With the mindset of a long-term investor, you can avoid a lot of the worries that afflict the frightened hordes. But you can’t really avoid sequence of returns risk.

Oh I know you’re not scared of a stock market crash.

Nor do you pile in at the top.

You have the tough-under-fire attitude of a Vietnam veteran on his third Tour of Duty. When share prices plummet and others quiver before CNBC, you go surfing, Apocalypse Now-style.

“Is that all you’ve got?” you laugh as the market falls 10%.

The average after-inflation annual return from shares globally is 5.3% per year1.

So as long as you sit tight and don’t panic, you’ll be rewarded, right?

Well… yes. Probably.2

The sequence of returns matters

But you’d better know there’s another kind of risk to think about, and it can be a doozy.

Assuming we’re both adding or taking money out of our portfolios over different periods of time, the return you get will be different to the return I get.

This would be true even if we saw the same average 5% real return from our portfolios.

Huh?

I know – it’s counter-intuitive.

It also has a clumsy name: sequence of returns risk.

Sequence of returns risk is the risk that fate will deal you a shocking hand. That the timing of bear markets and bull markets will fall worse for you than for another investor.

This danger is especially high when you’re taking money out of a portfolio during a market crash.

It’s why we’re urged to reduce our exposure to the riskiest assets as we approach retirement age.

Young versus old

Stock market falls are great news for young investors who invest more throughout the turmoil.

The best time to get a bad hand from the market is when you’re starting out as a saver.

You’ve got less money to lose in a market crash. Better yet, what you buy with new money at a lowered cost basis will grow in the good times to come. (Plus you get used to volatility early.)

In contrast, the last thing you should want the day before you retire is to have all your money in shares, only for the market to plummet.

You’re retired. You need that shrinking portfolio to live on.

How to multiply your money

You might not think it matters how the market tosses up its treats and its treacheries.

Returns from investment are multiplicative, after all. You multiply your money!

And every precocious child knows that it doesn’t matter what order you multiply numbers together. You still get the same result.

For example:

1 x 2 x 3 x 4 = 24

4 x 3 x 2 x 1 = 24

3 x 4 x 1 x 2 = 24

It’s exactly the same with investing.

When the market delivers a 20% return, it goes up 1.2 times.

When the market falls 10%, you multiply it by 0.9 times.

1.2 x 0.9 = 1.08

0.9 x 1.2 = 1.08

Okay, so why does it matter to us poor strivers exactly when the sturm und drang of a stock market crash hits us?

Well it wouldn’t if you were a member of the landed aristocracy and you were simply managing a big pile of loot before passing it onto the next generation.

But most of us are saving and investing over our lives to ensure our financial futures. We’ll have to withdraw money from our savings in retirement for spending.

And it’s because we add and subtract money from the market over time – at different times – that the sequence of returns risk can have its wicked way with us.

Here’s one we did earlier

Let’s consider a real world example.

Here are the total returns from the FTSE 100 for the five years from 2008 to 2012:

Source: FTSE

Do the sums and you’ll see that’s an average annual return of 3.9% per year.

Now let’s imagine you invested £100 at the start of 2008. Here’s where your money would have stood at the end of each year:

Note: £100 compounded for five years, as per the returns listed.

The first thing to note is you’ve ended up with less than you might have expected.

If you plug 3.9% into a compound interest calculator, it will spit out £121. You got £10 less.

Why? Because investment returns are geometric, rather than arithmetic. But that’s for another article…

For now remember we ended up with £110.56 after this five year run.

Investing in Bizarro World

Back to the sequence of returns risk. Let’s imagine you fell through a wormhole and ended up in an alternative reality, five years in the past.

(Stay with me here.)

Being a good Monevator reader, you shrug off your trip through time and space and head to the nearest stockbroker. People always need to save and invest for their retirement, even in Bizarro World.

But things aren’t entirely the same here.

In this alternative reality, the order of the annual returns from 2008 to 2012 are reversed:

Source: Bizarro World Bank Headquarters broom closet.

This time the big crash comes at the end of the five year sequence. Rather than at the start as it did in our reality.

Do the maths and you’ll see the Bizarro World market averaged the same 3.9% return.

But what about a £100 investment?

Note: £100 compounded for five years on Bizarro World.

Because returns are multiplicative, we end up with exactly the same £110.56 in Bizarro World as we got on Planet Earth.

That was true even though the sequence of returns was reversed.

We expected that. So far so good.

Now add sequence of returns risk

The complication comes if you are saving or taking money from your investment over the years.

Let’s say you add £20 at the end of each year to your portfolio.

The result in our reality on Planet Earth:

Note: £100 initially invested, then £20 added at the end of each year.

What about in the alternate reality, where the sequence of returns was reversed?

Here you got a different result:

Note: Again, £100 in, then £20 added each year. Alternative return sequence.

As you can see, you’re left with a different sum. Falling through the trouser leg of time3 and investing in Bizarro World reduced your final total by around 10%.

Now I don’t know how much things cost on Bizarro World. But I’m sure anyone would rather have that extra spending money.

More seriously, this is exactly what happens in real-life to different investors with different saving and withdrawing schedules.

The sequence of returns varies over time. And so two regular savers with the same general strategy but investing over different periods will see different sums accumulated by the end.

Even if they enjoyed the same average annual return.

People who retired in the mid-1990s as the stock market soared were laughing.

People who retired in 2001 in the midst of a severe market decline?

Not so much.

The science bit: As well as the multiplication, we now have addition in our sums. So the order now matters.

Withdrawal symptoms

As I mentioned – and more scarily – all this is equally true when you’re withdrawing money as when you’re saving.

I say ‘more scarily’ because there’s not much you can do about it once you’ve stopped earning.

At least if you see a bear market while you’re accumulating money, you can try to find more cash to invest before you retire. You might even enjoy a market rebound on that extra cash you put in.

Once you’re retired though, you’ve no new money. So maybe you’ll have to spend less and cancel your subscription to Caravan Monthly.

Withdrawal method

Imagine you had £100,000 in 2008.

For the sake of this example let’s say you put it all in the stock market.

You withdraw £4,000 a year.

In the table that follows the third column shows how £100,000 would fare if you kept all your money invested. The fourth column shows the impact of withdrawing £4,000 at the end of each year:

Note: £100,000 in with no withdrawals, versus £4,000 taken out each year.

No great surprise. Taking £4,000 out a year reduces how much money you’re left with, compared to keeping it all invested.

But let’s now turn our telescope to Bizarro World. How does the alternative sequence of returns play out with the same £4,000 withdrawal rate?

Note: Alternate sequence for retirement assets on Bizarro World.

Column three reruns the £100 example. With no withdrawals, the hands-off portfolio of £100,000 compounds to the same £110,564 in both instances.

However in Bizarro World with £4,000 per year withdrawals, its sequence of returns proves more favourable for the retiree.

She ends up with £5,000 more in the pot in 2012 than her spirit sister here on Planet Earth.

Hard luck

Interestingly, the result for the retiree on Bizarro World is the opposite of what we saw with its regular savers. Savers did worse there over the same five-year period than we did.

But let’s not get hung up on these specific numbers.

The point is that sequence of returns makes a difference to how your retirement plays out. But we cannot know what returns we’ll get in advance.

Which makes it an especially thorny problem.

Don’t risk doing badly

Can you do anything to sidestep the sequence of returns risk?

Not a lot. Its impact is mainly down to luck.

You might try to guess if various markets are cheap or expensive. You could try to shift your investments accordingly.

But many people – probably most – will do worse using such active strategies than if they had just saved and rebalanced automatically.

I think the main response to sequence of returns risk should be:

• To de-risk your portfolio by rebalancing towards safer assets as you approach retirement

• To consider locking in some income. Perhaps enough to meet your basic spending needs when you do retire, perhaps through an annuity.

All investing involves risk. But by diversifying your portfolio and playing a bit safer, you can reduce the role of luck, and increase the odds of your plan working out.

Next week we’ll consider what to do if you think sequence of returns risks is about to savage your retirement. Subscribe to make sure you see it!

1. Source: Credit Suisse Global Yearbook 2022 [↩]
2. A handful of markets, such as pre-communist Russia, have been completely wiped out. Never put all your eggs in one basket. [↩]
3. Apologies to the late Terry Pratchett. [↩]

What caught my eye this week.

I kept coming across inflation articles this week, and tried to be judicious about what was earmarked for Weekend Reading. Yet I still ended up with all those below and more on my shortlist:

• Rising fuel and food costs push US inflation to 7.9% – BBC
• Analysts predict year of 7% inflation for UK – FT Adviser
• Petrol hits new record above 160p per litre – BBC
• Higher inflation is increasing the cost of servicing Britain’s public debt – Economist
• An energy shock and high inflation: are the 1970s reborn? [Search result] – FT
• UK farmers warn rocketing gas costs could cut food production – Guardian
• Hedging future energy costs with shares in a Ripple wind farm – DIY Investor UK
• Energy bills are forecast to double, but switching is pointless – ThisIsMoney
• Netflix hikes prices for the second time in 18 months… – Guardian
• ..and other subscription fees are rising too. Here’s how to save – Which
• Typical payments on cheapest fixed mortgage deals rise by £840 a year – ThisIsMoney
• Are we heading for recession? – A Wealth of Common Sense

This list could have been five times as long. It could be the same next week.

We are facing a hyper-inflationary environment for articles about inflation.

War footing

Of course it’s a trivial concern compared to actually suffering an invasion from a waxwork germophobe gangster armed with nuclear weapons, but it’s the war in Ukraine that has turned our inflation expectations up to eleven.

And it could get even worse.

Only a few weeks ago I was expecting inflation to start to roll over about now. Investors would have to be ready for quantitative tightening, sure. But interest rates would probably be rising against moderating inflation, as supply chains righted themselves.

Weaponising the energy market has changed all that. Higher oil prices could continue to juice – both directly and indirectly – the inflation statistics. A few pundits see oil doubling to $240 a barrel. Russia is warning of $300.

Saner voices anticipate demand destruction well before we hit those levels. Yet that means using less energy – just when the global economy was meant to be rebooting after Covid.

Dear oh dear

Could Europe see fuel rationing, no-drive days, and other throwbacks from the energy shocks of yore? It’s not impossible. Indeed it’d be a righteous thing to do, compared to spending hundreds of millions of dollars a day on Russian energy that further funds its war effort.

However in the short-term choking off energy use could hurry along a recession, even as rising prices force central banks to raise interest rates.

I raised the dread prospect of stagflation before Russia invaded Ukraine earlier this year, though I mostly waved it away as an outlier. That was because I didn’t think inflation would become embedded.

But war has changed the odds. All kinds of commodities – from oil to wheat to nickel – are being disrupted by the war. We may yet see something of a wage spiral. (I still believe recovering trade and technology and productivity gains can take the edge off.)

The end of super-low interest rates has meant tweaking our investing expectations. It now looks like everyday earning and spending will be worth reviewing, too.

Have a great weekend!

[continue reading…]

This is part three of our series on planning and paying for long-term social care. 

Part one dealt with the gap between genuine need and available State provision. 

Part two explained how the means test values your assets (including pension and property) and when it excludes them. 

Now we’ll consider what happens when you qualify for funding – and when you don’t…

Navigating the UK social care system is like being forced through a ramshackle Heath Robinson machine held together by elastic definitions and loopholes.

You’re propelled down different funding chutes in a process obscured by sooty clouds of subjectivity.

Depending on the outcome of your local authority1 financial assessment (the means test), you’ll end up in one of three buckets:

• Max funding
• Partial funding
• No funding

Even then, State funding only applies to your eligible care needs. Which may only bear some relation to the care you actually need. 

A financial assessment divides your assets into capital and income, as covered in our previous post.

(Reminder: the social care definitions of capital and income diverge significantly from their familiar meaning.)

Your capital is tested against one set of social care thresholds. Income is scored against another.

Your social care funding can be docked to zero on either count.

The system may produce odd results, depending on how your finances are structured. And even if you fail initially, you may run down your resources and qualify later.

Let’s now examine how the two-stage means test crunches the numbers.

Social care thresholds for capital: test one

Test one compares your capital against these thresholds:

Above the upper threshold – you’re in the ‘no funding’ bin. At least, that is, until your capital expenditure sinks your assets below the threshold. Or you hit the social care cap in England. We covered the pitfalls of the cap in part one.

Even if you’re above the threshold, you’re still eligible for universally available support. (This includes free personal care in Northern Ireland and Scotland.)

Wales also caps care at home costs for your eligible needs.

Below the lower threshold – you qualify for local authority funding. But your level of income can still reduce or entirely eliminate your funding entitlement. We cover that in the social care allowances section.

Between the thresholds – This is the twilight zone. You qualify for funding, but some of your capital also counts as income. This mechanism acts as an extra counterweight, forcing your funding down as your assets rise.

This extra skim from your between the thresholds capital is called tariff income. 

Tariff income between the thresholds

Tariff income is calculated differently across the home nations.

Wales

The single social care threshold means tariff income doesn’t exist here.  

England

Your capital between £14,250 and £23,250 increases your means-tested income figure.

Your income increases by £1 per week for every £250 of capital you have between the £14,250 and £23,250 thresholds.

If your capital amounts to £14,500 then your income total is increased by £1 per week.

If you have £23,250 of capital then your income is up-weighted by £36 per week. (£9,000 / £250 = £36).

Your income ratchets by £2 per week if you have £14,501 in capital. That’s because any remainder is counted as a fresh £250 block.

Tariff income will be applied the same way for the new social care thresholds from October 2023. (Assuming they come in as planned.)

Northern Ireland

The same tariff income formula applies for residential care as in England.

Care at home is free, so tariff income doesn’t apply in this case.

Scotland

Tariff income for residential care is calculated at the following rate:

Your income increases by £1 per week for every £250 of capital (or part of) you have between the £18,000 and £28,750 thresholds.

Tariff income for care at home is worked out differently:

Your income increases by £1 per week for every £500 of capital (or part of) you have over £10,000, if you’re above State Pension Age.

Your income increases by £1 per week for every £250 of capital (or part of) you have over £6,000, if you’re below State Pension Age.

There’s only one threshold here. This can catch out people who thought they were below the headline £18,000 threshold.

However, Scotland provides free personal care and nursing care for all. So the care at home means test applies only to chargeable services. Think housework and shopping (sometimes known as domestic assistance).

Intermission: get ready for the second test

Once tariff income is established according to your country’s rules, it is added to your other income to make the next part of the means test harder to pass.

Incidentally, the social care threshold table shows why it matters if your house falls into the means test.

Its value will catapult you beyond the upper thresholds. This immediately rules out local authority funding – unless and until you trigger any applicable social care cap.

Social care allowances for income: test two

Everyone must contribute something towards their eligible care needs, so long as they’re left with a minimal weekly income.

That’s true even if your capital falls below the lower social care threshold.

Your assessed income can wipe out any local authority funding you qualified for in stage one.

The level of weekly income that can’t be touched by fees is called the social care allowance. Here’s how much income you can keep:

This is the weekly income per individual that’s protected from social care fees.

The amount of local authority funding you receive is reduced by your remaining income above the relevant minimum that applies to you from the table. (For example, either £24.90 or £189 in England).

Apologies if you had to re-read that sentence twice to understand it. We didn’t write the rules!

Income outcome

The income contribution formula is:

• Calculate eligible income 
• Add tariff income if capital is over lower threshold
• Deduct weekly social care allowance
• Remainder = your contribution to care that would otherwise be funded by your local authority

So if you weren’t eliminated at the capital stage, this second test could hobble you.

You can easily imagine someone with pension income – but little else – seeing most of it disappear on care fees. Even though their eligible capital is below the lower social care threshold.

In England, that could leave you with £24.90 per week (£1,294.80 a year) to call your own.

You do get to keep any income that’s disregarded. That’s typically State benefits.

What about housing costs and inflation?

A ray of light is that some housing costs should be deducted from your income before it’s checked against the Minimum Income Guarantee.

The definition of housing costs differs per region, but includes:

• Council tax (after housing benefit or other reductions)
• Mortgage repayments (England) or mortgage interest (Scotland)
• Rent
• Ground rent (England)
• Water bills
• House insurance (Scotland)

There seems to be some discretion for local authorities to increase the Minimum Income Guarantee, particularly in Wales.2

Note, the Minimum Income Guarantee applies to care at home fees, not residential care.

Do the social care allowances rise with inflation? Well they’ve been frozen since 2015 in England. The link looks haphazard in the other home nations.

That’s a tax rise by any other name. But at least both allowances are due to rise in line with inflation in England from April 2022.

What if I run out of money?

You can re-apply for funding if your financial situation deteriorates.

You’ll need a new care assessment and financial assessment. You might now drop under the critical thresholds – especially if you’re funding your own care at home.

The social care guidance also mentions scenarios such as a large fall in the value of shares as a valid reason for reassessment.

If you’re facing a permanent move into residential care, consider a deferred payment agreement. This is designed to protect you from a forced sale of your home. (See our previous post on social care funding.)

Of course, fortunes can be restored as well as lost. An inheritance, for example, could cause you to bob back over the social care thresholds. You could then lose local authority funding.

Care bare

The social care system is so convoluted that it’s probably best expressed in pictures and not words. And when I say picture, I don’t mean Edvard Munch’s The Scream.

I mean a diagram.

Our flowchart below boils social care funding down to its bare essentials. Hopefully it’ll help untangle all the ifs, buts, and maybes.

Start from the ‘Individual seeks help’ button.

Are you negotiating the social care system right now? In that case I can recommend the guidance on Money Helper.

Age UK’s social care factsheets are also superb. Here’s its coverage per region:

• England (scroll to the social care section at the bottom)
• Northern Ireland
• Scotland
• Wales

Finally, a number of local authorities have online care cost calculators. These walk you through the means test steps I’ve covered in this post and the previous episode to estimate your social care fee contribution. 

Google: social care financial assessment calculator + your local authority’s name to find yours. 

Part four of the series shows how you can estimate a plausible cost of social care from available data.

You can then plug that number into your financial plans to stress test them against social care scenarios. 

Take it steady,

The Accumulator

1. Health and Social Care trust in Northern Ireland. [↩]
2. Both forms of social care allowance are called the Minimal Income Amount (MIA) in Wales. Unfortunate acronym, that. [↩]