A holding of individual inflation-tracking UK government bonds is the way forward if you want an asset class to hedge UK inflation. But how do you actually buy index-linked gilts?
Thankfully, your neighbourhood investment blogger is here to clear that up.
I’ve personally been pushing this task around my own plate like a seven-year-old told to eat his greens, due to…
- Telephone dealing: “I hate you!”
- Dirty pricing versus clean pricing faffology: “Stoopid!”
- Accrued interest deductions: “Don’t wanna!”
In short, buying individual index-linked gilts meant dealing with the unfamiliar and, as far as I could tell, deeply sucky.
I put the task off for months. Yet now I’ve done it, it doesn’t seem so bad after all.
I suspect I’m not the only one discouraged by mental barriers when looking to buy index-linked gilts.
And so today I’ll walk you through my recent index-linked gilt transaction to demystify the process. I’ll explain any important mechanics as we go, and we can sort any remaining bafflement in the comments.
Missing link(er)
First challenge: not every broker allows you to trade individual gilts.
Of those that do, some enable you to trade at the click of a button, others make you speak to another human at the end of a telephone. (What is this? The Dark Ages?)
Even then your broker may not trade every bond you want, or it may not trade every bond online.
I diversify across two brokers. Of those, only AJ Bell lets me invest in individual gilts.
Thankfully, AJ further enables me to click-to-buy all but two of the UK linkers currently on the secondary market.
No humans required!
If you’re building an index-linked gilt ladder, know that only the 2033 and 2054 rungs are missing from AJ Bell’s roster. (And it might let you buy these by phone too. I’m not sure.)
As it is, I’m building a short-dated rolling linker ladder as modelled in the No Cat Food decumulation portfolio.
How to buy index-linked gilts, step by step
My objective is to keep a portion of my SIPP in a very low-risk, inflation-hedging asset. Three years’ worth of index-linked gilts fits the bill nicely.
- See our members’ article on building an index-linked gilt ladder if you need a refresher.
Let’s get on with it!
Step one: free up some cash
I flogged off my incumbent global inflation-linked bond ETF (GISG). It’s the best passive short-dated linker fund available in my view, but it still suffered a real terms loss in 2022.
Step two: choose your individual linkers
My rolling linker ladder will consist of three index-linked gilts, ideally maturing in one, two, and three years.
Assuming I don’t need the dosh, then I’ll annually reinvest the cash I get from the latest maturing gilt into a new linker with three years left on the clock.
The snag is there isn’t a linker maturing in 2025. So my first three picks will redeem from 2026 to 2028.
With that decided, the choice is simple as there’s only one linker available per year:
| Gilt | Matures | EPIC code | ISIN code |
| UKGI 0.125 03/26 | 2026 | TR26 | GB00BYY5F144 |
| UKGI 1.25 11/27 | 2027 | T27 | GB00B128DH60 |
| UKGI 0.125 08/28 | 2028 | T28 | GB00BZ1NTB69 |
No two organisations label their linkers exactly the same way. Search for – and double-check you’ve found – the right security by using its EPIC or ISIN code.
Once surfaced, you can click-through to trade your gilt – assuming your broker is on the grid.
Otherwise, it’s the telephone, or postal order, or semaphore trading for you m’lad / lass.
Brokers who facilitate online gilt trading
Disclosure: Links to platforms may be affiliate links, where we may earn a small commission. It doesn’t affect the price you pay. Your capital is at risk when you invest.
AJ Bell lists its gilt line-up on a specific page.
Hargreaves Lansdown also has a dedicated linker page. Click the Maturity header to place them in a sane running order. But beware, most of HL’s linkers apparently require an expensive telephone trade. See this super-helpful comment from reader Delta Hedge.
iWeb lists linkers too. (This page appears organised by the Muppet Show. Click through on the names to trade.)
Halifax and Lloyds use the same platform as iWeb but in nicer colours.
Interactive Investor trades linkers online but I can’t find a public-facing page. Individual conventional gilts are listed though. You can find index-linked gilts on ii by searching using EPIC codes.
Charles Stanley trades gilts but it looks like a telephone-only service.
Fidelity is an obvious absentee here. Sort it out Fidelity!
Let us know of any other brokers you use in the comments.
Step three: understand how individual linkers are priced
Things can get pretty confusing because of the way index-linked gilts are priced.
Most brokers and online data feeds show each linker’s clean price before you order.
The clean price is typically the nominal price for each gilt.1
That isn’t much use because the price you pay is the dirty price.
The dirty price is typically higher than the clean price. That’s because the clean price excludes:
- Inflation-adjusted principal and accrued interest for three-month indexation lag linkers.
- Accrued interest for eight-month indexation lag linkers.
Bear with!
Inflation-adjusted principal
Inflation-adjusted principal is the bond’s original £100 nominal value modified by the change in the RPI index since it was first issued.
In other words, if RPI inflation has increased by 10% since the linker hit the market, the value of its principal will have increased to £110.
It’s this inflation tracking property that makes linkers so valuable in the first place! (Along with their inflation-adjusted coupon or interest payments)
The clean price does not include inflation uplift on principal for most linkers, whereas the dirty price does.
While we’re here, I’ll just mention that all index-linked gilts are due to switch their link from RPI inflation to CPIH inflation from 2030.
Also while we’re here, bonds are a psychological hellscape of impenetrable jargon. Take the edge off it with our bond terms pain relief.
Also this Debt Management Office (DMO) glossary is a godsend.
Accrued interest
The dirty price includes inflation-adjusted accrued interest. Accrued interest is interest you’ve earned from owning the bond since its last coupon date.
By rights, that accrued interest belongs to the seller who held the bond until you swooped in.
Paying the dirty price (pumped up by the accrued interest) means you compensate the seller for the interest payment they won’t receive – because you now own the bond.
It’s a bit like pass the parcel. The previous owner handed the bond on to you while the music still played. And if you’re still in possession when the music stops, you scoop the whole prize – a semi-annual interest payment no less.
Thankfully, bond traders recognise that a children’s party game is no basis on which to build a thriving capital market. Thus accrued interest keeps everything fair and avoids foot-stamping temper tantrums.
This is also why bond trader parties are no fun.
Your broker will show accrued interest as a cost when you buy a gilt. You’ll make it back next time your linker deposits sweet, sweet income into your account. If you decide to sell a bond early, then someone will pay you any accrued interest in return.
Ownership of the gilt is determined seven business days before each coupon payment date. That seven day stretch is the ex-dividend period – beginning with the ex-dividend date.
If your purchase settles during that period (but not including the ex-dividend date itself) then you don’t pay accrued interest. Instead, you’re entitled to rebate interest. This will show as a Brucie bonus on your contract note.
What’s actually happened is that the seller has already been declared the winner of the next coupon. So if, for example, you take ownership of the gilt on the first day of the ex-dividend period, they owe you for the seven days of interest earned before the coupon paid out.
Just like accrued interest, rebate interest is a ‘fair’s fair’ mechanism. It ensures each party earns the right amount of interest for their period of ownership, regardless of where the coupon apples actually fall.
Fun fact: if your trade settles on the coupon payment date then there is no accrued interest (or rebate interest). Yin and Yang are in balance on this day.
Indexation lag
Eight-month indexation lag linkers upweight principal and coupon using RPI readings from eight months ago. For example, a coupon paid out in December is inflation-adjusted according to the previous April’s RPI index.
Eight-monthers are very much an endangered species. They were issued before 2005 and as mentioned only two remain in circulation: T30I maturing in 2030 and T2IL maturing in 2035.
Three-month indexation laggers represent the latest in UK linker engineering. They only trail inflation by three months.
Under the pricing bonnet, eight-month clean prices include inflation-adjusted principal and three-monthers do not. That’s why eight-monthers look more expensive at first blush.
In reality, it makes no difference. All gilts are bought at the dirty price and if you want a linker that matures in 2030 and 2035 then it’s an eight-monther for you.
Why don’t they show the dirty price?
God knows. It’s not as if they don’t calculate it when you make a purchase. Perhaps someone who knows about the live price plumbing can supply an answer. But it’s an annoying omission.
It’s also the reason why some brokers ask you to state a cash amount when ordering linkers rather than a unit number.
If you’re building a non-rolling linker ladder predicated on buying a certain number of gilts then it’s probably best to over-egg it.
That said, here are three sources of dirty price information:
- Tradeweb – Sign up for a free account. Select Index-linked in the Security Type menu and press Submit. Set the Page size to 50 to see every linker on the market.
- YieldGimp – Dirty price = Net Price (inc. Accrued) column on the spreadsheet.
- LateGenXer – Scroll down and switch on the Index-linked toggle in the left-hand column. Enjoy dirty prices!
Tradeweb is the official supplier of gilt stats to the DMO. However, it only provides the closing dirty price, which it publishes around noon the following day.
YieldGimp updates its dirty prices throughout the day, so this is your go-to source if you want a rough and ready take on how many gilts you can expect to purchase. It won’t be spot-on, as we’ll see shortly. But it’ll be pretty close.
LateGenXer has developed a superb app to help UK investors build linker ladders. The dirty price is updated towards the end of the day. Extend the ‘Number of years’ in the left-hand column to see more linkers.
You can also calculate the dirty price from the clean price on the fly. Updated clean prices are available from the London Stock Exchange. Search using EPIC or ISIN codes.
It requires some spreadsheet kung-fu to beat the dirty price out of the clean price, so we’ll save that for the next thrilling episode of Arthur C. Accumulator’s Mysterious World (of linkers).
Units vs gilts
Okay, one last point on the linker pricing imbroglio.
Gilt prices are typically displayed in pounds not pence. If you see a two or three figure price then that’s the price in pounds per gilt unless it says otherwise.
Tradeweb, YieldGimp, and the London Stock Exchange display prices like this.
The brokers generally do the same. Until they don’t.
Now, just in case you were finding all this too easy, you don’t buy gilts in handy bundles of gilts.
You buy them in units. Each unit is worth a hundredth of gilt.
So if a gilt has a nominal value of £100 then each unit has a nominal value of £1.
Which sounds simple enough but we’re all busy people and it’s easy to forget.
Especially when your broker mixes unit values with gilt prices!
Here are the crazy scenes in my account:
I’ve bought 14,850 units of mystery brand linker A. But my mischievous broker displays the gilt price not the unit price.
- 14,850 x £148.8817 = £2,210,893
I’m rich! Oh balls, I’m not rich. I just put the decimal place in the wrong column again.
The unit price is £1.488817 because each unit is worth one-hundredth of a gilt. Which explains why the value column is £22,108.93 and I haven’t bought a one-hundred bagger linker.
A single-figure price typically indicates a unit price. A two- to three-figure price suggests gilts, unless some eejit is showing you the price in pence, which some brokers randomly do. Good to keep you on your toes!
If you track your linker winnings on a spreadsheet and something isn’t adding up, then this units/gilt farce will often be the reason. At least it is for me.
Coupons, accrued interest, you name it – the amounts are typically quoted in pounds per gilt, so should be multiplied by your units / 100 when you’re totting them up.
Step four: lose the will to live
Revive with a coffee, a beer, or a fortifying hot chocolate to suit.
Step five: submit your order
I can’t believe it! I’m submitting my order already. So soon?
As I mentioned, nobody knows what the hell price they’re be paying so you’ll be asked to put cash on the table.
Once I did that with my trade, I was treated to this quote screen:
The clean price is just so much screen clutter. Fuggedaboudit.
Although that said, the £1 difference between the clean buy and sell price shows that you may pay a spread of about 1p per unit. In reality, I was charged almost exactly the mid-price.
The indicative price is per unit and wasn’t too far out. I’ll explain more about this price in a sec as it’s dirty-ish but not strictly dirty.
The dealing charge was a fiver and very reasonable too. It works out at less than 0.023% of the transaction.
The order type was a market order or a limit order. In the end, I went for a market order.
Notice the small print that says: “Accrued interest payments will also be applied to the estimated total.” The bill for that is coming right up.
Anyway, dear reader, I submitted my order.
Telephone orders
I have not made a telephone order, but Monevator readers Mark Dawse and Sleepingdogs, among others, have reported on the process:
- Know which index-linked gilts you want to order in advance.
- Identify each one by their EPIC code. It’s much easier than using the longer ISIN number, and will knock precious minutes off the call!
- The broker’s agent will repeat back the gilt’s code and other identifying details to ensure you’re both talking about the same thing.
- They should quote the fee and an indicative price. You then confirm whether you wish to proceed.
- The agent is likely to put you on hold while their team places the trades.
- Once all trades have gone through, your agent will list your purchases and the actual prices paid.
- Set aside plenty of time for the call, especially if you’re placing several orders in one go.
Step six: “Congratulations on your purchase of UK government debt”
Here are my contract note highlights (never thought I’d find myself saying that):
After the sale, you’ll finally know how many units you’ve bought.
That’s 14,850 – or 148.5 gilts – in this case.
The price per unit is higher than indicated on the quote screen. No biggie.
The consideration number tells me I’ve bought £22,094.15 of linker TR26. (Our mystery brand revealed!)
And I owe 23p in accrued interest. Could be worse.
Notice how accrued interest is a cost on top, like the dealing charge.
Step seven: incur an immediate loss
Every time you buy individual gilts, your broker is likely to show you’ve made an initial loss (unless the price moves sharply in your favour).
Here’s the losses weighing on my three linkers shortly after purchase:
There’s nothing like getting off to a great start, right?
The loss comprises:
- A £5 dealing charge
- Accrued interest
- Unfavourable price moves since purchase
By the time I took this shot, the 2026 linker (TR26) was down 56p price-wise. Meanwhile, the prices of the other two were up £6.59 and £4.54 respectively, reducing my initial losses.
Fam, it’s a rollercoaster.
You may show a much worse loss if your broker values your linkers using the nominal clean price.
If AJ Bell did that then my valuation would have looked approximately like this:
| Gilt | Units | Clean price | Value |
| UKGI 0.125 03/26 | 14,850 | £99.16 | £14,725.26 |
| UKGI 1.25 11/27 | 10,660 | £103.40 | £11,022.44 |
| UKGI 0.125 08/28 | 15,932 | £99.92 | £15,919.25 |
My holding would have appeared down by nearly £25,000 if it was valued by the clean price. (Remember the clean price is divided by 100 to get the unit price).
If you are seeing massive losses like that then there’s almost certainly no cause for alarm. (Assuming they’re caused by the clean price method which they probably are.)
Your index-linked gilts are actually valued by the dirty price. This includes all that lovely inflation uplift and accrued interest.
I’ll include a spreadsheet in the next part of this series so you can properly track the value of your holdings using the intra-day dirty price.
Inflation-adjusted clean price and this accrued interest business
Although AJ Bell isn’t valuing my linkers by the nominal clean price I don’t think it’s using the dirty price either.
If it was, then my portfolio wouldn’t show a loss due to accrued interest – because accrued interest is included in the dirty price.
So it must be valuing my units by the inflation-adjusted clean price. That is:
The dirty price minus accrued interest. Or, in other words, the clean price incorporating inflation-adjusted principal.
Thus my linkers should be worth a little bit more than shown in the last screenshot above. Because if I sold them immediately after purchase, I’d be due the accrued interest I’d bought, but never received, because I sold out before the next coupon payment.
It’s all relatively easy to calculate but let’s leave it for the spreadsheet episode to come. Tradeweb also publishes accrued interest figures per gilt (see the link waaaaay above.)
Step eight: stop writing about index-linked gilts
Don’t mind if I do.
Hope this all helps someone.
Take it steady,
The Accumulator
- Eight-month indexation lag linkers include inflation-adjusted principal in the clean price. However, there are only two eight-monthers left: T30I maturing in 2030 and T2IL maturing in 2035. [↩]
Absolute perfect timing, it’s almost like you’ve read my to do list to look into but never got round to doing, love this site and that’s why I subscribe, thanks! iweb on there to which is what I use for other bits so a possible already 🙂
Thanks TA for this extremely helpful article. It is reassuring that IWeb, who I use as my unsheltered platform, has a good selection of index-linked gilts that can be purchased online.
For selecting nominal gilts, the only sort I have so far, I have used YieldGimp and your translation of Dirty Price into their terminology is useful to bear in mind.
Finally, I have only bought nominal gilts through IWeb. When I did, the trade did not happen immediately and took a few minutes before I received the acknowledgement of completion. If you try to access the contract note immediately, it appears in a crudely formatted presentation. The accrued interest is not shown but it appears as if it is a cost of purchase (i.e. dealing fee). You have to wait until the following day to get the formatted contract note with accrued interest clearly separated out.
Thanks for this. TBH, it all goes over my head and, hopefully, my DB pension and rental property will, in effect, be my Bond/Gilt Ladder.
But would something like these Invesco Bullet Shares ETFs serve the same purpose?
https://www.invesco.com/uk/en/capabilities/etfs/bulletshares-ucits-etfs.html
If not, what the difference? Thank you.
Thanks TA, I haven’t yet made it as far as purchasing individual linkers so it’ll be great to have your thorough guide to hand if and when I do.
Thanks for that comprehensive tutorial! A very valuable resource as the platforms are not very helpful on the whole process.
FYI I know this is not an article about tax – but you need to keep track of all that accrued interest on purchases and sales because HMRC will want to know about it! Accrued interest received on a sale is taxable as income; and on purchase is claimable against income. Interesting to see whether EOY broker Tax Certificates show all that!
https://www.gov.uk/government/publications/accrued-income-scheme-hs343-self-assessment-helpsheet/hs343-accrued-income-scheme-2024
Although Hargreaves Lansdown require you to telephone the order through, I believe the price is now as per their online charges (rather than £40 previously).
Wow this makes my head spin a little, so glad it’s so simple…
Not quite at the stage for this but I’ve been looking at funds such as Vanguard Sterling Short-Term Money Market Fund (VASTMGA) to cover the lower risk end of my portfolio when I need to reduce my stock exposure.
Great article! I have bought a few as well in recent months (AJ Bell and iWeb, the latter values them with the clean price in my portfolio, but otherwise it works well). I bought them outside tax wrappers because capital gains on gilts are not subject to CGT. Buying gilts with very low coupons then means almost the entire gains are tax free. I assume this works effectively the same way for index-linked gilts, but I am not entirely sure. I’d assume that the gain from inflation is a capital gain that isn’t taxable. If that is right then why buying these low coupon gilts in a tax wrapper?
Brilliant.
@helfordpirate, in my experience brokers do not properly report accrued interest properly in EOY statements. Coupon payments they report just fine, but not the accrued on trades.
Remember as well that if you have paid accrued on a purchase, that accrued is offset against the next* coupon, which could be in the following financial year. ie the accrued is taken of next years bond interest, not this years. Unless you sell before year end of course.
*some people confusingly, or maybe not, like to call this the current coupon, as it is the one currently accruing. Next coupon is the one after! Might possibly be a French thing.
@EMcG67, there are differences
– ETFs are subject to capital gains tax, gilts and most GBP corporate bonds are not.
– The ETFs contain corporate bonds instead of gilts, so carry credit risk.
– The ETFs hold USD and EUR bonds and so have currency risk. The GBP hedged versions should mitigate most of the risk though.
There may be some uncertainty over the actual return as well, but I haven’t delved deeply enough to say for sure.
@ EMcG67 – the main issue is those ETFs don’t contain index-linked gilts, so don’t hedge inflation. Also, I’ve opted for a rolling ladder whereas Bulletshare ETFs are designed as a collapsing ladder i.e. you use them to ensure delivery of a specific income amount per year.
@ David V – Thank you for that note on iWeb’s service, especially as quite a few people around here use it. AJ Bell output the contract note within a very short space of time. Less than an hour.
@ Helfordpirate – Great point about tax, thank you for the link. Hey, I clicked through to your linker ladder spreadsheet the other day but it was down. Don’t know if you know?
@ Gizzard – Good to know, thank you!
@ sevenseas – My tax wrappers have room to spare! Moreover, much of what I own was bought thanks to generous tax reliefs on pension contributions. Finally, linker coupons are inflation-adjusted so that can add up pretty quickly.
@Gizzard – are you sure about the pricing, the last time I asked Hargreaves Lansdown about it they told me it would be the telephone dealing charge.
However, I was wondering, AJBell charge about £3.50/month to hold gilts for you but only have a £5 dealing charge. Hargreaves Lansdown do not charge at all for holding gilts for you but charge £40 or so to buy (unless @Gizzard is correct). However, is there anything to stop you setting up an AJBell account, buying your gilts and then transferring your gilt investments to Hargreaves Lansdown to hold? I’m planning on creating a long term non-reinvested linker at some point where I hold all bonds until maturity so looking for the most cost effective solution.
NB I think the reason clean prices are shown and not dirty prices is that it makes the bonds easier to compare, especially if you intend to hold them to maturity because it immediately shows you the baked in return or loss you will suffer.
@TA (10)
I don’t know the exact delay before IWeb produce the fully-formatted contract note. It’s just that having been confused by the initial format I phoned the helpline to query the ‘charge’. When it was explained that this was indeed accrued interest, which I suspected, I waited until the following day to have another go to access it. Unfortunately, unlike HL, IWeb don’t send an email to notify you about the contract note. It’s quite possible it would have been formatted within the hour, as with your A J Bell experience – I simply don’t know.
@TA : Thank you for the excellent write-up; understanding linkers was on my To-Do list forever!
Out of interest, does Monevator cover the risks associated with linkers in any of the posts; specifically the deflation risk (deflation floor etc.)? It would be great to see your take on that topic.
This is really interesting. I am trying to research what is the closest product (ETF?) you can buy that mirrors what is being suggested in this article. Is this closest you can get that is pure index link gilts without anything added to the mix – iShares Up to 10 Years Index Linked Gilt Index ?
@Gibbo — We wrote about this fund when it launched:
https://monevator.com/short-duration-index-linked-gilt-fund/
Note that while it is lower duration than other index-linked gilt products in the UK, there will still be some interest rate risk versus holding individual linkers to maturity. 🙂
@Colin (13)
I’m working a bit from memory regarding the HL dealing costs. I’m pretty sure they sent me an email or something on the subject.
However, it’s perfectly feasible to buy on AJB and transfer to HL. I did exactly that myself – in order to take advantage of a cashback offer.
@ Colin and Gizzard – Gizzard you are right. Just gone to HL’s share dealing page and it says: Index-linked gilt deals made via telephone are charged at online dealing rates. So £11.95 a pop unless you’re a frequent trader.
@ Gibbo – yes, that’s the closest.
@ Winter Mute – In theory deflation is a risk for UK linkers in that – unlike US versions – the value of principal and coupon payments declines if the RPI index drops. In practice, the UK hasn’t endured a single negative year of inflation since 1933. Obvs other countries do experience deflation periodically but we seem more prone to the opposite problem. My sense is that the Bank of England would fire their big bazooka at will if deflation was on the cards.
Still, every asset class has its achilles heel which is where the ol’ diversified portfolio steps in. I’d be trusting my conventional bond holdings and cash to do the business if deflation stalked the land.
This is very helpful indeed. I had ditched my linker funds (as the fund structure doesn’t seem to work for inflation protection) and then put off the complicated job of buying individual linkers too.
A final concern: How does one know if the offered price for the bond is fair? With stocks and ETFs, the bid/ask is obvious, and from experience I have a sense for what is a sensible spread.
In the above example, it is ~1% which seems expensive. That is, if the displayed spread on the clean price corresponds to the actual spread (?)
@ Sparschwein – really good point. I didn’t properly complete the thought about the spread. Even though the spread implied by the clean price shown was high, in reality I didn’t pay anything like that. Based on my price check just before and after pressing submit, I was charged almost exactly the mid-price (clean) on all 3 linkers or about 2p on the dirty prices. I estimate around 0.012% of the value of the transaction.
TI bought an 8-monther through a different broker and the spread on that was minimal too.
@TA – that’s good to know, many thanks.
@TA – thank you for another excellent article. I am just wondering as a percentage of your defensive portfolio, how much have you allocated to linkers? Due to my age and risk profile I am currently comfortable with a 80:20 split between equities and my defensive/diversafied investments. However, it’s the split of the defensive/diversified element of my portfolio, that I’m always most concerned about. Normal government bonds to protect against recession and linkers to protect against inflation risk. Is there a general consensus or rule of thumb on a sensible weighting between government bonds and linkers? From reading comments on your other articles, it feels like linkers are usually a comparatively smaller hold in any portfolio compared to normal government bonds but I guess some investors are pro-actively adjusting this split as their perceived risk for UK inflation is going up and down. Any insight into your thought process around this area would be much appreciated.
Thanks TA,
Like miner2049er, perfect timing for me.
I bought some GB00BZ1NTB69 back in 2022 , later figuring I needed to know more on this.
Periodically & as reassurance I ‘phoned HL to check what I would get if I sold & they gave me this:
https://www.dmo.gov.uk/data/pdfdatareport?reportCode=D1D
as the go-to place for “index ratio for settlement” the HL lady said they used
it to quote sales prices. Hope that was right (& not fools gold).
Good back-to-school prompt so out with the pen and exercise book/excel for me.
Mike
@TA Great article – I’ve got individual gilts but have been procrastinating about individual linkers. I think it is time to dip a toe in the water…
@TA:
Nice post.
As a long time fan of floor & upside (F&U) I am more than happy to see so much recent discussion about linkers, ladders, etc.
However, a word of caution if I may.
There are a plethora of ways in which you can lay out static flooring; both at/near the point of retirement, and, often more efficiently, in the period prior to retirement*.
However, I worry that the recent discussions risk leading people to conclude linkers is the only way to go. Whilst linkers currently offer good value for money, this has not always been the case (see e.g. last sentence at https://monevator.com/retirement-withdrawal-strategy/#comment-1722740) and may not be the case again in the future.
Furthermore, some [adventurous] folks may even wish to eschew static arrangements all together and keep all of their “current flooring cost” exposed to the market and manage the risk.
There are many ways to skin this cat, and IMO linkers should not inadvertently become the flooring “Kool-Aid” equivalent.
*perhaps up to maybe thirty years in advance!
@ Kelvinho – There’s so much to say on this that I think I need to write a post on it. It’s a great point and also a dilemma that I think hinges a great deal on your personal objectives. Can I ask, does your 80/20 split suggest you’re quite young with some way to go before retirement?
@ Treetops – that DMO link is correct. There’s another one that is also sometimes needed for index ratios. It’s part of next week’s article which is essentially a linker tracking spreadsheet post. Stay tuned!
@ Al Cam – Personally, I’m not using index-linked gilts as a floor but I still needed to do a lot of work to understand them.
And that’s what all this is about. I’m doing my best to demystify an asset class so people can decide whether or not they want to use them, and whether or not they represent good value.
Re: floor / safety first approaches. I understand your perspective though I’m going to counter – more for fun than anything else.
I think ‘safety first’ is more about affordability and psychology than value for money. If you can afford it why wouldn’t you squeeze the risk out of your retirement? Why would you fret whether some other route might have eked out a higher yield?
My point is you pay the going rate for peace of mind. If you can’t afford it then you don’t get that peace of mind.
I’m using a probability first method because I can’t afford the life I want using ‘safety first’. And I suppose because, psychologically, I can live with the risk of a probability-based approach.
I’ll give you quite a personal example of why I’m down on worrying about value for money. I know someone following a safety-first approach. It’s working really well with the floor secured by an index-linked annuity. Yet periodically that person frets that they may not live long enough for their annuity to make a profit versus the level-annuity alternative. OMG! They’ll be dead! And in the meantime, they’ve got all the money they need. In fact, they’re still able to put savings aside for the proverbial rainy day. So why do they care about an alternative universe in which they owned a level annuity and carked it early?
Anyway, if you’ve time, I’d be interested in your response to that off-load because I know it’ll be a thoughtful one and likely to expand my field of view 🙂
I’m also intrigued by your “there are many ways to skin this cat” comment. What do you have in mind as alternatives for someone who wanted to eliminate inflation risk from their retirement? You can’t have defined benefit pensions cos they’re not widely available anymore. Also, no products that would be lovely but don’t exist in the UK e.g. deferred annuities 🙂
I’m scratching my head because I can only think of linkers and escalating annuities topping up the State Pension. What have I missed?
@TA:
Re: ” … but I still needed to do a lot of work to understand them.”
Yup I can understand that, and, as I said, it is a “Nice post”.
Re: “I’m also intrigued by your “there are many ways to skin this cat” comment. What do you have in mind as alternatives for someone who wanted to eliminate inflation risk from their retirement?”
Firstly, I made no mention of inflation. But seeing as you have brought it up, you can use any type of nominal flooring and couple it with an assumed rate of inflation [profile] of your choice if you want to*. FWIW, this seems to be the way annuities are developing in the UK, and a lot of [non-public sector] UK DB schemes provide capped inflation protection, known as limited price indexation (LPI). WRT flooring products, off the top of my head the choices include: UK government bonds (inc. strips/bullets if you can find enough**); overseas govt bonds; savings bonds (or CD’s as our US cousins like to call them); non-callable corporate debt, annuities (in multiple flavours), guaranteed minimum structured products, and for more sophisticated folks risky assets paired with derivatives.
*IMO RPI is a flawed measure of inflation;
**which in some situations eliminate some of the pesky side-effects of using full (principal plus coupons) bonds
Re: your counter – I may reply later, but please note I am not having a go at you, just pointing out a possible unintended consequence. What in particular I noted was no mention of any alternatives to linkers in the posts and, possibly more worrying, none in the comments either. @ZX’s note on costings was the closest I could find to any challenge/push back and I vaguely recall somebody else mentioned nominal gilts at some point too.
@AlCam, @TA
I oscillate on the floor and upside thing. Our investments, ages, expected expenditure and bond yields are now such that we could exceed our income requirements through index linked pension annuities and a ladder of linkers.
At first sight this looks like a sensible thing to do. Why not eliminate all investment and sequence of returns risk if you can afford to? It is tempting, but we choose not to for 2 main, but overlapping, reasons. The first is the value for many point that TA raised. This is very personal, but as TA has said, for us the safe route is poor value and I hate poor value. The second reason is that we feel we are investing for others (charities/beneficiaries) and want to do the best we can for them whilst also being cognisant of having to look after ourselves.
Over the long term equities are likely to outpace inflation, but in the short term decumulators need to mitigate the sequence of returns risk of equities. That mitigataion can be done using cash deposits and gilts, which is our approach.
We came very close to buying pension annuities last year, but eventually chose not to. We will consider this again early next year, but I suspect we will come to the same conclusion. The logic is something like this: An annuity is similar to a ladder of linkers plus a longevity guarantee. Instead of an annuity we could build a ladder of linkers for say 25 years and take the risk that will be long enough. Alternatively we could buy a 15 year ladder and leave the rest in equities. The ladder mitigates the sequence of returns risk for 15 years. By that time the equities should have out performed the 11-25 year linker ladder that we could buy now. The shorter ladder + equities is higher risk and absolutely not suitable for everyone, but for us would seem to be better value.
Again, everyone is different and has different circumstances. Annuitising, or partially annuitising with F&U, might be right for many people.
@TA re:
“@ Kelvinho – There’s so much to say on this that I think I need to write a post on it. It’s a great point and also a dilemma that I think hinges a great deal on your personal objectives. Can I ask, does your 80/20 split suggest you’re quite young with some way to go before retirement?”
perhaps best decribed as middle aged with another 20 years to go before I retire. Personal objectives align with making some adventurous decisions to obtain additional growth.
Terrifically interesting article and posts – thank you everyone.
For what it’s worth, I’ve got an index linked gilts and TIPS ladder (constituting about 60% of my investable assets) taking me to age 85 (I’m currently 60). Will very likely me see me through to death and I’m guessing will provide c.75-80% of the income I want (assuming the UK and US governments don’t default).
The balance of my investable assets (i.e. 40%) are in a mix of cheap index funds (invested broadly, 40% US and 60% rest of world).
In aggregate, taking into account my TIPS and US investments in my index funds, I suspect around 50% of my total investments are in US dollar assets.
I’m repeatedly told I’m taking on too much currency risk – and I’m not going to dispute that – but I just can’t help thinking that over the next 25 years the US will outperform the UK and the currency will reflect that comparative performance. If you want to make God smile tell him your plans…..
I guess I’ve got to ask myself one question: “Am I feeling lucky, punk?” (apologies to Dirty Harry).
Personally, I think linkers have a solid place in the portfolio.
Yes, there are clear issues. Inflation indexing only protects against cost of living increases, not standard of living (which requires something that moves with earnings). In the second half of the 20th century, inflating your living expenses with RPI would have seen your relative standard of living fall substantially over a 30 year period. The difference to earnings of around 1-1.5%/annum really compounds up. Moreover, the specific inflation metric, RPI/CPIH etc, is not directly applicable to the individual.
Nonetheless, in terms of providing a simplistic floor, I see a linker ladder as the obvious choice to reduce the path dependence we see from other more volatile assets. The approach I’m building uses a tapered linker ladder, with maturities up to 30 years to provide a floor. In year 1, it will cover basically 100% of likely expenses but by year 30 that drops to around 25%. The weighted duration is around 15 years or so.
I see no need at around 50 years of age to buy annuities or use ultra-long linkers (out to 50 years). I do see some value though in hedging near-term path dependence, hedging inflation shocks or hedging a return to negative real yields. I’d also note I own linkers in others countries so as to diversify aways from Gilts.
For what it’s worth, I’m 60, just retired and this is my arrangement (ignoring cash buffer):
– 60% of investable assets in index linked gilts and TIPS ladder until I’m 85.
– 40% of investable assets in cheap index funds (c.40% US, 60% rest of world).
– The gilts/TIPS should cover c.80% of my day to day living expenses (I hope).
– I’m taking on a decent amount of $ currency risk. I can’t help thinking the US dollar will outperform sterling over the next 25 years. (If you want to make God laugh, tell him your plans…..!)
– My thinking is this arrangement should deal with either deflation or inflation. But time will tell!
Any thoughts?
@ JPGR I hold some TIPS in my SIPP (Interactive Brokers). I bodge the FX hedge with the ‘Micro’ GBP/USD future, M6B. They’re only liquid for the next IMM period (so currently December, then March, then June etc), so you have to roll them with a spread trade each quarter. In theory the FX hedge should obviously be to the end date of each TIPS, but this bodge will roughly work unless the £ and $ interest rate curves diverge significantly in the future.
You can obviously then choose how much of your FX exposure you want to choose. I’m all ears if anyone has a better solution!?
@ ZX, do you just run unhedged FX too?
@ Kelvinho – Cheers! For now, I’ll just mention that there is no consensus. A powerful voice is Zvi Bodie who advocates 100% linkers. IIRC, he means for the entire retirement portfolio and not just the defensive side. He’s US-based and perhaps the ultimate ‘safety first’ advocate. Prominent voices on the Boglehead forum default to splitting their bond allocation 5o/50 between nominal and index-linked bonds. It’s generic advice however, not particularly thought through. (Though it does acknowledge how hard it is to *know* much less optimise.)
@ JPGR – As long as your withdrawal rate is low on your 40% upside portfolio then you seem all set. Plus I guess you have the State Pension to look forward to before the ladder runs out.
I’m struck by the fact that you seem to be overweight US TIPs but underweight US equities?
Why take the currency risk at all with the ladder? It doesn’t seem worth it to me. There’s also the issue that US inflation typically undershoots UK inflation. Unless you will spend time in the US?
If you haven’t seen this post before, I think it may contain food for thought. Especially the part heavily inspired by / cribbed from ZX (Laddered couple section):
https://monevator.com/should-you-build-an-index-linked-gilt-ladder/
@ Al Cam – I appreciate you weren’t having a pop 🙂 As ever, you wrote a thought-provoking comment which I wanted to engage with. Not because I violently disagree but because I enjoy the debate as much as anything.
Perhaps where there is a clear difference between us is that I believe a floor has to be as inflation-resistant as possible.
Hence I only consider index-linked assets or, in the last resort, an escalating annuity with a high-inflation cap to be suitable floor material. (Unless known health issues or family medical history lead me to discount longevity risk.)
I’d happily take my chances with RPI or CPIH over my own forward-looking estimate of inflation.
However, ZX makes a great point about standard of living outstripping inflation which is one of the reasons why I’ve shied away from building my own floor.
The other reason is the difficulty of predicting an annual income figure (based on my own experience plus the testimony of your good self and others).
A floor, I think, needs to be paired with sufficient assets for a substantial upside portfolio. I’ve cut it too fine for that, hence it’s probability first for me.
I also need to acknowledge Naeclue’s legacy point. Not an issue for Mrs TA and I, but will be for many others.
For inflation-hedging more generally – which is the rallying point I’ve hung this post from – it’s linkers, or commodities, or an appropriate annuity and that’s about it unless you’re able to run a sophisticated trend-following strategy. Commodities are highly problematic due to the volatility so the options are thin on the ground. Obvs, you’ve got equities and property etc if you only need to beat inflation over the long-term.
Folks,
Looks like my “word of caution” might just have flushed out some great stuff!
Thanks for sharing.
Some other thoughts if I may:
a) Zwecher and Milevsky both posit that for low withdrawal rates flooring adds little, if anything, to the resilience of the plan – they do slightly disagree however about the cut off point for the North America scenario;
b) I am sure I read somewhere (although I cannot lay my hands on a reference) that Z himself is not really a fan of static F&U implementations, preferring to keep [some of?] his flooring at risk in the market and managing the risk;
c) my own experience (and many others inc @TA’s) testifies to the difficulty of predicting [in advance] an accurate annual income figure for retirement; so scaling that to thirty plus years is probably rather problematic;
d) no matter how much time you spend developing your plan things will change and often in ways entirely outside your control and/or influence; and
e) in the end, it is about far more than nice tractable numbers and you have to end up doing you; fortunately (IMO at least) we are all different with different situations, fears, and hopes
@ZX:
I am intrigued by your tapered approach, is this based on the probability of still being alive or something else?
@TA:
FWIW I ruled out commodities entirely, and am not so fearful of my forward-looking estimate of inflation. To date, since I pulled the plug , I have been far more accurate than the the BoE – which isn’t saying much, but it is only really a hobby for me! Oh, and I used it to help build the initial parts of my floor (i.e. pre-DB pension).
@Naeclue:
Looks a bit like Z’s allegedly preferred approach; see b) above; albeit I suspect Z’s [risk] monitoring frequency is somewhat higher.
P.S.
@TA:
Re: “A floor, I think, needs to be paired with sufficient assets for a substantial upside portfolio. I’ve cut it too fine for that, hence it’s probability first for me.”
AIUI, most life cycle economists would cut that the other way i.e. in extremis: annuitise and forego any upside!
@The Accumulator – thank you for your thoughts. All very good ones, of course.
Yes, my withdrawal rate should be quite low (c.2%).
You’re absolutely right that I’m underweight US equities. My US equities and TIPS (the latter constituting something less than 25% of my ladder) result in aggregate US assets of approximately 31%. I’m not marking to market my TIPS so it’s all a bit rough and ready, but it’s in the right ball park.
My thinking (if you want to generously call it that) is, as regards US equities, that there is no particular reason to think that for the next 30 years they will outperform Rest of the World in the way they have done for the last 10-15 years. I wouldn’t be surprised if there was some reversion to the mean. So I’m comfortable being underweight in US equities.
As regards TIPS, it’s just a diversification point. I don’t especially want to hold 100% of my ladder in UK sovereign debt and I’m prepared to pay the price of currency risk for diversification. Although I don’t mark to market my TIPS (given the intent is to hold them to maturity) you’re absolutely right, and, were I to mark them to market, I would have already suffered a material FX loss. Perhaps I’ll rethink this aspect of my planning to really stress test it.
Who knows how this will pan out over the next 25 years?
@TA US inflation typically undershoots UK inflation (especially with our current RPI measure), but US TIPs have been trading at much better real yields.
I put on my TIPS ladder last year (duration ~7y) at US CPI + 2.5%, when the equivalent UK ladder was about UK RPI + 0.8%. All tax free if you hold it in a SIPP and less chance of Ms Reeves changing the rules and messing with your retirement plans. The FX you can roughly hedge if you wish (I mostly do, I’m looking for the real yield, not a huge FX trade), though note that the hedge does eat into the returns a little. (I’m hoping someone improves on my solution here).
Looking this morning my US TIPS ladder is roughly priced at US CPI + 1.6%, whereas an equivalent UK ladder is roughly UK CPI + 0.3% (leaning mainly on the low coupon linkers).
Can work as a ‘floor’ or as the 40 of a 60/40. & arguably better value than linkers (in a SIPP at least), assuaging some of @Naeclue’s concerns.
@ Al Cam – interesting point that a low enough withdrawal rate is effectively as bomb-proof as a safety first approach. Can you remember the ballpark thresholds?
re: your point about annuitising in a tight spot – this is an important scenario. From memory, that’s because an annuity provides a better income than a well-managed drawdown portfolio. You’re also likely to have to choose a level annuity and cross your fingers re: inflation. But annuitising the entire portfolio leaves no buffer to cope with unforeseen difficulties, the proverbial boiler fail etc. I instinctively chafe against the lack of optionality. But this is what my grandparents did. In their case, no annuity just the State Pension. And their upside portfolio was friends, family and community.
Anyway, very interesting.
@ Vroom and JGPR – Your point about diversification is well made. Perhaps this is something that innovations like Bulletshares ETFs as mentioned by @EMcG67 will make much easier one day (with GBP hedged versions of TIPs ladders).
I don’t know that I want to be running my own FX hedge in my dotage, but I suspect that’s a problem that’ll be solved by the industry.
So then the decision rests upon your personal preference for diversification vs an accurate inflation hedge vs simplicity.
Additional considerations being superior yield on GBP-hedged TIPs as pointed out by @Vroom. Could probably argue that’s a wash given UK’s persistently higher inflation.
How accurate a metric is inflation as mentioned by @ZX and @Al Cam?
For diversification: I intend to be pretty dependent on the largesse of the UK state in the future, re: State Pension and NHS.
Against diversification: My equity portfolio is 95% ex-UK. I’m reasonably confident that UK Government finances will continue to be well managed in the future. Or at least no worse than they have been 😉
Re: inflation – I don’t see that there’s a better productised (yukky word) yardstick for the inflation lapping around my finances than UK headline inflation. Moreover, that’s the primary enemy I’m trying to neutralise with a portfolio of linkers.
That along with a desire for simplicity tips me personally in favour of a ladder of UK linkers.
The argument for diversification is strong though. Especially if time and resources allow. Really interesting to think about. Cheers!
@TA maybe a combination of individual UK linkers and TI5G would be a pragmatic option?
You gain hedged diversification into TIPS but could use the linkers to make sure the overall duration meets your needs. TI5G has a duration of about 2 years so it should be possible to make the overall duration acceptable.
@ TA (wrt#28, #40):
Re” Re: your counter – I may reply later, …”
Well here we go.
I have given this some thought and I reckon you might actually be onto something if you combine your counter with some other bits of info/chatter above.
You seem to be implying that the sort of folks who will readily adopt a floor & upside (F&U) approach are likely to be the people who will least benefit from such an approach with regards to plan resilience as noted by Z, M, et al. These punters are (by definition, according to Z, M, etc) over-funded, so the value for money aspects of the flooring are probably fairly moot to them. So far, so obvious – I hope.
However, if it is also true that the folks who would benefit most from adopting an F&U approach (wrt resilience according to Z, M, etc) are the least likely to adopt such an approach*, then IMO we might have an issue; which IMO is only further exacerbated if the flooring options do not strike them as good value for money.
Re: “Can you remember the ballpark thresholds?”
See: https://monevator.com/risk-of-ruin/#comment-1779664
P.S. I would express the point slightly differently as follows: if you are rich enough (versus your lifestyle and NOT in absolute terms) then provided you do not do anything daft you will probably be OK.
Re: “But annuitising the entire portfolio leaves no buffer to cope with unforeseen difficulties, the proverbial boiler fail etc. ”
You might note that I specifically advocate for holding “reserves” in drawdown at the same comment.
*I am not sure I have seen terribly much objective evidence for this (but I have seen some); OTOH I do not recall seeing much contrary evidence either.
This has turned into a very interesting discussion. These decisions are still years away for us, but I’d like to throw in a couple of thoughts from the spectators’ back seats:
I wonder about annuities without inflation protection. Doesn’t this defy the main purpose of an annuity, to have a basic standard of living guaranteed? Instead of gambling that inflation will remain low for decades, I might as well gamble that stonks only go up, or that I won’t live beyond a certain age…
I suppose the key question is whether inflation-linked annuities are reasonably priced compared to a DIY linker ladder?
The NHS has deteriorated so much, in our experience, that private insurance has become essential. Fortunately we are covered through my partner’s job. Axa quoted ~£150/month for an equivalent personal insurance, so that’s ~3.5k inflation-indexed* on top of our yearly retirement budget.
*or more realistically, indexed by CPI + X% because healthcare costs have been outpacing inflation
@Sparschwein (43)
You may be able to get private medical insurance for ~£150/month at the moment, but how much are you expecting it to cost when you are retired? It will not get any cheaper as you get older and will be eye-wateringly expensive by the time you are 80. Your CPI + X% escalation has omitted to include an age escalation factor.
I’m retired and together with all my retired friends, none of us has elected to continue private health insurance into retirement. The normal attitude is that for anything acute and life threatening we will rely on the NHS, while for common surgery – hips, hernias etc. we will just pay up for private treatment if necessary.
@Vroom. FX is a totally discrete decision to holding TIPS (or any asset class) i.e. I always think in terms of locally funding any asset. If it doesn’t make sense to hold an assets vs. local funding, then it doesn’t make sense to hold that asset at all. I’d be better off in local depos. The fx overlay is separate.
@AlCam. The taper is not related to longevity. It’s driven empirically by the observation that I’m most sensitive to the path dependence (or SoRR) early on. This is the same observation that drives other solutions such as reverse equity glidepath etc.
@ZX:
Thanks for the additional info. Got it.
OOI, are you [progressively] building your ladder now (such that it should be [fully] in place before/when you plan to retire) or is the plan to build it near(er) the point of retirement?
My primary reason for asking is that you are the only person so far who seems to have picked up on my comment (with a footnote) about the “period prior to retirement”.
Having said that, for some reason, I would have thought that you might not be too inclined to use a static solution and might prefer to keep your flooring at risk and manage the risk.
@DavidV – that’s a good point, and a serious concern for us. We’ve experienced the absurd NHS delays (e.g. 4 months for diagnostics of an officially “urgent” serious heart concern; a whole year for my partner while she could barely move) and just don’t trust the system anymore. I certainly hope that the new government can improve it, but they’ll have their work cut out to fix 14 years of underfunding and mismanagement.
So this might mean that our “number” just went up by a few 100k.
Or our vague ideas of retiring somewhere in continental Europe should be top of the agenda.
This excellent discussion has me rethinking my drawdown method.
I’m really attracted to the idea of using the bond portion of my portfolio to match the state pension for both myself and my partner. Utilising tax efficient Gilts (GIA+ISA) to run a kind of fixed term annuity until SP age 17 years from now. This would also form an equity glidepath, moving from ~60% to ~80%. The drawdown from the Gilts would be pegged to the State Pension each year so there is a seamless transition once it comes on stream. I would additionally take a variable monthly ‘upside’ from equity at ~3.5%/12 with no inflation adjustments. There’s also a BTL income similar to the SP in value that sits somewhere in between these two (20%). This would remain alongside the equity (80%) once SP kicks in.
Assuming this is sane, I’m wondering how best to build the ladder. Should I target a rolling weighted duration of say 6yrs, or try to build the rungs out for the full duration with an assumed rate of inflation (3%) and compound return minus withdrawals each year to set the initial capital allocation to the Gilt ladder?
I’m also stuck on whether Linkers should be just used as two or three year’s expenses rolling insurance against shock inflation and spent in that event, with the rest in regular Gilts, or 50/50 as widely suggested?
Apologies for the long brain dump, but I wanted to see if anyone else is planning/doing something similar or has remarks for further consideration?
@ZX, @Vroom [& @JPGR]:
Assuming I have correctly understood you both, it could be that you are taking opposite views on currency hedging (to the £) US TIPS?
Interesting.
FWIW, I would tend to agree with @JPGR’s view (at #33) and would leave it unhedged – especially if I could foresee being a fairly frequent traveller to the US.
Nice note re VFM of TIPS @Vroom.
@Ade
If you are using gilts to provide an inflation-linked income each year until your state pension starts, why wouldn’t you use a collapsing linker ladder as described in the earlier Monevator article?
https://monevator.com/index-linked-gilt-ladder/
This would give you near-certainty of inflation-linked income each year. It wouldn’t quite match the state pension as the income would only go up by CPI inflation and not the pension’s triple lock. You might want to over-provision slightly to allow for this, or top up the difference each year from your upside portfolio.
@Ade,
Thanks for sharing your thinking. I for one am glad to see that you are considering options other than UK linkers.
FWIW, I would begin by costing an appropriate fixed term annuity and go from there. AFAICT, such products are available, but IIRC there are some issues about [income] tax (something to do with how much of each payment is deemed return of your capital and how much in interest – but I am very vague/out of date on the subject).
If you are prepared to look at nominal products I would not rule out FSCS guaranteed savings bonds (aka fixed rate [savings bonds] or CD’s as our US cousins like to call them), especially for the near term rungs – I used some. My reasons [at that time*] included: rates/terms on offer for CD’s, [high] cost of gilts, familiarity with CD’s and relative unfamiliarity with bonds/gilts etc.
If you want to dial up the risk a bit (and presumably lower the cost too) , I would look at non-callable corporate debt and diversify accordingly. This market is massive and I would imagine there could probably be many things to suit you.
FWIW, when I set up my ladder I [also] opted for a flat (ie unshaped) rate of inflation that I assumed [at the time] to be conservative. I opted for 3.5%PA. Initially, I was well ahead, but we all know what then happened. When I started my DB pension, average CPIH across the period from jumping shape was 3.6%PA – so not too bad. Having said that, I had never thought of anything like your idea of using a small batch of linkers as rolling insurance – what do you think would be the downside of this approach?
However, before going too much farther into the weeds I would point you at items c), d), and to some extent e) in my post #36 above. In essence, things will change! FWIW, I set out with the majority of my ladder to cover ten years until I took my DB. In the end I took my DB about four years earlier than planned when I “discovered” actuarially reduced it would probably be “enough”. This also meant I could [largely] abandon/jettison the extreme tail of my [largely notional at these later ages] ladder, ie beyond SP commencement. It could, of course, have gone the other way and I could have under-estimated the need. And, no doubt, there may be some more bumps in the road before I reach SP age – but that is kind of the point really!
Lastly, I still keep reserves.
I really hope you get some other views – as this is just my take and I am far from expert in any of this stuff, so YMMV.
*I jumped ship at the end of 2016, although I did have quite a lot of the elements in place a number of years in advance
@Al Cam, “Zwecher and Milevsky both posit that for low withdrawal rates flooring adds little, if anything, to the resilience of the plan.”
That is the view I have formed. Obvious in a way – a 2% withdrawal rate can be considered to be a 4% withdrawal rate from half your portfolio, the other half put aside to mitigate the relatively small risk of the 4% withdrawal rate failing. Do you have links to any publicly available material by Zwecher and Milevsky?
On estimating future spending, that is enormously difficult, but from what I have witnessed and read, there are some common themes. For the first few years spending is relatively high as retirees do things they had planned to do but not had the time. After the initial splurge spending can be relatively stable until circumstances such as ill health and/or lack of energy result in declining time being spent on activities retirees used to enjoy. On the flip side, spending on care can increase substantially for some, especially if residential care is required.
We are passed the splurge stage, probably, and spending for the next 10 years or so at least looks relatively predictable and stable, in real terms. Having said that, it is impossible to know what life might throw at us at any point in our lives.
@Naeclue:
See: https://monevator.com/the-slow-and-steady-passive-portfolio-update-q3-2024/#comment-1839651 and subsequent comments
Another useful source is Ed Thorp and what he considers the rate is for a perpetual portfolio.
Worth noting all these guys thinking is IMO inevitably rather NA centric
@ Ade – a collapsing index-linked gilt ladder is made for your scenario, as suggested by David V.
If you’re not concerned about inflation then you could use a bond or savings bond ladder.
Sounds like you’re too young for an annuity to be value for money but I haven’t checked the market recently. It certainly would be a good idea to take a look as Al Cam suggests.
Re: index-linked rolling insurance – I do exactly this. Right now a fair proportion of my emergency cash is in a couple of index-linked savings certificates. However, they’ve changed the rules to make it much more costly if you need to cash them in early.
So I probably won’t roll over the certs next time. I’ll likely plough that money into index-linked gilts instead.
The 3-year rolling ladder I’ve just built (as mentioned in this article) is a version of the same thing.
The certs jumped in value during the recent inflationary surge, so I was very glad to have them.
Ludicrously, I inflation-protected other sums by parking it in a new kitchen and bathroom (I had a refurb coming up). This did actually work when I revisited the prices for those goods some 18-months later. Not sure this is a replicable strategy 😉
@ Al Cam – I wasn’t thinking about the financial means of people who choose safety first retirement strategies – though I do think that’s an interesting topic too.
I was thinking about the psychological value of security and how that can be underestimated by the “value for money” perspective.
If the objective is a financially secure retirement then, I think, the first order of priorities is surely to calculate the combination of assets that can best deliver that security.
That requires some sense of the amount of income required, a hierarchy of threats to be neutralised (in so far as that’s doable), plus a margin for error.
It also seems that one needs an understanding of the plan’s probable weak points i.e. the events most likely to push it off the rails.
Finally, I think the plan’s operability must suit the individual (and dependents) with thought given to its continued execution in the event of early death or a horror such as early onset dementia.
The issue I have with “value for money” is I think it interferes with, and can easily overwhelm, more important strategic priorities.
Don’t get me wrong. I do think “value” matters. There’s no point choosing an expensive option that delivers £30K income a year when you could buy an alternative that offers £35K p.a. and delivers on all the same strategic priorities.
But this is rarely the case. Often we must sacrifice something important to get a “better deal”. Moreover, our brains are wired to discount the future.
Annuities are a useful illustration. For example:
You calculate you need £35K p.a. to live really well.
– You can buy a level annuity that delivers £38K p.a.
– Or an index-linked annuity that delivers £33K p.a.
The annuity market implies that many people opt for the £38K option.
Heavily discounting inflation and the comfort of their future selves as the level annuity fails to keep pace with the standard of living.
And also discounting the ease with which they could probably live on slightly less. Whereas, they’re pretty likely to have to live on significantly less in the future if they’re relying on that level annuity.
In this example, I think there’s a human tendency to over-value the highly tangible immediate income figure, and under-value the inflation protection which will only really make itself felt at some vague point in the future.
I think we hate the idea of getting a bad deal. There’s a sense in which we feel like we’re being taken for mugs.
But a deal includes many components. To go back to my original anecdote. The person I was referring to kept forgetting about the value of the inflation-protected income that dropped into their account without them having to lift a finger (relative to their earlier period of financial anxiety). Because they kept reading (bad) newspaper reports criticising annuities. And because they kept remembering the slightly higher nominal income they might have had.
To be fair, they have stopped worrying about it over a decade and one inflationary shock later.
@Naeclue:
This might also be of some use (albeit it ultimately takes you to a rather comprehensive annotated bibliography):
https://monevator.com/the-slow-and-steady-passive-portfolio-update-q3-2024/#comment-1839651
@ A1 Cam re currency hedging (#49):
I hedge my TIPS with a variable hedge using the M6B forward GBP/USD futures.
• Doing it this way in Interactive Brokers allows me to zero my non ‘home currency’ spot positions, which reduces funding costs.
• The futures allow me match my FX exposure, or do more or less etc – to run whatever FX I want.
• My own default GBP/USD FX position is flat as I don’t anticipate future $ expenses and I don’t have a strong view on this currency pair at this level (I’d pick a hard currency against both!). I just want the TIPS yield.
• The M6B futures are actually priced off the forward GBP and USD interest rate curves. I’m still trying to get my head around exactly how relevant that is to my TIPS position. If I was just buying US T-bills, the forward hedging would roughly convert my T-bill yield into the comparable Gilt yield, so would be a little pointless. The TIPS has the inflation overlay on top so it’s more complicated. To my understanding of the maths (hello envelope), I’m still well up on the equivalent linker yield even with hedging costs. But I’m all ears if anyone has thoughts…
AIUI, @ JPGR runs his TIPS unhedged, so has a big FX position (& you suggest you’d do the same, as you anticipate future $ expenses for travel etc).
AIUI, @ ZX chooses assets versus local funding (so a guaranteed 2% in Japan is attractive if you can fund it at 0.5% etc). He then builds his portfolio, looks at what FX positions he’s net created and then chooses how much to hedge them.
If you have a portfolio of assets in different currencies, @ ZX would seem the smarter approach. I just need to try and get my head around how that would work with trackers held in an ISA and hedged in a GIA etc…
@TA (#54):
Thanks for your reply. I think I can see where you are coming from, but I cannot help thinking people’s financial illiteracy (FI) is getting in their way i.e. they just cannot properly assess VFM and therefore are unable to discern a good deal. Not a lot we can do about that.
From experience I know just how rife FI is. Not so many years ago I had to work bloody hard to persuade several colleagues to refuse DB pension PIE offers – strangely enough, they all get it now*. Your comment “To be fair, they have stopped worrying about it over a decade and one inflationary shock later” says much the same thing.
*some of them did get it earlier when I pointed them at paragraphs in another DB schemes annual report where the trustee was commenting on how much money their recent PIE offer had saved their scheme; as it happens IMO it was a pretty derisory amount – but that says more about that trustee than anybody else
Holding ILSC’s through the recent inflation surge was indeed a rare highlight. The [ILSC] rule changes are noteworthy. Have you considered taking a slightly contrarian position at all, see: https://simplelivingsomerset.wordpress.com/2024/04/11/vanguards-cautionary-tale-hidden-in-plain-sight/#comment-42590
and the subsequent chatter.
@TA (54)
I don’t think the tendency of most annuity buyers to discount the future and so buy the level annuity is quite as straightforward as you suggest. I am instinctively drawn to the security of assured, inflation-protected income. I am fortunate to already have a DB pension (RPI capped at 5%), the state pension and a very small level annuity (bought because of a quirk of a Section 32 policy), so have no need for further assured income. I’m also dangerously close to the HRT threshold so need the flexibility to manage my additional income carefully.
However, if I were in the market for another annuity, my first instinct would be inflation linked (I did after all reject the Pension Increase Exchange option on my DB pension). If I received quotes similar to your example, where the level annuity pays only 15% more than the inflation-linked, it would be a no-brainer IMO to choose the inflation-linked.
However, the reality is very different. From HL’s best-buy annuity tables the differentials are ~66% at age 60, ~57% at age 65, ~45% at age 70 and ~32% at age 75. It would take a long period of sustained high inflation for the crossover to occur, and even longer for the cumulative totals to match.
I conclude, therefore, that many people reject the inflation-linked annuity not because they are blind to the dangers of inflation, or discount the future, but purely on value for money grounds.
I believe Cazalet in his 2014 paper “When I’m Sixty-Four” argued that inflation-linked annuities represented poor value and set out some reasons why he believed this to be the case.
@ Al Cam – That’s interesting. Well played for talking them out of it.
Re: index-linked certs – the contrarian position being to hold a five-year version in case of further T&C erosion?
This would probably be a bad bargain from my perspective 🙂
I hold them because there’s a fair chance I’ll need the money – and it makes sense to me to keep a supply of inflation-protected reserves on hand. (No DB pension.) Sadly, I don’t have a ladder’s worth, they all mature in the same year.
So taking the Accumulators circumstances into account, it seems better to have a flexible rolling ladder of short-dated linkers, now I understand them. There’d be some interest rate risk but not much. Obvs, won’t be great if yields go negative again.
@ David V – Super interesting! My guess, based on no more than my gut plus anecdotal evidence, is that few people model out potential scenarios.
I’ve personally witnessed people ditching their index-linked certs a couple of years before Covid because, “they’re hardly earning anything,” regardless of the fact that nominal interest products were uniformly underwater at the time.
I think recency bias looms large.
The cross-over point surely depends on the inflationary scenario under consideration.
I was too young to be much affected by 1970s style inflation. I barely had pocket money so wasn’t hit too hard. But as I understand it, many pensioners finances were ravaged.
I think a high cross-over point is probably worthwhile to avoid that kind of risk, even if you do think the BOE is more equal to the task these days.
Perhaps another major consideration is your overall allocation to inflation-hedged assets?
That annuity, or a ladder of linkers, is worth more if inflation-linked pensions are a small proportion of essential income.
We haven’t really discussed genetics and personal health history on the thread but I think that’s also an important part of the picture. If near relatives have or are living to a ripe old age; if you’re staying off the fags, keeping a lid on the booze; eating your greens… it’s still a lottery but.
Having said that, I’d guess you have made a calculation, re: annuity market. I’d be interested to hear your considerations if you’re happy to sketch that out.
Re: expense – this is where ZX’s approach surely comes into its own? He’s covering the all-important early years with linkers and will rely on his upside portfolio to beat inflation in the long run. He’s not forcing some insurance company to price the risk of him living until age 110.
I’ve read the Cazalet paper but can’t remember the section you mention. I must go back to it.
Re: the annuity puzzle more generally. That does make more sense to me. I think people hate the loss of optionality from handing over an enormous bag of loot for an income that seems ok but may not be.
@TA (59)
I am old enough to remember the high inflation of the late ’70s and early ’80s. I was already well into my working life by then and my father retired in 1981, so I am all too aware of the dangers of inflation and the levels it reached in those days. (For reference the highest mortgage interest rate I paid in late 1981, shortly after taking it out was 15.75%, although we did get tax relief in those days!).
The relevant section of the Cazelet paper starts on page 68.
I did do my own analysis spreadsheet when I was 65 and was considering whether to buy an annuity with my SIPP. At the moment the comparative annuity figures are set to earlier figures (possibly 2021 when I last saved the spreadsheet, or possibly 2018 when I turned 65). Inflation is set at the moment at a level 3% but I can set any profile I want. I did try some 70s/80s -type inflation profiles at the time. I’ll have a go at updating it and provide some answers for different inflation scenarios.
I don’t know the optimum answer to provide secure income that can keep up with inflation. I think phased annuitisation with level annuities is possibly the best approach. Every time the level annuity income fails to meet expenditure because of inflation, some more of the pot is annuitised. Hopefully the inflation will have caused annuity rates to increase in the interim. The balance of the pot could be invested at risk in equities, but a safety-first approach would suggest a rolling gilt ladder (maybe not of linkers as nominals could beat linkers when interest rates are relatively low and annuity rates are correspondingly poor).
For info, @ZX’s reply to my Q’s at #46 & #49 above is posted here:
https://monevator.com/weekend-reading-trading-places/#comment-1840286
@DavidV (#60):
Lots of work shows that on average retirees real spend generally falls through retirement. This could be equated to a lower inflation rate – what do you reckon?
@TA (59)
I’ve revisited my annuity comparison spreadsheet, updated the figures and run three scenarios. My memory of the high inflation years was a bit confused as it turned out that the peak in recent history was in 1975 (24.2%). I took the annuity figures as of 10 October from HL’s website for someone aged 65, and compared a level annuity (5-year guarantee) with an RPI-linked annuity (5-year guarantee). These were £7167 and £4554 respectively for £100k.
I modelled three inflation profiles: level 3%, level 5% and the annual RPI series from 1970. This starts at 6.4% rising to 24.2% in 1975 and dips to a low of 1.5% in 1999 (I only modelled to age 100). Note that 3% RPI approximates the BoE 2% target for CPI as RPI is generally about 1% higher.
For each profile I had two calculations – real and nominal. For the real calculation the level annuity is discounted each year by the inflation figure while the RPI annuity remains ‘level’. For the nominal calculation the level annuity remains level while the RPI annuity escalates each year by the inflation figure. The method of calculation has no impact on the crossover age but does impact when the cumulative totals match.
So, drum roll please, the results:
Level 3% RPI – crossover age 81, cumulative match (real) 99, (nominal) 94
Level 5% RPI – crossover age 75, cumulative match (real) 86, (nominal) 83
RPI from 1970 – crossover age 70, cumulative match (real) 75, (nominal) 73
According to the ONS life expectancy calculator, median life expectancy at age 65 is 85 male and 87 female. So arguably a RPI annuity provides good value for money if RPI remains around 5% for the next 20 years or so. It provides excellent value for money if we experienced inflation as high and as sustained as in the 70s and 80s. Presumably if there was any sign that this was to be expected it would be priced a lot higher.
Picking up from Al Cam’s discussion of PIE in #57, he, ermine and I recently discussed this over on SLIS. I mentioned there that although I rejected the PIE offer made to me over five years ago and stuck with a fully RPI-linked pension (albeit capped at 5%), I have yet to reach crossover, let-alone cumulative match, after five years that included the recent bout of high inflation.
@Al Cam (62)
I suppose equating declining spend in retirement with a lower inflation rate is one approach. ZX on the other hand has frequently pointed out that ideally you should aim to match the general increase in standard of living, represented by wage rather than price inflation. Therefore, even if your income matches price inflation, there will be a steady decline relative to average wages. I’m also not inclined to think that the declining spend in retirement is anything like smooth, as health incidents could produces jolts either downwards or upwards.
@Naeclue:
The link I gave above at #55 is wrong.
My bad, it should say:
https://monevator.com/now-could-be-a-better-time-to-retire/#comment-1827402
@Vroom (#56):
Thanks for the additional details.
Did you see @ZX’s response, see #61?
What do you think about my foreseen expenses point – I think this is perhaps an IRL example of his comment about [currency] pairwise active decisions.
@DavidV (#63):
Seems Ned C’s conclusions from a decade ago still hold. IIRC, Ned also ran a case where he include the opportunity cost of investing the annuity cost in something pretty safe for the duration too – like an interest paying Bank/BSoc a/c.
Do you have any idea why the RPI linked annuity is relatively such poor VFM. For example, did you compare a fixed rate of indexation annuity?
@ZX has indeed consistently made that point. IMO however, this is just not reflected in any of the studies. I take the point that the averages quoted in the studies do indeed mask lots of variation (ie path dependence).
Expect the reason the dirty price is not shown is because linkers TRADE on a clean price but SETTLE on a dirty price. These are likely two different systems with a completed trade passed from one to the other and they don’t talk to one another.
They trade on a clean price so all prices are comparable. Dirty prices are all dirty in their own way. Also, if you buy a conventional bond at a discount to par you still pay par for the accrued interest.
Where a bond pays PIK interest (i.e. interest compounds to the principal balance) people will say it “trades on a factor”. That just means the price is still quoted excluding the PIK interest but then settles with the price multiplied by a factor representing the PIK interest. It’s the factor adjusted price which is the most relevant, particularly in distressed scenarios (which is when PIK interest is most often seen).
@ A1 Cam: Agreed, matching currency exposure to future expenses can make a lot of sense.
But great to be able to make active FX decisions as you say, so worth considering too how you might potentially hedge currency exposure if the need arose. You have more freedom to invest in TIPS or whatever if you’re not constrained to having to match your future $ exposure (or running a huge FX position you wouldn’t otherwise have chosen to run).
If you don’t want to start getting into FX futures etc there are other things you can do balance things off. e.g. increase the amount of £ hedged ETF’s you run to net out your overall FX position to the exposure you want.
@Al Cam (65)
I have no theories of my own why RPI-linked annuities provide poor VFM, but those that Ned Cazalet postulates on page 70 of his report seem credible, viz. inflation is an added level of uncertainty over longevity and the two compound; there is a relative scarcity of index-linked gilts compared to nominal gilts to hedge the risk; and those in issue are in high demand by pension funds, which affects the price.
I have not recently done a comparison with a fixed escalation annuity, but the HL website shows the 3% escalation annuity for a 65-year-old at £5173, i.e. much closer to the RPI-linked, as would be expected, than the level. When I have chance I’ll plug that into my spreadsheet and report the results.
@ David V – thank you very much for running that analysis – it’s good of you to take the time.
My initial take is that anyone buying the level annuity is optimistically betting on the 3% average inflation scenario. (Unless they have other sources of inflation-linked income).
Or, looked at another way, insurance companies are keen to deter purchasers of the RPI-linked product because otherwise they could be picking up a very large tab – if buyers live a long life / inflation surges.
I guess this relates to why DB pension holders were being made such tempting offers to sell.
From what I know of 1970s inflation, it was unexpected. Inflation was historically high in the run-up but got out of control.
Same again this time: the main Central Banks acted late.
If high inflation was expected then it’d be embedded in nominal bond yields. It’s the unexpected stuff that hurts.
@ platformer – cheers!
@DavidV (#68):
Ned’s suggestions seem credible.
My own view is that the uncertainty introduced by indexation (primarily due to massive shortfall of sufficient linkers) introduces risk on the insurers side and their actuaries (who like all actuaries are required to be prudent and are also required, at a minimum, to fully comply with the law) possibly over-react somewhat. IMO, he who pays the actuary often determines exactly what prudence looks like. Perhaps UK life insurers (LI’s) provide a text book definition of safety first on a massive scale, where they can also exploit the probabilities.
Another interesting comparator is how annuity rates in the UK stack vs the US. OTOH, the US have – as things stand – abandoned indexed annuities. In this respect, I do sometimes wonder what the US LI’s know that we do not know yet? To my eyes this could be a signal that if you want an indexed annuity (in the UK) get it now whilst you still can!
WRT your model, when you get a chance to do the fixed rate indexation calcs, is there any chance you could try out your proposal of phased annuitisation at #60 at the same time?
@Vroom (#67):
Thanks for the thoughts/suggestions.
OOI, do you have some skin in the FX game?
@TA:
@DavidV’s observations re the near insatiable demand for UK linkers (at #68)* is another factor driving the cost of linkers. Whilst linkers may currently be cheaper than they were – they are not – and are very unlikely to ever be – cheap! Hence, my keen interest in alternative approaches.
OOI, did you pick up on @Vrooms VFM comment (at #39) re TIPPs?
*which IIRC excludes any demand from outside the UK
@ Al Cam (#67). I don’t currently run much FX. I don’t have a strong view or any great insight on £/$ at this level (other than I’d pick a hard currency against both, #56). I just want the TIPS yield (#39), so for me hedging out most/all of the FX risk makes sense (#56).
@ Al Cam – Yes, a government-backed index-linked promise is a valuable thing. Not a cheap option. But may well be worth paying for all the same – dependent on personal situation, risk exposure, resources.
I get why you would want to thoroughly explore other options.
I’ve very much enjoyed the debate and am particularly grateful to David V for running the numbers. I may well copy his approach in a future Monevator article. We haven’t written nearly enough about annuities.
You are right when you say there are many ways to skin the cat. (Poor cat). But there are fewer when you view through the lens of individual circumstances. Value is in the eye of the beholder!
Index-linked gilts still look very useful to me so long as yields remain positive.
For anyone thinking about a non-rolling index-linked gilt ladder, ZX’s insights about a reverse equity glidepath strike me as excellent food for thought. Meanwhile, a wonderful advantage of an RPI-linked annuity, if affordable, is simplicity and, fundamentally, peace of mind.
@Vroom (#73):
Fair enough and thanks.
Lastly, could you say a bit more about what you mean by a “hard currency”?
@ Al Cam (#75). If I had to guess whether the £ will strengthen or weaken vs the $ in a few years time… I don’t know. If it was at historic lows or highs or the Big Mac index was miles out of whack or there was a big change in a government’s policies or whatever I might have a view. But right now, I don’t really. Maybe relative interest rates or money printing or budget deficits might give you a steer? My own prediction skills from ‘doesn’t look miles out ‘ levels are a toin coss at best. At the margins, if you had to make a choice now you’d probably rather be stuck with $ than £ with current governments? But then you’d probably have said the same thing a year ago and you’d be 10% down already?
Against that, what’s going to happen to gold and inflation and the S&P 500 and everything else that’s denominated in £ or $ with current governments and policies? My view is that that’s a safer bet, that overall they’ll continue to ‘surprise’ to the upside until sounder money comes back into fashion and deficit spending etc is brought under control. So, my focus would be to be long inflation and long stuff generally and worry more about those allocations (whether to dial down equities for commodities etc) than to get too caught up in whether the £ or $ are currently being devalued faster?
This continues to be a very interesting discussion that I will surely revisit when drawdown approaches.
Wade Pfau’s “RISA matrix” may help explain/resolve some of the differences in opinion and approach:
https://www.morningstar.com/retirement/whats-your-retirement-income-style
@Al Cam (65 & 70) @TA
Okay, as promised in #68, I’ve run the spreadsheet again for an annuity escalating at a fixed 3% (£5173 starting) and compared with the level annuity (£7167), both for aged 65. HL only show 3% escalating on their website now – I think in the past they used to show 5% also. For the real calculation I’ve discounted with an assumed 3% inflation to match the escalation factor.
Results are:
3% Escalating – crossover age 77, cumulative match (real) 89, (nominal) 86
The crossover age was so close to being at age 76 – it only missed by £5/£6. Comparing with the results reported in #63, the cumulative match is much closer to life expectancy than the RPI-linked annuity when inflation is 3%, but not quite as close as when inflation is at 5%.
Al Cam (70) – I’m afraid you’ll have to wait a bit longer for me to do a phased annuity analysis. It’s not such a simple modification to the spreadsheet and I have to think what assumptions to apply (e.g. percentage of pot to annuitise initially, return on remainder of pot left invested). As the RPI annuity is 63.5% of the level at age 65, I’m thinking of initially level-annuitising 65% of the pot. This gives a small initial ‘win’ over the RPI annuity. The remaining 35% is then invested in something safe. As I have level annuity prices for ages 70 and 75, I’m thinking I’ll level-annuitise half of the invested residual pot at age 70 and the rest at age 75. I think I’ll need to compare results against both the 100% level and the RPI (and maybe also 3% escalating). The inflation profile will only impact the RPI annuity explicitly, but it will also influence the return I should assume on the invested remainder of pot. I’m thinking I can only work with nominal figures as real will get too complicated. Any thoughts on methodology or assumptions?
Also, I’ve thinking more generally about the VFM of level vs inflation-linked annuities. The main virtue of an annuity is that it pools longevity risk. Insurance companies have been doing this for over 200 years and are highly skilled at predicting mortality. So even with allowance for a profit margin, they can price level annuities keenly. When it comes to inflation risk, though, they have no expertise better than any other economist or actuary working in finance or government, and know it is notoriously difficult to predict. They have therefore to have a much larger safety margin in their pricing, as has already been discussed.
@Al Cam @TA
Oops, I forgot that when I do the phased level annuity analysis, I need to use a higher proportion of the pot than to just beat the RPI annuity. This is to make some allowance for inflation until the second tranche is bought at age 70.
@TA (#74):
Re: “… you say there are many ways to skin the cat. (Poor cat).”
I wonder if it is the same moggy that appears in Michael Zwecher’s short essay about path dependence: “They each only get one whack at the cat”?
@Sparschwein (#77):
See point e) at #36 above, re “doing you”. AIUI, the RISA is a tool to help you characterise your preferences. Further details at comments #22 & #29 at: https://monevator.com/the-slow-and-steady-passive-portfolio-update-q3-2024/
P.S. your moniker has long intrigued me; anything you can add?
@DavidV (#78, #79):
I suspect as in all such exercises the assumptions will begin to suggest themselves to you as you tackle the problem. FWIW, I had overlooked the fact that you would need [annuity] prices at the later ages and these would be limited to those available [at HL, specifically 70 and 75].
Re pricing inflation risk: – tricky, so expensive I guess. Also, I am not sure what, if any, role probability (ie pooling) plays. In a round about way this brings me back to my contention that you can probably price inflation yourself without having to worry about any profit margin.
@TA:
If you can find a copy of it, David Blanchetts 2017 paper LDI Misapplied is IMO worth a read. He concludes:
“Building efficient retirement income portfolios is complex. It is possible for individual investors and their advisors to borrow some of the liability-driven investing techniques used by pension funds, but it is important to understand how individual liabilities differ from those of institutional investors. For example, retirees have a soft liability, since the investor can adjust spending in retirement if needed, while pension funds are legally bound to provide payments at set levels regardless of its funded status. Also, the retiree’s portfolio is only one of a number of assets available to fund the retirement liability. Many retirees receive guaranteed pension benefits, such as Social Security retirement benefits, which should change the risk target for the portfolio.
The growing use of LDI is certainly a step in the right direction for retirement investors; however, it is important to proceed with caution.
Modeling the wrong liability can result in equally inefficient portfolios, usually ones that are overly conservative. Our analysis suggests that most investors are likely best served with portfolios that are more balanced and diversified in nature.”
@Al Cam – I’ve heard about RISA in a podcast recently and have yet to figure out where I stand. It is surely one of the “hybrid” (read: contradictory) quadrants. The MV community is way ahead as usual.
“Sparschwein” means piggy bank. The word has some connotations of “luck” or “lucky escape” (on my mind as I got late into the FI game) and it can be read as “the pig who saves” – so it works as a succinct introduction…
I bought some gilts about a year ago. A couple of conventional ones and some IL gilts. It’s infuriating that the IL ones sit in my account at the clean price when I know it’s missing around 25% of the amount I paid for them! Come on brokers…. We’re almost 25 years into the most advanced tech century we have ever had!
@DavidV (various):
A couple of things occurred to me overnight:
a) the fixed indexation annuity initial pay-out is quite close to that for the RPI linked one – does this mean that the costing* of the unknown (and unknowable) course of RPI over the annuity is not such a biggie (vs a flat 3% assumption), or is it compounding at work, or …
FWIW, I think viewing the the relative pricing (of 3% fixed indexation & RPI indexed) the other way round tells us that the RPI pricing is >3%PA flat for the duration, but possibly not that much greater. Perhaps however, the LI can ‘pool’ fixed indexed annuities (possibly with other LI products too, such as life insurance) in a way that an individual just cannot hope to emulate.
One way to possibly examine this further would be:
b) in your partial annuitisation model ideally it would be nice to examine three cases for the accompanying investment [of the non-annuitised part(s)], specifically: one that exceeds assumed inflation, one that matches it, and one lower
What do you reckon?
*assuming fair pricing
@Sparschwein (#84):
Thanks – now I know!
Pity that unravelling the pricing of indexation is not so easy.
For some reason the RISA reminds me of the Myers Briggs Type Indicator (MBTI) albeit with a quarter* of the types. I understand that one of the most controversial issues with the MBTI is whether your type can/does change with time.
P.S. the Benz (@morningstar) article you linkedto is IMO nicely written
*although originally the RISA could have had 36 types, yikes!
Many thanks for the responses and suggestions to my earlier questions.
I’m just turning 50, so the fixed term annuities that I’ve been able to get prices on start from age 55. Not really a big deal to wait though.
The hesitation to build all the way out for 17 years with ILGs is the commitment with duration. I assume the same lock in would apply to the fixed term annuity.
I think A1 Cam’s point around things changing on the journey makes sense to me, keeping as many options as possible sounds wise.
@A1 Cam, I guess having a short rolling ILG allocation would be a one shot deployment. It would need rebuilding out of the equity allocation in the ‘good times’ if and when they returned. The length of the ladder is also really going to be bit of a guess.
The treatment of income is also super important as much of the ‘upside’ spending will be coming from a taxable drawdown pension. The low coupon CGT tax treatment in the GIA is attractive until I can fold into 100% ISA.
If I’m understanding it correctly, the uplift in ILGs would mean they would be better placed in the ISA tax wrapper for income tax reasons.
The main reason I’m attracted to matching the SP in the run up is mostly psychological. The SP is coming regardless unless some wild politics gets in the way, meaning I have a trackable target and known dates. It should also mean there is no change to the spending budget during transition to partial SP funding.
One possibility simplistic question I have often wondered is, why doesn’t cash and short duration debt provide enough inflation protection given the primary response of the central bank is to raise the bank rate to reduce demand, meaning cash or short duration Gilts respond quickly in response as they have in this recent cycle?
Really excellent article, thanks. I’ve learned a lot from it.
To help my understanding I reproduced the YieldGimp dirty price for the 1.25% index linked treasury gilt 2054 from the clean price from first principles. My rounding is a bit rough and ready.
I’ll show the calculation here (based on price at time of post) just in case it helps with cross checking your own spreadsheet calculations/methodology that you mention you’ve done and are going to cover later.
Incidentally is the inflation-adjusted principal strictly speaking the modification of the clean price by the change in the RPI index since it was first issued, rather than the bond’s original £100 nominal value modified by the change in the RPI index since it was first issued. I appreciate it’s very difficult to describe it precisely in words and you really need to see the numbers. Or I have I misunderstood something there?
1¼% INDEX-LINKED TREASURY GILT 2054
Coupons paid on 22nd May and 22nd Nov
RPI (Dec 2023) 379.0
RPI (Jan 2024) 378.0
Issued 14/03/2024
Issued less 3 months 14/12/2023
Interpolated RPI at issue 378.58
(18 days of 379.0 and 13 days of 378.0)
Today’s date 14/10/2024
Today less 3 months 14/07/2024
RPI (July 2024) 387.5
RPI (August 2024) 389.9
Interpolated RPI today 388.58
(17 days of 387.5 and 14 days of 389.9)
Indexation ratio 1.02642
(=388.58/378.58)
Clean price = 95.61
Accrued interest (22/5/2024 to 14/10/2024)
(= 145/182 x 1.25% x 0.5 x 1.02642 x 100) =0.51
Indexation of capital
(= 95.61 x (1.02642-1)) = 2.53
Dirty price = 98.65
@Ade (#87 & #48):
It is a shame you got relatively few replies – but you did get some and the other chatter presumably contains some useful stuff for you too.
Some other points have occurred to me:
a) are you currently solely dependent on your BTL for income or are you still working?
b)BTL income is a tricky one if a F&U framing. The purists seem to suggest it should not be counted as flooring (although IIRC they do not actually advise how to treat it); the pragmatists suggest it be treated as more risky than pure flooring and discounted accordingly (see e.g. Section 3 of Ken Steiner’s actuarial financial planner overview (a PDF file IIRC) at his semi-retired website: https://howmuchcaniaffordtospendinretirement.blogspot.com/)
c) Do you plan to dispose of your BTL at some time
d) If you want to keep some of your flooring at risk (ie not build out the whole 17 years) then you probably should develop a method for monitoring that you still have sufficient funds to purchase the “missing flooring”- some people suggest monitoring the cushion above the funding needed (ie your net upside) and acting (by purchasing the “missing flooring”) if that cushion falls to near zero; if you like: bolting the stable door before the horse has bolted – to mangle yet another animal metaphor!
In the round, it looks to me like you may have some distinct sub-phases in your 17 year road plan. If that is the case and you are still working and not overly keen to lay it all down in one go it may even be worth giving some thought to favouring the distant rungs* a la @ZX, see link at #61 above.
Having said all of the above – a lot will happen in those 17 years!
*as opposed to the default near term rungs
@snowman
The reference RPI for a particular date should be calculated according to page 33 (ANNEX B: METHOD OF INDEXATION FOR INDEX-LINKED GILTS WITH A 3-MONTH INDEXATION LAG) of yldeqns.pdf available on the DMO site.
In your workings above, “”Interpolated RPI today” is:
387.5 + 13/31*(389.9-387.5)
which yields 388.51 rather than 388.58. The resulting index ratio is therefore 1.02622, which agrees with that available from report D1D on the DMO site.
Hope that helps.
@ Snowman – hey, thank you! I get the same price as you. The DMO description of the calculation says it’s the clean price modified by the index. They use the term “the real clean price”. Which sounds very hip now I come to write it out. Anyway, the terminology threw me initially because I think of “real” as meaning inflation-adjusted. In a financial context anyway. The links to the DMO’s version of the calculations are here:
https://www.dmo.gov.uk/media/1953/igcalc.pdf
https://www.dmo.gov.uk/media/1954/indexlinked3m.pdf
https://dmo.gov.uk/media/15002/3monthgiltcalcs.xls
@ Al Cam – “They each only get one whack at the cat” 🙂 This is key and a lot falls out of this single observation. Perhaps one for our next debate!
@ Ade re: central banks – I think plausible explanations are:
Inflation was persistently underestimated for years (post-war through 1970s)
Authorities struggle to take the necessary action in time
Are or were restrained due to political pressure
Anti-inflationary moves may come into conflict with dual mandates (e.g. the Fed’s mandate is to support employment as well as control inflation)
Inflation is not easy to predict
The transmission mechanism is imperfect
Government may prioritise financial repression to inflate away debt (i.e. keeping interest rates below inflation)
I’d also add that while short-term UK cash instruments are beating inflation right now, they typically lost money in real terms 2008 – 2022.
You said ‘the clean price is typically the nominal price for each gilt. That isn’t much use because the price you pay is the dirty price’
I agree it causes problems with understanding how many units to buy. But I think you can make an argument that the clean price is very useful.
The clean price is useful in that theoretically the prices of two index linked gilts with the same coupon and same redemption dates would be the same even if they had been issued in different years. If you see only the dirty prices then the prices would be different depend on what inflation uplifting has occurred so far on each index linked gilt. But the (dirty) prices would be different even though your cashflows from say a £20,000 investment in each gilt were the same. Dirty prices mean you need to know the indexing history to understand the price, whereas clean prices takes out the need to know that history. The clean price also gives you a feel for what real return you will achieve, if it’s clean priced above/below 100 then the real return is roughly speaking lower/higher than the coupon.
@A1 Cam – BTL is an odd one. In a perfect world I’d get rid of it as it is not hassle/risk free by any means, and not very liquid or tax efficient for that matter. That said, we’ve been running a couple of small flats for about 25 years and they have mostly tracked just above inflation on the valuation side and in-line with the rental income. Very few gaps too luckily. CGT due on disposable though – no current plans to sell.
I’m mostly ok with them in the floor side of the pie.
I’m now one year into living off of the investments following a slightly earlier exit from work than planned. BTL income is with my wife, I’m topping up with GIA funds from the total investments ex-BTL at 3.5%/12 on a monthly basis. So no income tax at the moment.
I’m fortunate enough to be able to access the pension from 50 if I wish due to age protection. This might I mean I draw a mix of 12k taxable with some top-up from tax-free cash if needed. The MPAA issue is one issue I’m aware of given my age and potential to return to work. Taking 12k personal allowance also has it’s merit as extraction of funds is still important from a tax perspective. Choices, choices.
The real boon of this FI business in my opinion is optionality, hence the reluctance to commit to anything too long term – just got out of that situation leaving work. The RE is a ‘maybe’ at this stage. Travel has been a large part this past year, probably going to keep going unless some relatively straightforward contract work lands on my lap.
The travel budget would be the first to get hit in a crisis.
Another little idea I’m currently running with this variable drawdown approach is any over or under spend from target is added or deducted from the future target monthly spending allowance. Currently set at a sixth of the surplus/deficit to add some smoothing. This is mainly due to travel spending coming in lumps. Looks good on my spreadsheet if nothing else!
@The Accumulator – thanks for the explanation – makes perfect sense.
@ Snowman – That makes sense and is the best explanation I’ve read for why prices are presented that way. The issue, I think, is brokers not designing a consumer friendly interface that takes both elements into account.
I don’t think retail investors want to look at thousands of pounds worth of losses on their account or be confused about the value of their portfolio.
I appreciate that this may well be a big IT problem to solve. Hence the Monevator sticking plaster due out tomorrow.
@Ade (88)
>”The hesitation to build all the way out for 17 years with ILGs is the commitment with duration.”
With ILGs you retain the optionality to cash in fully or partially at any time, although you run interest rate risk if you do this before the individual ILG’s maturity.
>”I assume the same lock in would apply to the fixed term annuity.”
With an annuity you are locked in.
>”If I’m understanding it correctly, the uplift in ILGs would mean they would be better placed in the ISA tax wrapper for income tax reasons.”
I’m not sure what you are understanding here. You know that low-coupon gilts are attractive to hold outside a tax-shelter as they are not liable to CGT, while the (low) coupons are liable to income tax. The same applies to ILGs. So if your ladder has mainly low-coupon ILGs, it is reasonable to hold them in your GIA. If your ladder has higher-coupon ILGs you may want to consider if they are best held in a shelter. There is no reason why you can’t mix-and-match – not every component of your ladder has to be in the same place.
@DavidV – thanks for the reply and info.
I misunderstood re the taxation of the inflation uplift. If ILG uplift is a capital gain for tax purposes then as you say, they are the equivalent from a tax perspective and can be selected based on which wrapper they will sit in.
@The Accumulator
Many thanks for those links to the DMO calculations. Really definitive information on how the calculations are done, that I hadn’t come across.
I’ve always avoided conventional gilts on the basis that the gross redemption yields at the shorter terms have been typically about 0.5%pa lower than fixed rate savings accounts of the same term. I always assumed that the demand from institutional investors (such as pension funds) to match liabilities was driving down the yields on gilts hence this 0.5%pa differential. And I’ve assumed the same differential applied to index linked gilts although there was no real savings comparator to confirm this. When I last looked, which was a long time ago, index linked gilts were offering negative real returns which for many reasons, including psychologically, was putting me off.
I will now be giving some serious thought into whether to invest in index linked gilts as part of my savings and investments, so this brilliant article was just what was needed. The idea would be that these index linked gilts would add to the secure income in the future from my state pension and a couple of small defined benefit pensions covering my very basic inflation linked needs, and leaving scope for my other investments to be in equities.
@Ade (#93):
As you say: “Choices, choices”.
There are a lot of moving parts involved in your deliberations including I guess a possible return to some form of paid work; and I am assuming (from your phraseology) that you may not want to go back to the FT employee route.
That you can draw your pension from as early as 50 is notable.
I also assume that you probably received a decent severance package from your former employer – as I have inferred you were a long term employee.
Surplus/shortfall to annual budgets in a [static] F&U framing is an interesting area, see e.g. https://monevator.com/should-you-build-an-index-linked-gilt-ladder/#comment-1733714
My approach of not “upsiding” any surplus is iaw F&U one-sided re-balancing rules but came at a non-trivial opportunity cost*. Having said that there were other concerns and issues afoot that favoured taking a conservative approach.
I am sure you will work it all out in due course. Like the rest of us you will inevitably make some decisions that might seem like mistakes in hindsight – but that is just par for the course.
Go well!
*I only fairly recently summoned up the curiosity/courage to enumerate this
@ Ade – Income tax falls due on unsheltered index-linked interest. The Starting Rate for Savings does apply though, if you qualify for that.
No tax due at all on index-linked principal. See: https://www.dmo.gov.uk/responsibilities/gilt-market/buying-selling/taxation/
@ Snowman – I’m very happy to hear that! Especially given how much you’ve contributed to community understanding of finance over the years – not least my own.
Your requirements chime with mine. Index-linked gilts expanding the scope of inflation-protected income – while the wider portfolio handles other considerations.
Now I’ve got to grips with them, index-linked gilts are as much a no-brainer as index-linked saving certificates were (so long as yields are positive). It’s been a battle though 🙂
@TA, @Ade, @DavidV
A possible way round this pesky interest (see #28 above) would be to use stripped linkers, so no interest accrued and just a bullet payment was due on maturity. However, I am not sure if any stripped UK linkers actually exist. IIRC, stripped normal gilts do exist, stripped TIPS exist, and some other countries issue stripped linkers too, see e.g. https://www.dmo.gov.uk/media/s3idzxqf/stripart.pdf
which is admittedly a bit dated.
@Al Cam (82, 86)
I agree that I don’t think pooling gives insurance companies any advantage in pricing inflation risk. This is in contrast to longevity risk where pooling is critical. Re your comment at #86, I can’t think of how pooling could help in pricing fixed escalation products, but then institutions use products well beyond my limited personal finance understanding.
Your observation that the 3% fixed-escalation annuity is not much more expensive than the RPI-linked product is interesting. We can look at this the other way and compare how much it costs to buy £1000 p.a. initial income at age 65:
Level £13,953
3% Fixed Escalation £19,331
RPI-Linked £21,959
We can regard 3% as our baseline expectation (hope) for RPI as it is 1% higher than the BoE target for CPI. Therefore we can see that it costs £5378 (£19331 -£13953) premium to buy baseline expected RPI inflation protection. It costs an additional £2628 to buy protection from the unknown future path of actual RPI. Note that this almost 50% of the cost of baseline protection. Is 50% additional premium for protection from variability from baseline expectation expensive? Discuss!
I’ve also been thinking more about how to tackle my phased annuitisation analysis. My latest thought is that a rational 65-year old is not going to use this approach if it ever, within life expectancy and preferably well beyond, produces an annual income less than the RPI-linked annuity would provide. So, for a given inflation profile, I plan to buy a level annuity at age 65 with just enough of the pot to produce an income that matches the RPI-linked annuity at age 69. For the first four years I will be ahead, then equal for a year. At age 70 the RPI product would jump ahead, but I will then spend more of the pot to buy another level annuity to top up the income to what the RPI product would produce at age 74. At age 75 the RPI product would jump ahead once more, but I will then spend the rest of the pot on a further level annuity. This would be the last annuity purchase in the analysis as I have no data on pricing for higher ages.
From my original results in #63, we can see that the RPI-linked annuity provides fair value at around a constant 5% p.a. RPI. I shall initially test phased annuitisation against the RPI-linked product with this level of constant inflation. I expect it will fail badly as there will be little of the initial pot left to cope with future years inflation. Next I shall assume a constant 3% RPI and test phased annuitisation against both the RPI-linked product and the fixed 3% escalation product. As mentioned previously, I think I shall only be able to analyse the cumulative match in nominal terms, as I can’t get my head around the real analysis when I am making further annuity purchases to top up one actual monetary amount to another actual
amount.
Depending on how the results look I can try different investment return assumptions on the residual pot. To keep it simple I will initially assume the return matches the inflation profile being analysed, i.e. zero real return.
Regarding lack of annuity pricing data beyond age 75, it is possible that they become relatively more expensive at higher ages. Ned Cazalet discusses this in his paper. He argues that at higher ages variability in life expectancy becomes a much larger proportion of median life expectancy, so insurers have to price in this uncertainty. AIUI before the Osborne reforms, even if you qualified for and used one of the then permitted forms of drawdown, you had to spend the remainder of your pot on an annuity at age 75. Insurers therefore have little long term experience of selling annuities at higher ages.
@ Al Cam – stripped index-linked gilts do not exist.
I think you risk going down a rabbit hole trying to consider value arguments on linkers or linked annuities.
The whole retirement problem is not about winning or value for money. In the majority of path our portfolios will be just fine. In fact, they will probably leave us with too much money. It’s about not losing. That requires protection against downside skew scenarios. That protection is essentially “funded” (paid for) by selling some topside scenarios.
Going back to a simple 4 regime “all-weather” view of the world, the equity/nominal bond portfolio hedges the top-left and bottom-left quadrants. The most common regimes post WW2. Nonetheless, it’s pretty sub-optimal in the top-right and bottom-right quadrants. The bottom-right quadrant, especially, represents the most lethal environment – stagflation. This is what linkers are there to protect against.
So linkers are unlikely to offer value in the mean/mode/median outcomes. Yet you should not care about the mean outcome. You care about the downside outcomes. In those scenarios, the linkers are not expensive, they are cheap.
The UKTI 0.125% 2051 Gilt linker offers me a 1.45% real yield basically for the next 25 years+. Right now essentially tax-free. Sure, many other assets will do better in most scenarios over that period. Nonetheless, it’s hardly a disaster to lock-in 1.4% a year in real terms till I’m in my 70s.
@DavidV (#101):
Do you remember this comment and your reply that follows:
https://monevator.com/should-you-build-an-index-linked-gilt-ladder/#comment-1738350
If Alan S is reading perhaps he can add some further info?
@ZX (#103):
Thanks.
I agree with your value comment.
I noted you earlier comment re longer term hedges at the other post (weekend reading: trading places) and FWIW also sign-posted it to @Ade above (#90).
The “all weather” four quadrant view is an interesting alternative perspective – that may ultimately be more useful – but IMO it was not the premise behind this post. I could, of course, be wrong about that though.
@Al Cam (104)
Thanks for reminding me of that discussion. It was fascinating then to learn that a RPI-linked annuity with 30 year guarantee was almost as high -yielding as a 30-year linker ladder, with the added advantage of continuing to pay beyond the 30 years.
Although we have already talked about annuity providers complementing their liabilities with their other books, I’m not sure I’m any further forward with understanding hedging or pricing of their escalating or inflation-linked products.
Wonderful discussion and comments all-round.
@ZXSpectrum48k – I think you hit the nail very firmly on the head with your comments at 103, especially: “The whole retirement problem is not about winning or value for money. In the majority of paths our portfolios will be just fine. In fact, they will probably leave us with too much money. It’s about not losing.” Brilliant stuff that, to my mind, cuts right through.
Thanks to all, again. Genuinely enlightening and I don’t know of another forum that provides such great insight on these types of topics.
@ Al Cam – The post was about how to buy index-linked gilts, because they’re really good at hedging UK inflation.
@TA:
Indeed.
AIUI, the proposed short-dated rolling ladder provides a hedge against a relatively short-lived burst of [unexpected] inflation. Prolonged stagflation (70’s style) and deflation could still be challenging*. A longer ladder may address the former but not the latter. Like so many things in de-accumulation, a tricky trade off.
*OOI does anybody know how indexed annuities handle negative inflation, FWIW my DB (in payment) increases with inflation; so no increase if inflation is negative, but no cut either; whereas (before coming into payment) its revaluation would be negative if inflation was negative – and this did happen once IIRC during my period of deferral
@Al Cam — With respect to deflation, a diversified passive portfolio should have conventional bonds and potentially cash in the mix to help with that. Cash should also be helpful with stagflation.
There is indeed a tricky trade-off to be made with all these assets as you say. 🙂 But for diversified investors the trade-off should be something like “should I have 20% of my portfolio in linkers or 10%?, given all the pros and cons” rather than “should I have linkers or not, given all the pros and cons?” IMHO.
It’s great to kick around the pros and cons of different asset classes, but there’s no point looking for one asset to rule them all because it doesn’t exist (except owning a time machine or a crystal ball 😉 ).
Appreciate you’re not doing that but I do feel a false dichotomy can arise in these conversations sometimes.
We can only grope our way into the future with a clutch of different assets to try to see as through as many scenario as possible, where the chief aim is survival to our minimum standards through (almost) anything life or the markets throw at us.
@TI:
Unfortunately my time machine is currently in bits on the shed floor and totally unserviceable. The crystal ball remains fuzzy! And the quest for the silver bullet asset class remains unfulfilled.
There is a balance to be struck that is driven, at least in part, by: your circumstances, the current situation, and the unknowable future. That is, IMV there really is no one size fits all approach.
P.S. on reflection, my initial Kool-Aid comment was perhaps a tad provocative
Sorry, for the long post…
@Al Cam (#36)
I think Zwecher’s book implies a non-static F&U implementation (with a type of stop loss approach, IIRC)
@Sparschwein (#46)
Single life RPI annuities will almost always have better payout rates than the equivalent (i.e., covering a long lifetime) linker ladder. Joint annuities are a bit closer. https://www.williamburrows.com/calculators/annuity-tables/ is useful for annuity rates (wider range than HL) and https://lategenxer.streamlit.app/Gilt_Ladder is great for calculating ladder payout rates.
@DavidV (#63)
Level vs RPI annuities. Although your 1970s calculation does not, most calculations involve a smooth rate of inflation and thereby ignore ‘sequence of inflation’. Inflation of 20% a year after retirement has far larger consequences on income from a level annuity than 20% inflation a year before death. The long run RPI series at https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/cdsi/mm23 is worth a look.
@DavidV (#78)
I looked at using a single purchase of lifetime annuities in the wider context of a retirement portfolio in a paper at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4289339 (I’ve done some work with multiple purchases, but not published it). The problem with delayed purchases is that the portfolio value can fall in real terms faster than the annuity payout rate increases with age which means that you end up obtaining less income after the delay. IIRC, Milevsky and Young’s 2007 paper (Annuitization and asset allocation) found that occurred in about one-third(?) of cases
@DavidV (#102)
AFAIK, you can get annuities out to about 90yo or so in the UK – e.g., see the https://www.moneyhelper.org.uk/en/pensions-and-retirement/taking-your-pension/compare-annuities, but the number of companies offering them declines (so pricing competition decreases).
@ZXSpectrum (#102)
I think your second and 4th paragraphs neatly summarise the reasons for downside protection. I think it is exactly the same reason for buying any form of insurance – it is a complete waste of money until it isn’t!
@DavidV (#106)
Pfau’s annuity series that starts at https://retirementresearcher.com/income-annuity-101/ explains escalation (the escalation, or COLA annuities as the Americans term them in on the next page, ‘102’).
RPI annuities are identical to nominal level ones except that the nominal discount rate is replaced by the real discount rate. My limited understanding (I’m not an actuary!) is that for nominal annuities the underlying investments can be wide ranging (gilts, corporate bonds, etc.) and has a higher discount rate than just gilts, but for inflation linked annuities the liabilities can only be matched with certainty by linkers.
For ‘floor and upside’, I note that Zwecher’s book was launched shortly after the GFC and should be read in that context. While we now know that the following decade was a great one for US stocks, it didn’t seem that way at the time. Even the some bogleheads were tempted to ditch ‘buy and hold’ during the GFC (as a search for ‘Plan B’ on their forums reveals).
@Alan S:
Re Z’s book: non-static/stop loss or CPPI or, … is the content of chapter 9, most of the rest of the book is based around a static implementation – presumably because it is easier to write about – but he does not state his preference in the book.
“sequence of inflation” in that scenario is a good point which IMO is seldom mentioned
and IMO in some ways Z’s book portrays itself as a sort of Plan B too
@Alan S:
You have made the point before that delaying annuity purchase incurs risk* with reference to the 2007 Milevsky and Young paper. Thanks for the reminder and I can see the type of scenario where this could lead to loss; see e.g. #86 above. I could not locate a free to view copy of the 2007 paper but did find an interesting summary of the paper at the bibliography given at #55 above. The notes provided in the bibliography highlight that the 2007 paper uses a different approach to earlier Milesvky papers that used an option valuation approach to annuitisation; that is, the delay is an option with value. Interesting.
Alan S (112)
Aargh! I’ve now twice lost what I typed in response to your comment. The first when I pressed Submit without realising I had been signed out for some reason, and the second which occurred when I hit some key by mistake, which selected then deleted all my text. Where’s the Undo button?
Anyway my second attempt to recreate from memory what I originally replied:
Thank you for your detailed comments on my various and extensive musings and analyses on this topic. I totally accept that sequence of inflation will have a profound effect on its impact on a level income. The 1970s RPI series comes from my original comparison analysis a few years ago. It was my attempt to introduce a series that contained some years of very high inflation but also a lot of variability. Short of producing a new analysis using Monte Carlo techniques, I’m not sure how to improve on this.
As I have no need nor basic rate tax headroom to buy a further annuity, I have no skin in this game. I was provoked into resurrecting and updating my earlier analysis by TA’s example in the article. The difference in payout between the level and RPI annuity in this example was much closer than actually obtainable. The phased annuitisation was originally a throwaway comment of mine on a possible alternative approach. I was then challenged by Al Cam to apply my initial analysis to this!
Thanks also for the link to the William Burrows annuity tables. I note that the age range in the tables is the same as on HL’s website, but there is a much greater range of other options. Finally, thank you for the link to Wade Pfau’s paper on pricing annuities with fixed escalation. I shall have to check whether his examples show a similar differential from the level annuity as obtainable on the UK market.
@Alan S (112) @Al Cam
I attempted to look up the 5% fixed escalation annuity prices in the William Burrows tables, but it returns a blank. I suspect that no UK insurer is offering this escalation at the moment (perhaps it would be more expensive than the RPI-linked).
I do recall, however, that the deferred care needs annuity purchased for my mother in 2018 (from Aviva) had a 5% fixed escalation.
DavidV (#116)
I just tried the moneyhelper annuity tool – you can get a quote for a 5% escalation annuity, but you’re right that it is more expensive than an RPI (payout rates of 4.2% for escalation and 4.6% for RPI, for single life @65yo), so that may explain their absence from William Burrows.
I note that the implied inflation (i.e., the difference between real and nominal gilt yields) is currently about 3.5%, so annuities with escalations below roughly 3.5%* will have higher payouts than RPI annuities and vice versa.
* Since insurance companies may be get higher nominal yields than gilts offer, the ‘3.5%’ may actually be a bit higher.
(#115)
btw a fast way to calculate a very rough approximation of the annuity payout rate is using the pmt function in excel with nper set to the life expectancy (i.e., about 20 years at 65yo) and the rate set to yield minus escalation.
@Al Cam (#113) – you’re right about Zwecher’s book – for some reason I thought he’d expressed a preference.
@Alan S (#112) – that’s good to know. Many thanks for the links. So the RPI annuity seems the obvious choice to cover our essential spending.
I’ll defer the decision between annuity and linker ladder until retirement, in hopefully ~5 years (or I might work part-time for longer). So the idea is to start building a linker ladder now for ~5-25 years out (into my 70s). Linker prices should move roughly in parallel with annuity rates, so the linkers can be sold later for an annuity with little risk.
Does this make sense?
And I’m wondering if there is any point keeping conventional bonds in such a pre-retirement portfolio with, say, 50% stocks, 25% in total bonds, 5% cash and a chunk of gold, commodities and hedge funds. The linkers won’t spike like USTs in a deflationary bust, but linkers should hold up well enough as central banks push down nominal and real rates.
@Al Cam (#87): The MBTI gets criticised for being unscientific (most popular psychology is) but I find it quite useful. My partner is the same type as me, and friends are usually similar. It would be interesting to know MV readers’ types. Expecting lots of introvert-thinking types.
@Sparschwein (120)
ISTJ for me I seem to recall from my work days when I was subjected to such things.
INTP here – and yes, that’s how I felt about that “training” too
Sparschwein (119)
Yes, building the ladder to roughly match the duration of the annuity will keep the eventual amount of income fairly independent of changes in yields. Very roughly (it varies with yield), the duration of an annuity is (life expectancy)/2, i.e. at 65yo, LE~20 years, so duration~10 years.
FWIW, I’m in retirement with the majority of our income coming from inflation linked sources (DB pension now, SP later, and a short linker ladder), but have recently been giving a lot of thought to the fixed income in our portfolio. I’m now in the process of removing inflation linked funds from our portfolio and replacing them with global nominal bond funds (I also have concerns that the underlying investments with the DB pension are also largely linkers, so somewhat UK centric).
@Sparschwein (#119), Alan S (#123)
Looks like I may have to eat my words [again!] of only a few weeks ago, see comments #24 & #31 at: https://monevator.com/the-slow-and-steady-passive-portfolio-update-q3-2024/
Which is great!
@SW: before jumping in I would recommend that you get hold of a copy of Z’s book from e.g. a public library if you do not want to purchase it. Whilst I have repeatedly said that the book is somewhat theoretical and it is clearly written for the US – there is a lot of good stuff therein. Chapter 13: Products and Example Portfolios is IMO both pragmatic and quite comprehensive – and at c. 25 pages is the longest chapter in the book!
With the benefit of hindsight, at your stage (c. 5 years from jumping ship), I became too focussed on flooring and largely over-looked chapter 13 – which was a mistake. Chapter 13 relies heavily on the previous chapter Market Segmentation and uses a simple test (Wealth/Needs) to help you assess where you might stand with respect to benefiting from flooring. The various fundedness thresholds are of their time and relate to the US market – but I am sure you can re-cast them appropriately.
Personally, I have concerns both practical (re difficulty of estimating essential needs & things will change) and otherwise, about Annuitising from the off – but each to their own.
WRT building flooring in the transition from now to retired, and as I mentioned above, there are lots of ways to construct this and you may find a mix and match approach of various elements beneficial. For example, I note your comment(s) about your current portfolio construction, UST, and deflation and also Alan S’s note about his fixed income too.
P.S. to Alan, I have literally just seen your latest comment to the S&S thread, thanks
@Alan S (#118):
AFAICT, the common [US] perception is that Z’s book (and thus by extension: the authors preference) is all about static arrangements of annuities!
Earlier in this thread at #63 I presented the results of an analysis comparing Level vs RPI-Linked annuities for a 65-year-old in three different RPI inflation environments – constant 3%, constant 5% and the RPI annual series from 1970. (Fully accepting that the constant inflation scenarios are unrealistic.)
I later performed a similar analysis comparing a level annuity with a 3% fixed escalation annuity for the same 65-year-old and showed the results at #78.
Earlier at #60 in a qualitative discussion I raised the possibility that phased annuitisation using level annuities may provide better value than the RPI-linked annuity. At #70 Al Cam had asked me to do a similar analysis for this, and after thinking of possible approaches described my approach in #102.
In summary the aim was to buy a level annuity at age 65 that would stay ahead of the RPI-linked until age 69. At age 70 when the RPI-liked annuity would jump ahead, a new annuity is bought to stay ahead until age 74. At age 75 the whole of the remaining fund is used to buy the final annuity. As with the earlier analysis the crossover age when the RPI annuity finally overtakes the phased level annuities is determined and the age at which the cumulative income from each approach matches. Unlike the earlier analysis I could not easily use real (inflation-adjusted) figures for the cumulative match, so I worked with nominal figures only. After each annuity purchase I grew the remainder of the fund at the same rate as inflation. Note that the whole strategy requires taking a view of inflation for at least the following five years to know how large an annuity to buy to stay ahead of the RPI-linked.
Here are the results for three different constant inflation scenarios:
Level 3% – crossover age 88 cumulative match (nominal) 99
Level 4% – crossover age 83 cumulative match (nominal) 90
Level 5% – crossover age 79 cumulative match (nominal) 85
From this we can conclude that phased annuitisation can match the RPI-linked annuity for value for inflation up to around 5% (we are aiming to beat life expectancy of 85/87 male/female). Note that its success requires taking a view on inflation for five years ahead, and individuals who live long beyond expectancy will nearly always benefit from the RPI-linked annuity.
For comparison here are the results of the Level vs RPI-Linked analysis from #63 with the real figures stripped out.
Level 3% RPI – crossover age 81, cumulative match (nominal) 94
Level 5% RPI – crossover age 75, cumulative match (nominal) 83
RPI from 1970 – crossover age 70, cumulative match (nominal) 73
Finally, I also compared phased annuitisation against the 3% fixed escalation annuity. The results are
Fixed 3% escalation – crossover age 81, cumulative match (nominal) 89
For comparison the results from #78 comparing the level annuity vs the 3% fixed escalation:
Fixed 3% escalation – crossover age 77, cumulative match (nominal) 86
This shows that phased annuitisation can provide slightly better value than the fixed escalation product. However, it does involve risk of future annuity rates declining and growth of the residual fund unable to match the implied 3% inflation.
All-in-all if you want certainty of real income there is no alternative to the RPI-annuity. Other approaches are gambling on future inflation (as concluded by TA in #69) and/or future annuity rates.
Thank you @DavidV. I can imagine considering this strategy for a few years at the beginning of retirement in an attempt to avoid locking in what looked like a bad deal. For example, if annuitising circa 2010 or circa 2020. That said, I’d be very queasy about trying to predict the future path of interest rates and inflation. I think the strategy could also appeal to retirees who want to retain some optionality. Unsurprisingly though, I wholeheartedly agree with your conclusion 🙂
@DavidV,
Thanks for doing that.
I would infer from your results: all other things being equal, the effect of the growth rate of the residual fund is fairly intuitive, ie if higher than inflation then crossover happens later, etc.
I tend to agree with your conclusion re RPI annuity and certainty of income.
I think the answer to your “Discuss” point at #102 is: at a cost of less than that required to have a guaranteed 5%PA COLA and more than a 3% COLA, (probably costs somewhere around 3.5% COLA) it could certainly be seen as valuable insurance against unexpected inflation/stagflation over the lifetime.
Re deflation risk: do you happen to know how these Annuities would handle this, see #109?
Thanks again.
@TA (#127):
Re: “I think the strategy could also appeal to retirees who want to retain some optionality.”
Good point re my oft repeated [practical] concerns about annuitising from the get go, e.g. #124. Could also initially under (to assumed need) RPI annuitise and top up later if/as required. AIUI it is not possible to subtract after purchase!
@Ade (#94):
Re “Taking 12k personal allowance also has it’s merit as extraction of funds is still important from a tax perspective.”
AIUI you have about 17 years until your SP commencement. Assuming a full SP you will probably be a BR tax payer from SP age onwards.
This approx. 17 year “tax gap” is therefore potentially a window of opportunity, especially if you fear any of: increases to basic tax rate, prolonged fiscal drag, introduction of NI on pension drawdowns, changes to ISA’s, other pension changes (PCLS, IHT, etc), or ever becoming a HR tax payer. That is, use it or lose it.
Looking back on how I played my (somewhat shorter) equivalent “tax gap” I was possibly rather timid and once it is gone it certainly is gone!
Just a thought!
@DavidV (#126)
Thanks for the interesting summary of your results. There are a lot of moving parts in trying to determine the outcome of delayed annuity purchase, e.g., portfolio returns, inflation, bond yields, and changes in life expectancy. I think your final paragraph summarises it well.
However, one use of a level annuity is to help front load spending at the start of retirement where the retiree knows that their other sources of guaranteed income (e.g., state pension or DB pension) exceed their expected essential/core spending needs for the long term. For those of us who’ve had difficulties transitioning from saving to spending (personally, we still don’t spend all of our income), this can at least help remove a psychological barrier. I looked at various ways of providing a slowly falling real income (inc annuities and ladders) in a paper at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4245681 that might be of interest for some.
@Al Cam (#128)
“Re deflation risk: do you happen to know how these Annuities would handle this, see #109?”
AFAIK, the nominal income of RPI annuities will decrease during deflation unlike some (all?) DB pensions that tend to have a floor, i.e. nominal amounts will not decrease during deflation. There were a lot of articles about this back in 2008 and 2009 (a search for ‘2008 deflation effect RPI annuities’ turns up quite a few hits). The same will be true for ladders constructed with UK linkers but not necessarily for those made with US TIPS (I think the principal will reduce with TIPS, but not below 100, so there is some limit).
An (the only one?) advantage of going to CPI rather than RPI is that I think it is harder for deflation to occur with CPI.
@ Al Cam and Alan S – you could choose an RPI annuity with or without a floor. That was back in 2009-10 when I was in the market for one (not on my own behalf).
Whether floors are still an option in today’s market I don’t know. I’ve had a very quick look but am only turning up hits on a brief bout of deflation in 2009:
https://www.moneymarketing.co.uk/news/rpi-linked-annuities-sink-further-with-deflation/
Article confirms some annuities were affected, some not. A floor option is definitely worth scouring the T&Cs for. (Not an issue with fixed rate escalating annuities of course).
The lack of a floor wouldn’t affect my choice, though. Deflation being a minor threat relative to inflation for a retiree – assuming you’re not leveraged up to the eyeballs in your twilight years.
@A1 Cam (#99)
You guessed right; ~25 yrs service with a last chance severance that was to be ‘normalised’ the following year – very much to my disadvantage and added a greatly increased vulnerability to redundancy on poorer terms – so I jumped at it.
I’ve also had quite a few relatives pass away around me of late, some much earlier than expected, so I’ve decided to see if I can start a new life that is not bound by the need to return to work FT – time will tell.
@ The Accumulator (#100)
Thanks for the tax treatment info – I should be able to arrange things to take advantage of the Starting Rate for savings too. Getting a balance between the possible allowances needs a cashflow drawdown plan of its own.
@A1 Cam (#130)
I really appreciate your retrospective tips – Drawdown is my next ‘big’ decision. I turn 50 just before the end of the tax year, so my tweaker brain wants me to squeeze out the personal allowance from taxable drawdown funds. I’ve not quite made my mind up yet due to the finality of the MPAA coming so early in my journey. I’m bobbing around the old LTA due to some serious salary sacrifice over the years – meaning I’ve had a good ride down the pension tax relief route. I suspect the PCLS is highly unlikely to increase from here in any case – maybe now is time to begin drawdown. These are nice problems to have for sure.
I’ve had a play with some cashflow planning tools, and it does appear that blending the pension drawdown early, possibly even paying more lower rate income tax than strictly necessary could help reduce higher rate tax when the SP comes in.
I think Excel and I need another long chat so we can build in future tax efficient drawdown steps for two in addition to the equity glide path and rolling ILG ladders!
@TA (127, 133), @Al Cam (128), @Alan S (131, 132)
Thank you all for your appreciative remarks on my analyses.
I must admit I had assumed most RPI-linked annuities were sold with a floor, although I’ve never looked into this in detail or requested a personalised quote.
OOI my small annuity is level. I bought it from the taxable proceeds of a Section 32 policy, set up to preserve the ‘continuing rights’ of a short-lived occupational DC scheme set up after our DB pensions became deferred. The ‘continuing rights’ offered enhanced tax-free cash under pre-2005 (A-day) rules. A consequence, though, of taking enhanced tax-free cash under pre-2005 rules was that practically there were few permitted alternatives to buying an annuity with the remaining fund. The remaining fund was quite small, annuity rates were low (early 2019) and it was only a small part of my retirement income, so I went for the level higher payout.
Picking up on Alan S’s point in #131 I feel that many retirees opt for a level annuity precisely for these front-loading reasons. They are aware of the risks of inflation, but have the SP and maybe a smaller DB pension. They choose the level annuity to maximise their real income when they are still young enough to travel extensively etc. and are prepared to see it decline in real terms as they age.
@ DavidV and Alan S – really interesting point about level annuity as go-go years booster for someone whose floor is built from other materials. Also @Alan S: +1 your point about an annuity providing a useful psychological limit / target on spending. That chimes with my experience (as a closely affiliated third-party).
@Ade (#134):
RE:
“I’ve had a play with some cashflow planning tools, and it does appear that blending the pension drawdown early, possibly even paying more lower rate income tax than strictly necessary could help reduce higher rate tax when the SP comes in.
I think Excel and I need another long chat so we can build in future tax efficient drawdown steps for two in addition to the equity glide path and rolling ILG ladders!”
That is exactly what I was getting at! And, as I mentioned (at #130), with the benefit of hindsight, I was possibly a tad timid in my “tax gap”. When I finally jumped ship I was near 100% certain that I was not going to go back to work*. In a nutshell, during my subsequent “tax gap” I paid a fair bit of tax at BR (each and every year) but did not take it to the top of the band. I probably should have done so; albeit that that would have introduced some further complexity. Initially I had planned on my “tax gap” being about a decade, but in reality it was some six years.
Sufficiently emptying (at no more than BR), what I now assume is a fairly large DC pot (ref: your erstwhile LTA comment) to manage downstream exposure to HRT is not a trivial task. And it may take many years to execute too. However, at least you can determine year-to-year what you drawdown. DB pensions are just not that flexible. OOI, do you have any DB pension?
Cashflow planning tools are usually constrained to work within the current tax rules. These rules WILL change; and probably not to your benefit.
I completely see your issue around the MPAA and a possible return to paid work (with possible pensions too).
FWIW, I would stretch your redundo and take your time before doing anything irreversible. And, in the mean time do the necessary Excel** (does such a verb exist as distinct from excel?) to get a handle on how you may want to tackle your DC/DB.
As you said, “nice problems to have for sure”.
Happy to try and answer any other Q’s you might have in due course.
*I had previously had a gap year+ in my late forties before going back to work FT. I did also turn down a few well paid unsolicited offers of work after finally jumping ship at 55.
**other spreadsheets are available
@Ade,
P.S. meant to say that AIUI taking the PCLS from a DC scheme does NOT trigger the MPPA.
Can I ask a few questions about the practical side of buying ILG’s in GIA please?
I am accumulating on PAYE and do not normally submit SA. If I buy ILG’s in a GIA, do I need to register and submit SA for the coupon payments? What if they’re really low coupon ones like the T28 and the coupon payments are under the personal savings allowance? Finally, is there any need to declare Capital gains even though they are CGT free?
Are all the above correct for nominal gilts as well?
Many thanks.
@TA (#133):
Interesting info re availability of floor option back in 2009/10. Do you recall was the floor just zero or could you select other values, such as say 1%?
Beware low probability, high impact risks. In my experience, they have a nasty habit of materialising at just the wrong time! The other side of the coin is to make (overly) conservative assumptions, but this approach can also have consequences – see last para below.
@Alan S (#132, #131), @DavidV (various)
Thanks for the RPI annuity floor info, which was as expected. FWIW, I agree with your TIPS comments too. Are these points further evidence to support diversification? And, IIRC, bullet TIPS are available too. However, I am not sure how TIPS are viewed wrt UK CGT.
CPI and RPI are both structurally and mathematically quite different. Hence, they react differently to events, such as say a huge drop in mortgage interest rates. Assuming I have read the tables correctly RPI (monthly) was last -ve in 2009; however CPI (monthly) did go -ve as recently as 2015. I know this because my DB revaluation was based on CPI and it did go a tad backwards in 2016 based on Sept 2015 cpi of -0.1%! I do not recall an outcry about this (like this months CPI of 1.7%) – but I could be misremembering.
Have you noticed just how close CPIH and RPI are these days? As I understand it this is primarily down to the differences between CPIH and CPI!
Re: difficulties transitioning from saving to spending, front loading, spending drop on retirement and average retiree spending path (#62), etc:
My experience to date is that these could well be real.
FWIW my take is that:
a) excess flooring could be increasingly wasteful* over time and, in some cases, is irreversible (noting that survivor scenarios can, in some cases, be rather important); and
b) folks who fall into this ‘trap’ are likely to continue to accumulate (at least nominally and possibly in real terms too) unless they raise their spending/gifting … which by no means is the worst problem to have, but …. e.g. should/could you have retired earlier, etc ….
*but IMO entirely understandable without that rarest of things that Pfau christened “perfect foresight”
@ Al Cam – the floor is just zero.
Re: low probability, high impact risks – yes, the obvious move is to diversify into nominal bonds or cash if you fear deflation. At the same time, not all risks are equal. There’s an almost limitless range of low probability / high impact risks one could insure against. Hence it makes more sense to hold earthquake insurance in California than it does in the UK. I think this segues into your point about being overly conservative AKA we can’t avoid all risk.
@TA (#141):
Thanks for floor info.
Not to forget good old Rumsfeld and his “unknown unknowns” too!
@Al Cam, foreign currency bonds are subject to CGT.
Since we stopped work, over 10 years ago now, our withdrawal rate has gone from 3% to 1.5% and with stock market increases this year it is heading even lower. Much of that was down to investment growth (a very lucky sequence of returns) and some down to lower expected consumption. Flooring is far less important with a WR of 1.5% than it is at 3%, so having flooring you can reverse out if it proves too much is certainly worth thinking about. Tilting more towards bond ladders than annuities would be a good example. We lowered our flooring 4 years ago when we moved from 60/40 equities/bonds to 90/10 equities/cash, although that wasn’t how I thought about it at the time.
@WinterMute (139)
I do not own ILGs and have only recently invested in conventional gilts. However, I write from the perspective of someone who did not qualify to register for self assessment (SA) until this year, despite having had interest and dividends above their respective allowances for several years. It was only having CGT to pay this year that both required and permitted me to register for SA. (Note that I, perhaps unusually, regard SA as a ‘good thing’ as my relationship with HMRC before SA was frustrating and error-prone on their part.)
As far as I can tell, merely having coupons from gilts, conventional or IL, neither requires nor permits you to register for SA, unless it, together with your savings interest, exceeds £10,000 p.a.. Therefore, if your coupons, when added to your interest from conventional savings accounts, is less than the Personal Savings Allowance (PSA), then you don’t need to do anything. If the combined amount exceeds the PSA, you need to tell HMRC. You can, if desired, provide an estimate in the current year by phone, letter or by your online Personal Tax Account (PTA). After the year end, you should report exact figures by phone or letter. Note that the PTA, unlike SA, only allows you to report changes for the current year, so after the year end you can only use phone or letter.
All gilts, conventional or IL, are exempt from CGT, so gains should not be reported.
@Naeclue (#143):
Thanks for info on foreign currency bonds.
That is a pretty low withdrawal rate! And, I can see why reversibility would be an important consideration. OTOH, a bit of [additional to (in due course?) SP] regular income/simplicity might have a certain attraction too.
IIRC you mentioned that you were investing for others – hence you perceive a longer investment horizon. This was part of the reason why I mentioned Ed Thorp. Did you find the interview with him where he briefly discusses a permanent portfolio – both his views on the practical max w/rate and investment mix; which, as it turns out, both somewhat mirror your current set-up.
BTW, I do recall your portfolio transformation and likewise I did not think of it as effectively lowering your floor at that time either. We all, hopefully, live & learn.
Did you have any joy in hunting down the other references I mentioned, and did you get a chance to look through PJC’s pretty comprehensive bibliography?
@DavidV (144): Thank you for your insights; that helps a lot. Interesting that you regard SA as a good thing while I do everything in my power to avoid it. 🙂
@Alan S, @Al Cam and all – many thanks for the helpful tips. Given time I’ll delve more into the details of withdrawal approaches. In the meantime it seems a safe bet to start buying linkers up to ~half of what my best guess of an essential income floor would be. Lock in the real rate to some extent now, while it is relatively good.
A complication is that we may well decide to retire in the Eurozone. Does anyone have experience buying German Inflation-linked bonds?
> “roughly (it varies with yield), the duration of an annuity is (life expectancy)/2, i.e. at 65yo, LE~20 years, so duration~10 years.” [@Alan S]
This is important to know, and rather counterintuitive. (My uninformed guess was that duration ~equals life expectancy.)
Perhaps the topic is worth another Monevator article?
@Sparschwein (#147)
Annuity duration:
Have a look at Figure 5 in my paper at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4957553 (note that this was calculated using US mortality statistics for annuity purchasers – UK ones would change the values, but not the trends).
The duration of the annuity changes with two things: age and yield while LE only changes with age (hence why the LE/2 is an approximation).
The changes that occur with yield result from two mechanisms
a) The duration of the individual bonds in the ‘ladder’ that underlies the annuity changes with yield (lower yields=higher duration and vice versa)
b) The amount of money that needs to be placed in each ‘rung’ of the ladder decreases as yield increases which further decreases the weighted duration (e.g., imagine you are filling a rung that matures with £1000 in 10 years time, at 0% yield you would need to fill it with £1000 while at 4% you will need to fill it with ~£680, i.e., 1000/1.04^10).
Conventionally, ‘lifestyle’ annuity-purchase options in DC pensions appear to have used ‘over 15 year’ bond funds for duration matching (which to my mind does seem rather long). I’ve seen some fairly disgruntled posts on other boards where people who were actually going to use drawdown were unaware of this and found their pension pot dropping a lot when yields increased.
@Sparschwein (#147):
No personal experience of buying D linkers, but please note @Naeclues comment (#143) about CGT on foreign currency bonds.
Re: “Given time I’ll delve more into the details of withdrawal approaches.”
Try and find the time; I can only repeat my own experience of becoming too focussed on flooring, see #124.
Apologies for my delayed response.
Anyway, prior to 1986, the distinction between clean and dirty price was not made, so investors indulged in what was know as ‘bond washing’. The would sell the Gilt prior to it going XD, which meant the accrued interest was taken as a capital gain. And they would then buy the gilt back afterwards. Rinse and repeat and all the dividends which had been converted to gains would be tax free too.
Anyway, the accrued interest is split out these days and is account for separately, to stop this bond washing wheeze, you will see it separately on your contract note you need to declare it on your tax return.
In your worked example, although you declare all the interest received as income, you can deduct the 23p accrued interest from that, so a tiny little tax saving!
@TA – it’s possible I’m being pedantic or wrong or both but shouldn’t the following be “1p per unit”:
“the £1 difference between the clean buy and sell price shows that you may pay a spread of about 10p per unit”
Just to summarise my experience of buying the 2048 and 2051 maturity index linked gilts (3 month laggers) through Halifax Share Dealing.
Can do online and can specify £ amount to buy so avoids the need to calculate the dirty price in advance. Doesn’t show a price that you have seconds to accept, but you just have to proceed based on an indicative price. Didn’t check them all, but the two I wanted to purchase were both available to buy.
The settlement date is T+ 2 working days, so for example if you buy on Thursday (31st Oct) then they settle on Monday (4th Nov). The accrued interest and indexation are calculated up to the settlement date (not the buy date).
They show up in the account valued at the clean price (so showing a big loss) rather than being valued at the dirty price or clean price plus indexation.
Overall a straightforward experience if you’ve read the above article beforehand and know what to expect.
Incidentally Tradeweb data shows accrued interest and indexation based on T+1. So after midday today they will show the clean price around closing yesterday (Thursday) and the accrued interest and indexation that adds in to get to their dirty price will be up to today (Friday) and not Monday. In reality an index linked gilt bought yesterday will settle on Monday from my experience with accrued interest/indexation to Monday.
At time of writing index linked gilts still offering a reasonable real yield. The 2048 maturity is offering a yield of around 1.48%pa at the moment. I tend to work with RPI as my personal inflation index (and historically CPIH is around 0.8%pa less on average perhaps), so ignoring the next 5 years (before the switch from RPI) let’s call it 0.6%pa above RPI say. So acceptable for a safe bit of the portfolio.
Is it government intentions to issue a lot of debt based on budget plans that is pushing down prices (and pushing up real yields)? I don’t know I haven’t been following it.
@Snowman — Really helpful comment, thanks for coming back and sharing the extra details from your experience.
If anyone is following in your footsteps on Halifax Sharedealing, one can find its list of bonds/gilts here:
https://www.investments.halifax.co.uk/bonds-and-gilts-centre/details/?csid=55184397
You need the identify in brackets (e.g. TG51) to trade.
Talking of which, the graph of TG51 ought to go in a financial museum to represent the 2010-2021 era…
Re: your query about the spike in yields, yes some of the blame is being put down to the OBR comments on the magnitude of the fiscal loosening, and an increase IIRC of £28bn a year in borrowing. OBR sees higher BOE rates (very slightly, 0.25%) due to resultant inflation from public spending.
Perhaps, but it’s worth noting US yields have ramped up over the past few weeks and European yields are higher too. There was definitely a post-Budget response, but personally I think markets are more pricing in a soft landing also, which at the margin takes imminent recession risk (/defensive demand) off the table. But who knows. 🙂
No doubt we’ll discuss that in the comments to Weekend Reading so probably best we leave this thread for buying gilt chats I think. Cheers!
@CGT101 – you’re spot on. Thank you for pointing that out. I must have been on crack when I wrote that. Have updated.
@Snowman – that’s great to know, thank you for that. Seems probable that iWeb and Lloyds Bank Share Dealing will be the same. TI’s trade at HL was T+2 and I traded at T+1 at AJ Bell.
I placed a small purchase order for £300 with II on Friday for TR26.
I couldn’t place the order on line, because TR26 is not set up for on-line dealing, so it was a long 15 minutes on the telephone. The good news was that they didn’t charge me the telephone transaction fee of £49, but just the usual £3.99 (or in this specific case nothing because I was able to use a trading credit that the monthly fee gives me.)
Settlement was T+2 and the gilts purchased used the clean price, so showed a big loss, but a massive accrued interest.
Generally I agree with @snowman. It is not such a terrible experience, when you know what to expect. Plugging the values from the contract note into your wonderful spreadsheet really helped too.
I will drop II a line, to see if every index linked gilt can be added to their on-line dealing list. The phone call was just a pain.
I can see me buying more of these in future and especially cashing in my index linked national savings certs when they mature. They were wonderful through the period of inflation we recently had, but I am happy to lock in a 1% to 1.5% real return until the IL gilts mature, that is so much better than effectively no real return. That 1% pa extra really will compound up over time and is hardly a disaster to lock in that sort of return, to paraphrase ZX.
Can I ask a super nerdy question, since I tried to derive the DMO’s indexation ratio from first principles, and although I am very close, I have not got it correct.
My figures are for the Index Linked Gilt 2026 3/26 – 0.125%
First issued 16/7/2015 according to the D5I download.
Issued date less 3 months is 16/4/2015
RPI April 2015 : 258.0
RPI May 2015 : 258.5
So, the RPI at the date of issue is: 258.0 + (15/31)*(258.5-258.0) =258.24194
For settlement 26/11/2024, use RPI of 3 months earlier:
RPI August 2024 : 389.9
RPI September 2024 : 388.6
So, the RPI at settlement date is 389.9 + (25/31)*(388.6-389.9) = 388.85161
So, the ratio is: 388.85161/258.24194 = 1.50576, according to my calculations.
However, according to the DMO the actual value is 1.50563. (This is taken from the D1D report for settlement on 26/11.
I appreciate that 1.50576 compared to 1.50563 is normally not worth bothering about, it is just a few pence on my deal, but since I have followed the DMO formula for calculating it, I am wondering why there is a difference. It must be my figures, but I can’t spot it, can anyone help? Thanks.
@Jam – Thank you for the update. I completely agree that it doesn’t seem so bad once you’ve done it. I also agree that index-linked saving certs seem superfluous now, but I’m having a hard time convincing people 😉
Re: the maths. Just checking you’ve seen these links:
https://www.dmo.gov.uk/media/1953/igcalc.pdf
https://www.dmo.gov.uk/media/1954/indexlinked3m.pdf
https://dmo.gov.uk/media/15002/3monthgiltcalcs.xls
I found them all helpful, especially the Excel sheet.
I found that whenever I was close but no cigar it was usually because I’d miscalculated the settlement date.
Another danger is if the linker is ex-div.
Do Index Linked Savings Certificates still have some option value that you lose if you rely on buying individual linkers instead?
– Real rates might plummet again in the future. If so you’d once again have to buy linkers that lock in a negative real return
– Also, tax advantages. Not such an issue when linkers have very low % coupons, but that is not the case for linkers issued now, right?
Admittedly they might be quite expensive options!
Thanks @TA.
I take some comfort from the fact that you had difficulty calculating it too. I had seen the first two and my calculations followed their method, which makes it so annoying as to why I am fractionally out. It is the sort of thing that will drive me nuts.
I will have to have a look at the third link and play with their spreadsheet, that may help show my error.
Another deep dive into this is something that may have to wait until I am in a more masochistic mood though 🙂
@CGT101 – it’s an interesting question. Right now the real yield on saving certs is 0.01%. Near zero.
Right now you can lock in a real yield of 1% for the next 13 years with UKGI 1.125 11/37.
Or you could lock in a real yield of 1.5% for the next 20 years with UKGI 0.625 03/45.
And so on. You can go out to 2073 or come shorter.
While holding an asset you can sell anytime.
Tax treatment is the same, it’s easy to pick up a low coupon linker if you can’t keep them all in tax shelters. Danger of tail wagging the dog here.
Finally, you can keep rolling over your saving certs but you can’t buy new ones.
@Jam
The calculation should be 5 days at 389.9 and 25 days at 388.6 because November has 30 days. You’ve used 31 days not 30.
So 388.81667/258.24194 = 1.50563
Thanks very much @snowman.