @Boltt. Neither Mrs T nor I have any DB pension, so SIPPs and ISAs will (hopefully) have to supplement SP when it arrives for the duration. It’s really a question of balancing the order of drawing down in order to make sure we use the full PCLS, whilst avoiding the post-Budget additional savings tax, and maintain the most favourable IHT position should both of us go before we’ve spent the money!
@Martin T,
Thanks for additional info. I guess this will require you to take a view on what might happen to the PCLS going forwards?
@Al Cam we’re only talking relatively modest sums here, but yes, plenty of considerations to weigh up.
Hi @TA – I saw your latest post de-risking and realised I’d missed this one.
“If you’re concerned for your portfolio now, then how would you feel when the market is 42% down? When you are two years out from retirement?”
Well this is me so I look forward to reading your series with much interest!
@Matt – sorry, I missed your comment. There are plenty of scenarios that could justify a 100% stock allocation forever. If that’s the case then this article – in fact the entire series – isn’t for you. I’m doubtful there’s any disagreement between us on this particular point. I agree that if you’re investing for the next generation then 100% equities is quite likely the way to go.
However, many people are going to be squeaking through retirement or are more cautious by nature. They’re vulnerable to sequence of returns risk and 100% equities is inadvisable. I’m one of them.
@Weenie – Glad to be of service 🙂