What caught my eye this week.

Rishi Sunak didn’t hike capital gains tax in the Budget. I took it a little personally after I’d voluntarily conjured up a five-figure tax charge, partly fearing he’d double the rate I’d pay.

However I’m not too miffed.

For one thing, the unsheltered shares I sold were mostly of the MAD GAINZ variety that did ridiculously well in the pandemic. And these growth stocks have continued to be hammered since I sold.

Indeed at one point on Friday my former highest-flyer only needed to slip another 5-6% for me to be up on selling even after the future tax charge.

Alas, it bounced into the close. Bittersweet.

Another reason is I still have more capital gains to deal with in the future. Bitcoin, anyone? Though that one could well take care of itself in time, given its mercurial record.

Anyway, remember to always invest in an ISA or SIPP to avoid this nonsense.

Beyond the Budget

The more worrisome reason I’m not too upset that I sold is some pundits believe big changes could still arrive on so-called ‘Tax Day’.

That’s set for 23 March.

According to the Financial Times [Search result]:

A Treasury decision to hold a “tax day” three weeks after the Budget will be a bellwether for long-term changes in government tax policy, including on capital gains and environmental levies.

My standard policy has been to mostly ignore clickbait articles about this or that tax break being set to get the chop. Fearmongering comes up every year, and most of the time nothing much happens.

However we know the UK will have a harder time balancing the books in the future, thanks to Covid. Freezing personal allowances and nudging up corporation tax in the Budget was meaningful, but will it be sufficient?

Here’s all the Budget blues news:

• Key Budget points at a glance – BBC
• More main points from Rishi Sunak’s Budget speech – ThisIsMoney
• How to prepare for what comes next [Search result] – FT
• What was in the small print? – Which
• Extra 1.3m will start paying income tax over next five years – Guardian
• Sunak claims Budget measures will create ‘Generation Buy’ – Guardian
• How the government’s new 5% deposit mortgages will work – MSE

Have a great weekend all.

[continue reading…]

Money is power, as anyone who has watched The Godfather or read an expose of the shadowy interaction between oligarchs and the establishment knows. But I think of money as stored energy.

You work, beg, borrow, steal, or otherwise obtain money.

You put it aside – store it.

Later you discharge the power and make something happen.

A plane moves, with you on it. Food appears on a plate, a partner smiles at a gift, an Amazon delivery arrives. Your run the tap and hot water comes out.

I’ve thought about money so long this way I assumed everybody did. But then I had a conversation with a friend who evidently didn’t.

“Of course you must be right – I’ve just never seen it that way,” he genuinely said in unfashionable agreement.

We kicked the analogy around for a while.

Voila – a blog post!

The electrifying power of a pension

My friend always saw money more like a slightly advanced barter system.

He works and he gets things or experiences. Money is like a handshake between these things happening.

Given roughly half of people live paycheck to paycheck, he’s not alone.

My friend is not good with money, but he’s not terrible. He won’t be gunning for The Accumulator’s mantle anytime soon, but he’s not in debt, for instance. And he pays into a pension.

Actually, I noticed the words he used: “I pay the pension every month.”

Intellectually he knows he’s putting cash aside for the future. But through his money lens, his pension is another monthly bill to be paid.

I see a pension as surplus energy stored for the future. A long-term battery backup, or perhaps given the timescales involved something akin to the US strategic petroleum reserves. Power to be discharged when my everyday supply has dwindled or been switched off.

Money is stored energy: a grid

We can flesh this analogy out. Look at our personal finances like an energy grid.

I can see the blog now: The Money Power Grid – Light up your finances.

(Apologies if it exists. I dare not Google when I’m on a roll!)

Here’s a first schematic of my money energy grid.

Immediate power generation

You work and get paid for it. An energy transfer takes place from the buyer of your car to your bank account. In these and various other ways you fire-up energy on-demand, like an oil-fueled power plant can send electricity flowing into the grid. Stop burning fuel though, and the power goes out.

Trickle generation

Other revenue streams can top-up your energy supply in the background. Like the power generated by domestic solar panels, the money that comes in from small passive streams or a buy-to-let property won’t be enough to live on, but it all adds up. Especially if we can put it away for future use.

Short-term energy storage

In a world without bank accounts, everyone would have to spend most or all their money right away. But so long as inflation isn’t rapidly diminishing the power of our money, we can allow it to accumulate in the equivalent of batteries, to be discharged as needed. This short-term storage should ideally at least maintain our spending power. Impossible in today’s low interest environment, but that’s normally how we’d look to wire the grid.

Long duration energy storage

A drawback of renewable energy systems such as solar, wind, and tidal power is we’re not good at storing the intermittent power they generate. They’re like a freelancer who finds it hard to put money aside for their future taxes. Battery technology is improving, but for now the best longer-term energy storage solutions are quite cumbersome. For example a hydroelectric dam will use an energy surplus to pump water back up to a header lake. That way it has a renewed capacity to provide the juice when required.

Our long-term money energy storage comes with catches, too. You have to lock money into a pension. Shares best protect you against inflation over the long-term, but are volatile short-term. A rental property takes more maintenance than a savings account. Even with cash accounts, you expect to get higher interest rates the longer you lock your money away.

Transmission lines

We need to get our money energy from A to B. From our employer to our bank account. From our current account to our ISA. Unfortunately energy is lost in transmission.

In the real world, jostling electrons over tens of miles of power lines creates wasteful heat. In our money grid we can maintain all our power on the short hop between a current and savings account. But elsewhere we lose energy to fees, fines, and ongoing expenses as we charge our longer-term storage. Taxes can cause a mini brownout. Maybe the drain of the notorious latte factor fits in here, too. A smart financial grid is engineered to reduce these leakages.

Energy spikes

Sometimes our money grids must handle huge inflows of energy. It’s a good problem to have, but it can be tricky. One physicists’ controlled nuclear explosion is another one’s nuclear power plant, after all. Similarly a sudden windfall – a lottery win, or an inheritance – can bolster the long-term resilience and strength of our money grid if we’re ready to capture and store the energy. But the fact so many lottery winners wind up back where they started shows many people’s grids aren’t really fit for that purpose.

Fuel tankers, coal lorries, and power sharing agreements

I’m reaching for an equivalent to debt. Perhaps it’s in the sunk cost of the raw materials of power generation? Fossil fuels we ship in for energy here and now, regardless of the long-term consequences? That’s not quite right. A better analogy might be when one grid sends surplus energy to an adjacent grid that’s not generating enough power to keep the lights on. The inflow solves things for now, but all that energy will have to be repaid…

Electric shocks

Don’t stick a screwdriver in a socket. Don’t day trade Gamestop shares.

Feel the energy

I’ve slightly tortured the money as stored energy metaphor, but I do think it’s an interesting framework.

The consulting work I’ll do this afternoon sounds to me now like the roar of a gas-fired plant powering up. Meanwhile the adverts on this website and the shares in my ISA will be ticking away, sending pulses of energy into my grid.

Overloaded from a recent asset sale, my current account looks ready to blow – I need to get that energy flowing somewhere productive. Like up in Snowdonia, where metaphorically my monthly payment to my SIPP is pumping water thousands of feet high into the mountains, where it will wait until I open the floodgates and the energy comes flowing back out.

We could also have fun turning various laws of energy into financial rules of thumb. (I did this yonks ago with the first law of thermodynamics.)

Here’s one:

E= MC²
Stored energy = Money^(Compounded)

Well, it’s a start.

May your finances never blow a fuse!

Before we get into the sexy sounding business of dynamic asset allocation, a quick mid-series recap.

You’ll remember from my previous post that I’m on the eve of early retirement and I have my decumulation plan in place.

Please go read that article if you’ve not done so already.

Do you think there are risks to my strategy?

Yeah, me too.

Some risk is inevitable. As The Investor once wrote:

“Investing risk cannot be created or destroyed. It can only be transformed from one form of risk to another.”

With that admitted, I have back-up plans. We’ll get to those in the final installment of this series, so please don’t protest too loudly before you’ve caught them all.

Now let’s get into how exactly we’ll get money out of the portfolio.

What is dynamic asset allocation?

With a dynamic asset allocation strategy, you don’t automatically rebalance your equities and bonds to a favoured allocation, such as 60:40.

Instead you use a system that mitigates against selling equities when they’re down, or rebalancing back into them when they’re still dropping like a lift with a snapped cable.

Research indicates that a well-designed dynamic asset allocation strategy outperforms fixed allocations in most decumulation scenarios.

The trade-off is you could find yourself 100% in equities if the market doesn’t recover for many years.

That could happen deep into your dotage. Not a time traditionally associated with voluntary risk-taking.

Still, some octogenarians love motorbikes. Your appetite for risk in retirement is likely to depend on your own personality more than time-of-life stereotypes.

Prime directive

I’m going to use a dynamic asset allocation strategy called Prime Harvesting.

Prime harvesting was devised by Michael McClung. It is fully explained in his book, Living Off Your Money.

The main rules are:

• Sell bonds once a year to fund your annual expenses.

• Sell equities to fund your expenses if you’ve run out of bonds.

• Rebalance into bonds only after a significant run-up in the value of your equities. For example: 20% beyond an inflation-adjusted baseline.

• You don’t rebalance into equities, although your equity allocation (as a proportion of your portfolio) will rise as bonds are sold.

Otherwise, you rebalance between asset sub-classes as you normally would.

For example, you’d rebalance annually to maintain your ratio of linkers to conventional bonds.

McClung’s historical backtesting showed that an initial 50:50 equity:bond portfolio veered from 30% to 70% equities on average.

Commentators such as Early Retirement Now, EREVN, and The Bogleheads have all independently tested Prime Harvesting. They also found it fared well historically.

You can read more about Prime Harvesting via a free sample from Living Off Your Money.

McClung provides full details on how to use it in his book. He has also provided a spreadsheet to handle the calculation for you.

In my portfolio, Prime Harvesting would also mean I’d sell down cash and gold before equities to fund my expenses.

I’ll annually rebalance between my preferred defensive asset allocations as if they were all bonds in McClung’s system.

The risks of withdrawing on auto-pilot

A major cause of portfolio death in decumulation is jacking up spending by inflation every year, regardless of market conditions.

A combination of portfolio losses, equity sales, inflation, and escalating withdrawals over a few years can quickly take a toll.

For example, let’s say you withdraw 4% from a £1,000,000 portfolio for an income of £40,000 at the start of Year One.

Then imagine that – thanks to weak markets – your portfolio falls further to £672,000 by year-end.

Year Two’s mandated withdrawal is £41,200, after 3% inflation. Your withdrawal rate is now over 6%.

The portfolio then goes down to £536,180 by Year Two end, after a 15% loss. Unlucky.

Year Three’s withdrawal is £42,848 after 4% inflation. The withdrawal rate is now 8% and the portfolio balance has plunged more than 50% to £493,332 inside two years.

Just a few more years of bad luck and your withdrawal rate could be well into double figures. You need equities to bounce back – but that won’t happen if you sell too many.

Gulp.

Dynamic withdrawal rate

This is where a dynamic withdrawal rate can show its strengths.

• Dynamic withdrawal rates are responsive to the amount of fuel left in your wealth tank.

• They’ll ease your pedal off the money accelerator when the equity gauge flashes red.

• That can mean living on less, for a time, so your portfolio doesn’t run out of road.

• But dynamic withdrawal rates can signal that you can spend more, too.

If market conditions indicate full-speed ahead, then a dynamic withdrawal rate sends you up the gears, so you can live life in a faster lane.

This deals with a little-discussed drawback of conservative Safe Withdrawal Rate (SWR) strategies, which is that most people do not live through a nightmare scenario.

You could easily die with piles of loot unspent if you stick to rules calibrated to avoid the worst case. A worst case scenario that rarely happens.

In contrast, sophisticated dynamic withdrawal rates take into account market valuations and/or mortality.

The downside of dynamic withdrawal is your income may be curtailed for years if your sequence of returns proves ugly.

But the upside is you can choose a higher initial SWR – because your financial bungee cord prevents you from spending your portfolio off a cliff.

Dynamic withdrawal rate: which one?

There a number of dynamic withdrawal methods that are well-documented and designed for DIY decumulators.

They include:

• The Bogleheads Variable Percentage Withdrawal (VPW) method.

• Early Retirement Now’s CAPE-based withdrawal formula.

• Michael McClung’s Extended Mortality Updating Percentage Failure (EM) rules. See his book: Living Off Your Money or read my review.

Which is the best? None of them, really.

I eventually realised that I was searching for the perfect system. One which let me spend like my wallet was on fire, but also saved me from Armageddon.

That system doesn’t exist.

You always face the same compromises:

• Spending more upfront, risks cutting back more later.

• Saving your portfolio from a financial face-plant may mean cutting expenditure.

• Different systems outperform at different times, but you can’t know what conditions you will face.

How to decide between them? Here’s my own dynamic withdrawal rate criteria:

• The system should account for market valuations. We live in an era of high valuations, which I believe signals subdued returns ahead.

• The system shouldn’t front-load with an overly optimistic SWR, only to risk a severe spending cutback later.

• Mortality is recognised so you can up the spending ante as your candle burns low.

• There should be evidence that the system works during the historic nightmare situations that we all fear.

• The author(s) are open about the trade-offs.

• I need to be able to live with it. In other words, I need to understand how the system works, make the necessary calculations, and know what demands it could make if we’re unlucky.

Ideally the system comes with resources such as an active community – or at least a book’s worth of backtesting (including non-US scenarios), use cases, and advice on how and when to bend the rules.

McClung is the man

I could easily live with ERN’s or The Boglehead’s systems, but McClung’s Extended Mortality (EM) withdrawal rate formula ticks the most boxes for me.

Not least because he’s tested EM against historical returns for the UK and Japan, and because he considers the global portfolio, not just US.

Whichever system you choose, make sure you are comfortable flexing your spending down. (I guess we’re all comfortable flexing up.)

Mrs D. Accumulator and I could drop spending 15% and live happily.

We could drop 25% and still cover our bare essentials.

Dynamic duo

Dynamic asset allocation and dynamic withdrawal are additive, SWR-optimising partners.

They’re not panaceas but both tip the odds further in your favour.

I only have to make the calculations once a year and McClung has provided a spreadsheet to do the hard work for me.

I will have to stick to more complex rules under pressure, which is a risk, as is cognitive decline.

If that sets in then I’ll switch to Vanguard LifeStrategy and annuities.

So what is my SWR?

Taking into account our life expectancy, ‘failure’ tolerance, asset allocation, and high market valuations, McClung’s formula awarded us an SWR of 4%.

Or a real SWR of 3.8% after investment fees.

That’s much less than the 4.7% I previously got using Michael Kitces ‘layer cake’ SWR improvement method.

I backtested the 4.7% SWR using the brilliant Timeline SWR tool that uses historic global investment returns.

4.7% passed the test of history with a 99% success rate, although it cut spending drastically in 10% of scenarios.

Nevertheless I’m happy with a 3.8% SWR.

It was actually 4% (after investment fees) when I ran the numbers two years ago. Higher market valuations today have cost us two pips but rising share prices have also buoyed our portfolio in the accumulation phase. We’re better off overall, but it’s still a warning to beware of trouble ahead.

That’s why I’m not buying into the 4.7% that I can coax out of Kitces and Timeline.

No, 3.8% it is for us.

State Pension SWR bonus

Although a younger version of me would never have believed it, one day we’ll be drawing our State Pension. That will add fresh horses to the portfolio in a couple of decades.

The State Pension reinforcements bump up our SWR by 0.64% (along with Mrs A’s DB pension), according to Early Retirement Now’s superb Social Security and Pensions formula.

Note: UK investors should only use Early Retirement Now’s pessimistic Minimum Value table. His wider work is underpinned by those world-beating US historical returns.

Fortunately, we don’t need to front-load our SWR in order to live, so I’ll leave the State Pension bonus in reserve.

I prefer to think of the State Pension as the cavalry, ready to charge in to save us if our portfolio is battered by our late sixties.

Whether it will arrive resplendent as heavily-armoured cuirassiers or more like a few starving peasants on nags is debatable.

I’m relatively sanguine about it. If you’re not, bear in mind it’s only one of our decumulation back-up plans.

To get a gander at our belts and braces in full – and to conclude this mini-series of decumulation posts – tune in to the third installment.

Working title: Decumulation: A Better Finale than the Return of The Jedi.

Subscribe to make sure you see it.

Take it steady,

The Accumulator