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Weekend reading: Drawdown dramas

Weekend reading

Good reads from around the Web.

A post from UK blogger – and Monevator contributor – Retirement Investing Today took my recent article on sequence of return risk a step further.

For his piece, RIT ran some numbers to see how a UK retiree accepting a P45 a year before the crash in 2008 would have fared with various simple stock/bond allocations.

Here’s the pain dealt out with a 4% withdrawal rate:

07-to-13-drawdown

On the one hand, this is pretty sobering stuff. The heaviest 75% allocations to shares – represented by the green lines above – are down as much as 24%. That’s quite a drop in just six and a half years.

On the other hand, you could argue it’s reassuring how well the retiree’s position has held up, given the turmoil of 2008 and 2009.

Sure, it was a disastrous time for this hypothetical desk-dodger to go into retirement with his or her risk setting set to “Hell yeah!”

But thanks to the 25% bond allocation, it hasn’t yet been a total wipe-out. An income has been taken as planned, and there’s still some potential for shares to bounce back.

Of course many people who went gung-ho into OAP-hood with a 75% weighting towards stocks would take fright after a crash, and belatedly sell shares to buy bonds or an annuity. They’d therefore already have missed much of the rebound.

Far better to set your asset allocations prudently from day one.

A report from the retirement trenches

Another UK blogger, John Hulton, is already in income drawdown mode with his SIPP. He updated us this week on his progress.

John retired last year, so he’s already off to a more fortunate start than those hapless share-heavy retirees of 2007, reporting:

Including income, the total return for the 12 months is over 20% which is obviously pleasing. The market generally has performed well over this period.

The technical term for this is “jammy”, when it comes to sequence of returns risk. Early gains are a boon once you’re in drawdown mode.

At the core of John’s SIPP strategy is a portfolio of income investment trusts after my own heart.

Assuming I am rich and bold enough to have a healthy buffer zone when I eventually retire (and if not then something has gone very wrong!) then John’s approach is similar to what I’d do myself, with perhaps a few index funds in the mix, too.

By drawing income and leaving capital untouched, I believe you boost the chances of your retirement pot outlasting you – and I don’t care that Messrs Modigliai and Miller won a Nobel Prize for saying otherwise

Live off your income but never touch your capital, if you’re rich enough.

It worked for the landed gentry for generations. I suspect it will work for us, too.

From the blogs

Making good use of the things that we find…

Passive investing

 Active investing

Other articles

  • Bill Gates: What I’ve learned from Warren Buffett – LinkedIn
  • The second half of retirement – Vanguard blog
  • Research paper on ‘the ostrich effect’, which sees people logging in to check their share accounts more often in the good times and less in the bad [PDF]Download at SSRN (Via SquaredAway / Oblivious Investor)

Product of the week: Interested in buy-to-let? Mortgage deals are getting cheaper, reports This is Money, with The Mortgage Works touting a rate of just 2.49%. (Beware the hefty 2.5% fee though).

Mainstream media money

Note: Some links are to Google search results – these enable you to click through to read the piece without you being a paid subscriber of the site.

Passive investing

Active investing

  • Your last remaining edge on Wall Street – Motley Fool US
  • Top 10 holding of the ‘ultimate stockpickers’ – Morningstar
  • How to invest in farmland [Search result]FT
  • Three traps for bond investors [Search result]Telegraph
  • The long-term case for emerging markets [Search result]FT
  • Taper tantrums – The Economist

Other stuff worth reading

  • Swedroe: It matters how you frame your investing decisions – CBS News
  • Get a house to do up in Stoke-on-Trent, for just £1 – The Guardian
  • How to pay £400 tax on a £100,000 income [Search result]Telegraph
  • Test driving Britain’s cheapest car – The Guardian
  • Who’s rich? [Graph]The Economist
  • Going green could boost your home’s price by 16% – This is Money

Book of the week: A lot of DIY stock pickers read share blogs and magazines, and occasionally even a company report, but they never read business books. Yet some of the great investors – Charlie Munger and David Gardner, for example – read nothing else. A good halfway house to start with is The Outsiders, the definitive book on CEOs who were also excellent capital allocators.

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{ 30 comments… add one }
  • 1 Jon June 22, 2013, 2:12 pm

    TI, spot on, never really understood this 4% withdrawal rule when a selection of high quality ETFs, IT’s and HYP shares can yield 4%+ with inflation protection. I would be loathed to sell my capital assets that I built and nurtured over decades…..great feeling to know they are quietly generating passive income in the background even when I’m a sleep.

  • 2 SG June 22, 2013, 4:05 pm

    Living off the income and not touching the capital is what I am proposing to do when my other half retires (OK, I already have a DB pension, too, which helps a lot), at least for a few years. However, this is a big ask for most retirees, hence the drawdown interest.

    There has been a lot of American research on drawdown, some of which can be played with here:

    http://www.firecalc.com/

    and studied via Wade Pfau’s blog. I suspect in the UK you need to be more conservative, though.

  • 3 mucgoo June 22, 2013, 6:02 pm

    Buybacks are more popular in America and yields lows so thats probably why solely living of dividends is rarely considered.
    When you’re saying you’re following a 4% withdrawal rate system then dividends count as well so if you take the 5% dividend yield and don’t reinvest any of it your in effect using a 5% withdrawal rate with the greater risks that entails. If you also sold 4% of the underlying asset you’d be withdrawing at a 9% rate.

    High yield shares are not more profitable apart from the tenuous value effect. Its main actual advantage of providing a steady income is also overstated. You could quite easily rebalance a normal mixed portfolio of trackers every six months and in doing so pull out your next six months of living expenses over into a bank account.

  • 4 The Investor June 22, 2013, 9:07 pm

    @mucgoo — I don’t think anyone is saying here they are withdrawing a 5% dividend, and then a 4% capital withdrawal rate on top, making 9%, so not sure what you’re driving at there. 🙂

    Also, if I thought a 4% withdrawal rate was sufficient and had planned for such, I would reinvest any excess income.

    As for your second point, that’s a perfectly reasonable point of view to hold of course. I agree the value effect currently seems to be more a coincidence with other value traits, as I think you are implying.

    However my opinion is as I say that living off income will cause fewer problems. Perhaps it’s down to behavioural issues, and the fact that one is not forced to make selling decisions, if nothing else. Also, as I say I’d be using income ITs and trackers, not individual shares, and they come with diversity and in the case of the ITs a circa 1-year cash buffer, so I think a steady income is all-but nailed on. (Most got through the financial crisis with flying colours).

    If one is selling for capital gains, there are also tax issues to remember of course (and there may be with income, too). But your proposed strategy is valid as you say, if one prefers it — and as you suggest by creating buffers to smooth the income it could be pretty transparent. So certainly an option if one is a firm capital structure irrelevance adherent!

    @SG — Very true, most people are not going to be able to live off investment income without touching capital, although perhaps augmenting a pension from other sources is more doable, and will be attractive to those who want to pass on an inheritance.

  • 5 dearieme June 22, 2013, 10:07 pm

    Like so much about economists, their “Nobel Prize” is counterfeit too. It’s the Swedish Central Bank Prize. I might pay more attention to them if they started being honest about that – at least it would be a start.

  • 6 ermine June 23, 2013, 9:20 am

    Perhaps it’s down to behavioural issues, and the fact that one is not forced to make selling decisions, if nothing else. Also, as I say I’d be using income ITs and trackers, not individual shares, and they come with diversity and in the case of the ITs a circa 1-year cash buffer, so I think a steady income is all-but nailed on. (Most got through the financial crisis with flying colours).

    The absence of selling decisions improved my portfolio performance no end, I’m deeply grateful for some of your articles highlighting where the primary enemy lies. Even if I can’t stomach this passive investing lark 😉

    I would be quite happy to live off the yield of my portfolio once it has reached its target size in a few years of ISA allocations, and hopefully those income ITs will return to earth and a discount at some point. It’s not even like I haven’t got some dogs in my portfolio, but the day I decided to stop churning was the day I experienced a step-change up in performance, even the dogs slowly buy themselves out of the doghouse with divis. Buying them at the time I did was still a mistake, but the TR comes good in runs into positive territory as I hold.

    I’ve also observed over three years now that the ratio of the annual aggregate dividend income to aggregate purchase price is much more stable than combined market price of the portfolio.

    I’m taking pretty much the same policy line as SG. Theoreticallyregularly selling off lumps of a bunch of index funds to fund retirement may be the same thing, but once you don’t have a regular paycheque coming in it running down your capital sure as hell feels different and the gut-wrench aspect of that shouldn’t be underestimated. I appreciate in theory it isn’t running down your capital if you keep below the SWR and US taxation seems to favour growth stocks, but I wouldn’t like to do it 😉

  • 7 Alex June 23, 2013, 9:36 am

    1. Sorry if I’ve missed something, but you seem to have ignored an important story from last week: the departure of Bolton from the Fidelity China Special Situations Trust.

    2. Yet another lesson on star fund managers – and those who hype them (especially Hargreaves Lansdown in this case).

  • 8 DIY June 23, 2013, 9:38 am

    Funnily enough I was thinking along similar lines this morning – if you live on your investment income (as I am, more or less, at the moment) your capital is still subject to inflation, so is being ‘drawn down’ anyway. Of course, the older you get the more flexibility you have to spend or give away capital.

    For me, the great ‘aha’ moment was to realise that a two-pronged approach was needed: reduce expenditure to what I could earn passively and increase passive income to what was needed to live modestly but comfortably.

  • 9 Monk June 23, 2013, 1:12 pm

    He hasn’t gone yet Alex…!

    Although it isn’t without irony that news of his departure has been greatly exaggerated 😉

  • 10 Alex June 23, 2013, 2:47 pm

    @ Monk:

    Sorry, what I wrote is unclear. I meant that last week Fidelity announced the date of Bolton’s departure from the trust (and named his successor).

  • 11 helfordpirate June 23, 2013, 6:35 pm

    @TI “By drawing income and leaving capital untouched, I believe you boost the chances of your retirement pot outlasting you”

    Do you have any evidence for this statement or is it really just a belief?
    Of course if it just means by drawing “less” then someone drawing 4% on a total return basis, you are likely to last longer.. sure.

    But otherwise I struggle to understand why people see income and capital gains so differently. The only difference in my mind is the tax treatment both for the individual and for the corporation – each has plus/minuses.

    The argument about being a forced seller in a falling market is not strong, as most people in the distribution phase will have significant bond holdings. They will be rebalancing and likely will be selling bonds to fund withdrawal and maybe even buying equities. There is no hard decision to make – just keep rebalancing back to your asset allocation.

    Believing you can meet your retirements needs with income only risks chasing yield with a likely loss in diversification – unless you are very wealthy, in which case both approaches converge anyway.

  • 12 The Investor June 24, 2013, 9:27 am

    @helfordpirate — I wish I could point you to data (although to be fair most of the drawdown data is from the US, too) but it really is a belief.

    I appreciate this may be unsatisfactory.

    However the belief isn’t entirely whipped out of the air. For example, if you use a collection of income investment trusts as I suggest I might as discussed above, you’re looking at vehicles with substantial cash reserves and a long history (multiple decades, through may different market periods) of sustained real-terms dividend increases. In my view the majority are conservatively managed.

    By buying such a group and living off the income (combined with some slug of bonds, property, what have you), you effectively eliminate the risk of early drawdowns / sequence of returns / what have you decimating your portfolio in the early years. Provided you hold through the maelstrom, you can keep drawing an income.

    You can be to some extent oblivious to capital values. I think (believe!) this is a very valuable mindset if one is living off income *provided* your initial strategy is well-founded (not necessarily optimal, but well-judged to meet your needs).

    In contrast, the idea of selling assets in a 2008 scenario fills me with dread. As I say above, it’s partly behavioural / psychological — and I take your rebalancing point — but I would not like to go through, for instance, 1973/1974 selling down my portfolio.

    There may well be evidence out there (I’d be delighted to see it) showing a total return drawdown has delivered similar/better results in the past, but it still wouldn’t change my own plans.

    Of course, I would have swapped the risk I fear above for new risks — some sort of systemic failure of investment trusts or whatever equity income vehicle I chose most obviously, and I risk under-performing on a total return basis. It’d also be a nailed on certainty if the plan worked that I’d ‘risk’ outliving my money. (I’d be guaranteed to, if the plan worked…)

    Fully agree it’s all moot for most people though, who will need to draw on capital to meet their needs. (May prove that way for me, too — I’m still 25+ years away from pensionable age).

  • 13 helfordpirate June 24, 2013, 9:47 am

    @TI, you make a good point about ITs and cash buffers. My intention (when I get there) is to do the same but manually. I hope to have a 2-year cash buffer on deposit and retail bonds. If the market tanks I will a) continue to rebalance but make withdrawals from my cash buffer, b) try to reduce discretionary spending somewhat. A buffer like this also makes the management of a total-return withdrawal strategy easier as you only need to act 6-monthly or even yearly to keep the buffer topped up.

    Withdrawing 4% on a total-return inflation adjusted basis regardless seems a foolish think to do – even if the (mainly US) research shows that it should be ok!

    Indeed I think this flexibility is critical (and partly implicit in the IT approach) but worryingly absent in the HYP-only strategy. In a market downturn, here either the management of your high-dividend shares either continue to pay a growing dividend possibly to the detriment of the business, or they cut the dividend and your income and you are forced to sell equities at a low.

  • 14 dearieme June 24, 2013, 12:18 pm
  • 15 The Investor June 24, 2013, 1:59 pm

    Interesting comment from “ivanopion” on this subject on another post:

    http://monevator.com/diy-investor-retirement-family-sos/#comment-590698

    I may ask if he can chime in here.

    Not conclusive of anything, of course. But I don’t think this planning really can be 100%.

  • 16 ivanopinion June 24, 2013, 3:00 pm

    I’m not sure I have much to add over the post linked to by The Investor and the posts already made on this thread. But it’s nice to find some other thoughtful people who have obviously looked into this in some depth and come to the same conclusion as me in relation to income investment trusts and their use for retirees whose primary objective is sustainable (i.e., growing) income.

    The record of ever-increasing dividends for 20, 30 or even 40 years is quite seriously impressive. If they can survive the various crashes in the market that we have experienced over several decades, I think this is as close as you’re going to get to a sure thing.

    It was lucky that we ended up re-evaluating the portfolio in 2009, at a time when the likes of City Of London IT were yielding nearly 5%. We missed the first part of the recovery in 2008, but we also missed the crash in 2007/8. But this is still a good strategy to implement today, as long as the current yield will give you the income you need.

    There’s some excess income which I’m reinvesting. As it is excess, I have taken slightly more risk and put it into some ITs with shorter records, such as JP Morgan Emerging Markets Income. But >90% of the portfolio is in ITs that have increased their divs every year for at least 20 years.

  • 17 ivanopinion June 24, 2013, 3:15 pm

    The biggest risk with using income investment trusts is, in my view, the risk that even though the trust is managed very conservatively in order to minimise the risk that the dividends might ever be reduced, they might not keep track with inflation. As far as I understand it, the trusts that have totted up several decades of ever-increasing dividends (City of London, Merchants, Bankers, Alliance Trust, and so on) have not necessarily managed real terms increases every year. This perhaps partly explains why an investment trust like Alliance has managed to increase the nominal value of its dividend every year for 46 years and yet still only has a yield of 2.6%.

    In practice, I’m reasonably comfortable that even if inflation took off and dividend growth did not fully match this, these trusts would not fall too far behind. In practice, I think they are pretty close to being equivalent, in income terms, to an index linked annuity, but with the advantage that you (or your heirs) get to keep all of the capital and any capital gains.

  • 18 The Investor June 24, 2013, 5:59 pm

    @ivanopinion — Thanks for chiming in here.

  • 19 SG June 24, 2013, 9:13 pm

    Just thought I’d chip in again to make a fairly obvious point that is not usually catered for in the drawdown research per se (though many commentators acknowledge it).

    If you were in fact deriving a big chunk of your retirement income from investment returns and drawing off a regular “income”, then when you saw your assets tank, you would most likely batten down the hatches to weather the storm by reducing expenditure. In other words you would have an automatic ameliorating strategy. In fact, in this scenario, an existing frugal lifestyle would be quite a handicap.

  • 20 Roger June 24, 2013, 10:32 pm

    Methinks the pain is due more to poor asset allocation than the 4% draw down

  • 21 Dave June 25, 2013, 4:44 am

    This is a bit off the main topic, but I had a quick look at that Wikipedia entry on the Modigliani-Miller theorem and within the first few lines I read this: “in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market”.

    That reminds me of a physical chemistry lecture I once sat through in which the lecturer spent about half an hour deriving a formula for a property of an ideal gas from first principles, then said something along the lines of: “but at the beginning we made an assumption which is never true in a real gas, so this formula won’t work”.

    I suspect that the assumptions made in deriving the Modigliani-Miller theorem might make it equally useless when it is confronted by reality, so I didn’t bother reading any further.

  • 22 Grumpy Old Paul June 25, 2013, 9:42 am

    I don’t yet use Investment Trusts largely because of lack of knowledge. But, asset allocation is surely just as important with ITs as any other investment vehicle. Yet I never see it discussed.

    I’ve looked at a few ITs that have been mentioned and notice that many of the UK Income trusts a) Have a hefty proportion of their portfolio taken by the 10 highest holdings and b) Have a lot of commonality between trusts within their top 10 holdings. Therefore if you just buy 4 UK Income trusts with a good track record of increasing dividends, there is a risk that you are grossly over-exposed to the fortunes of a handful of companies.

    Can anyone enlighten me as to what happened during 2007/8? Were leading ITs over-exposed to the banking sector and, if so, what happened to the yields and value ?

    Suppose a bubble develops in the share price of high-yielding large companies and there is a strong sectoral bias followed by an unexpected hit to that sector such as ‘class action’ litigation in the US. Dividends can fall as well as rise.

    I am willing to be convinced but am cautious. Once retired, most people can’t afford to make big mistakes because they don’t have the capability (and later on, time) to recover.

    A word of warning about performance statistics at the moment. 10 year statistics are impacted by the massive market drop in the lead up to the Iraq war. 5 years ago, markets were already 20% off their peak although they had a lot further to fall.

  • 23 ivanopinion June 25, 2013, 11:15 am

    What happened in 07/08 to the sort of ITs I listed is that they continued to increase their dividends. There’s an analysis here:
    http://www.theaic.co.uk/aic/news/press-releases/investment-company-dividend-heroes-1

    Yields rose, because the share price fell and dividends did not.

    I do agree with you about over-concentration, though. But you can see from the analysis that it includes several ITs with a global mandate, such as Bankers and Scottish American.

  • 24 ivanopinion June 25, 2013, 11:35 am

    BTW, that analysis shows that these trusts are not just increasing their divs by tiny amounts each year, to preserve their record of increasing every year. They seem to have increased by between 80% and 120%, over the least 10 years. That’s well ahead of inflation.

    Of course, we all know that past performance is no guide to the future. However, there comes a point where past performance has been sustained for so long that I think it is reasonable to assume that it is probably a pretty good guide. In the absence of any better guide, I choose to take the tiny risk that one day there might come a crash that is big enough and long enough that these trusts can no longer keep hiking their divs.

  • 25 Grumpy Old Paul June 25, 2013, 11:56 am

    ivanopinion,

    Many thanks for the link and your views, which I find persuasive. The dividend statistics look pretty impressive. I think at my next rebalancing I’ll dip my toe in the water with two or three UK Growth and Income Trusts and see how it goes. The combination of the AIC website and Trustnet should provide enough stats to help me with my selection.
    Within an ISA especially, a portfolio of ITs looks like a good potential source of additional income in one’s dotage.

  • 26 The Investor June 25, 2013, 12:20 pm

    @GrumpyOldPaul — As ivanopinion has explained, equity income trusts have long been a rare unpolluted pool of quality in the murky waters of active investment. You might want to check out this article I wrote a couple of years back.

    However beware that most are currently trading at a premium to net assets. You can definitely get them cheaper sometimes, if you’re patient!

    Also, while I like the vehicles, they’re not a magic solution to living off income instead of capital drawdown. As discussed earlier, you could live off investment income perhaps just as well by using passive products such as the Vanguard Dividend Aristocrats ETFs, or even if you’re sufficiently wealthy normal index funds (the snag being lower starting yields). You would also of course include fixed income etc in your mix. By creating a cash buffer (that’s same link — really think it’s relevant!) to smooth payments from the underlying assets, you’d create the same sort of safety buffer that you pay for with an equity income IT.

    That could be attractive for anyone who understandably can’t get past active fees (though most big ITs in this sector sport relatively modest TERs), and would also get rid of the risk of under-performing the market. You’d still suffer if dividends were slashed, of course, although your buffers would help.

    The biggest hurdle for 90%+ of people to living off income is going to be insufficient capital.

  • 27 ivanopinion June 25, 2013, 12:32 pm

    @GOP

    As long as your main objective is a reliable income stream, then some income investment trusts are well worth consideration. That was the decision I made for my mother-in-law. For me personally, I’m some years of retirement, so at present I have not invested in income investment trusts, as I am more interested in growth. That’s not to say that income investment trusts would not necessarily provide good growth, particularly if I were to reinvest the dividends, but I don’t think the evidence is as strong in favour of using them to generate growth.

    You may already know this, but just in case you don’t, some of the things to watch out for are the expense ratio and premiums. Some investment trusts have very low expense ratios of perhaps 0.5%, but many others are considerably higher than 1.0% and are therefore quite costly in comparison with clean classes of unit trusts.

    Many of the best investment trusts tend to have a share price at a premium to the value of the underlying investments. If you are investing in order to generate income, then perhaps it is not worth worrying about a small premium of 1% or 2%, but if you expect to sell the shares at some point in the future, then the premium might put you off.

    If you are in no hurry, I would wait until something happens which causes prices to fall and a bit of panic to set in, because this will have two beneficial effects. First, it will mean that the yield will rise. Second, it might mean that the premium becomes a discount, so you get to buy the shares at less than the value of the underlying investments.

  • 28 ivanopinion June 25, 2013, 12:44 pm

    Note that although the yield of an IT like City of London can go up and down, this largely reflects fluctuations in the value of the shares of the IT. (If the value increases, and the dividend stays the same, the dividend is a smaller percentage of the value of the share.) However, the yield you are receiving as a percentage of the amount you originally invested will only fall if the dividend per share falls.

    If the dividend per share increases, then the yield on your original investment increases. I don’t know what yield City of London was paying in 2001, but let’s assume it was 3%. Since then, the dividend per share has increased by 83%, so the yield on the original investment has increased to 5.5%, which is pretty tasty. If the dividends had been reinvested since 2001, the number of shares would probably have grown by about 50%, so the yield on the original investment would probably be about 8% by now!

  • 29 Grumpy Old Paul June 26, 2013, 10:22 am

    @ivanopinion, @The Investor,

    Once again, many thanks for your advice and ideas. I’ve noted for my next rebalance your observations re Investment Trusts:

    a) Not a panacea
    b) Should be part of a portfolio with a defined asset allocation
    c) Be aware of over-exposure to individual companies
    d) Watch for high charges
    e) Best to buy when fear stalks the land and prices are lower, trusts trade at discounts rather than at a premium to NAV

    I’m also concerned about geared trusts which I’ll probably avoid and liquidity. Anyone got any ideas about how to assess the liquidity of ITs?

    I’ll also be considering:

    a) Past performance
    b) Manager’s tenure, track record and age
    c) Volatility
    d) Price fluctuations during current market instability
    e) Size of trust

    I’ll probably be plumping for UK Growth & Income sector ITs.

    I seem to be tinkering more than I should but as new information and better investment vehicles becomes available, I believe it to be justified. I keep models of previous portfolios on Trustnet so that I can see whether my tinkering is doing any short-term harm. I also document the rationale for all changes I make. This helps me to keep track of how much fine-tuning I perform and to maintain a consistent approach.

  • 30 ivanopinion June 26, 2013, 12:06 pm

    I suppose you can assess liquidity by looking at the underlying portfolio. If the trust is invested in listed securities, it is probably reasonable to assume a good level of liquidity. If it is invested in unlisted shares and private equity funds (such as Caledonia), then liquidity is probably lower, which probably explains the large discount on their shares.

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