Are We All Being Too Cautious?

In our retirement planning, we automatically play it safe. We scale down average growth of 7% and instead plan on spending 4%. We try to pay off a mortgage to own our homes outright, only to leave a legacy. And we are often shy of including our state pension in our calculations.

What if we look at the average case instead? With all the safety margin stripped out.

Let's say that I want to retire with £20k annual spending, and live with my partner in a £300k home. I'm 54, so I'll get my full state pension in 14 years.

We would normally start by saying I need £20k x 25 = £500k invested to give me an income. But hang on, if the "x 25" part of that is reflecting a 4% safe withdrawal rate, in this "average case" example don't we need to change the numbers to account for 7% average growth? That means (...plays with calculator...) we need "x 14.3". That would mean a pot size of £286k instead.

Furthermore, with state pension kicking in to provide £12k income in just 14 years, a part of that pot won't be needed. This is harder to calculate, as it involves a dwindling pot. I'll need a compound interest calculator for this. 

I'm aiming to figure out what starting pot size I need for 14 years of £1k per month withdrawals at 7% growth, for this bridging fund until my state pension kicks in. On top of that I'll need a second fund of £8k x 14.3 = £114.4k for that ongoing top-up from a state pension level retirement to a £20k spending retirement.

I'll ignore income tax in these calculations, since it is likely to be negligible. If I'm using a personal pension for most of this saving, £20k of income may mean under £700 per year of income tax.

Here's the compound calc result:

It thinks I'll need a pot of £107k for the heavy lifting part of the plan. 

£107k + £114.4k = £221.4k investment pot needed.

Finally, there's the house to pay for. Here there's another way to pare down the capital needed. We normally project to have our house paid off, leaving the capital in it as a safety margin which could be used for equity release or as a legacy after we're gone. Let's juice it instead.

We can use equity release to free up a maximum of 70% of the capital in our home. For ease of maths let's call that 66% and say that I only need £50k invested in my half of the £300k house. 

All together this means I need a net worth of £271.4k to retire at 54 with a £20k spending level. 

We had started out thinking I needed £500k invested + £150 house equity, so a net worth of £650k.

Remember, this is an "average conditions" plan. We've been applying a safety margin of 2.4x to our plans.

Conclusion

Certainly there is some safety margin needed. We could hit a poor sequence of returns with a stock market crash early in retirement. Or we could have unplanned spending, such as care home costs, which eat into the pot enormously. And certainly juicing the house equity won't suit everyone. But this does go to illustrate how much padding we normally apply.

If your numbers are anything like approaching these ones, you may be reassured to learn that you're actually finished with building your necessary pot of net worth, and are on the final task on adding the safety margin.

Want to read more of my ideas? I have a new book out - Build Your Retirement, 5 ways to improve your wealth in retirement.

Better than Bonds

Although bonds give a terrible return compared to stocks, the traditional advice has been to hold lots of them. A "traditional" portfolio contained 60% stocks, 40% bonds. Or you would be "lifestyled" into bonds gradually as you approached retirement - with some pension companies starting that process as early as your twenties (I'm looking at you, Nest!). 

That gives one hell of a dent to your performance. Why do it? What were people afraid of? Well, it comes back to the big problem with the stock market - its volatility, and the possibility that you retire right before a crash that then lingers for years with subdued prices and no returns.

The logic ran that bonds would tend to react in the opposite way to stocks. When stocks crashed, bonds would bounce up, providing a counterbalance which would smooth away your volatility.

The elephant in the room was this whopping 40% of your portfolio which was doing nothing the rest of the time. You needed far more stocks in order to be able to retire, which led to working for more years... a big mess, if you ask me.

Even worse, bonds now seem to be broken. That opposite action to stocks during a crash hasn't really happened during the most recent crashes. Ever since central banks took to printing money to get out of trouble ("quantitative easing") the bond markets seem wise to the fact that governments are trying to scam them, and bonds haven't bounced up as expected.

I think bonds are an awful thing to do to your portfolio (but then I am an avid owner), and this leads me to look for alternatives.

The Alternatives

There are three obvious alternatives to holding bonds continually.

1) Hold bonds short-term, whilst needed.

2) Go into retirement with a cash buffer.

3) Flex your spending.

The logic to each of these will become clearer if we have a look at the actual risk we're trying to manage...

Bonds are a blunt instrument to deal with "sequence of returns risk". This means the risk that a stock market crash comes along soon after you retire and wipes out enough of your portfolio that your drawings cause damage from which it will never recover.

We try to guard against this risk, to a degree, by applying a safety margin to our drawdowns. Earnings and typical growth are about 10% per year, and of that we start by leaving in 3% to cover inflation. We could theoretically go out and spend the remaining 7% each year forever, but in fact we play it safe and try to draw just 4%. This jiggle factor is an attempt to account for the stock market dips which come along all the time. And this'll work, with normal run-of-the-mill dips. 

If the big one comes along, and prices stay subdued for a number of years (instead of the more common profile of a crash which sees a recovery within months), then this may not be enough. We will spend years withdrawing an effective higher rate than our safe 4% and perhaps higher than our actual 7% of earnings.

Conversely, if we get a few "normal" years after we retire, the difference between those 7% earnings and our 4% spending starts to add up and our portfolio grows. Our withdrawals reduce, as a proportion of this now larger pot, and over time a 4% withdrawal rate turns into a 3.5% withdrawal rate. If we were to encounter a bad crash now, we are much safer. Few crashes would ever have wiped out someone using a 3.5% withdrawal rate.

Let's take a look at those three solutions.

Bonds - in the short-term. The usual way to do this is to create a "gilts ladder". Gilts are UK government bonds, and you can buy short-dated ones which will pay out in a matter of months. You still earn a little on them, but they're safe as houses. I could buy one which matures next January, another one which matures next April, and so on, to build myself a series of dollops of income which will drop every few months over the next couple of years. By using these I'll not need to dig into my main portfolio for income, or at least not much, and I'm still holding an asset which earns me at least some return in the meantime.

A cash buffer. This works in a similar way - I'd move a chunk of money from stocks and into cash, which earns me some interest but ultimately it's safely waiting there to be spent.

Flexible spending. This one works well if your retirement plan includes some excess over and above your core spending needs. With flexing you leave the money invested in nice productive stocks, and you say I shall reduce my spending whenever the market is badly down. If your original withdrawal rate was 4% and then in a crisis you are able to cut it to 3.5% or 3%, we're back in extremely safe territory where few historic crashes would have killed a portfolio.

Which is best?

I like any solution which only takes you out of a full allocation in stocks on a temporary basis. In practice, probably a combination of some of these approaches will appeal to most people. Flexing certainly fits with our natural instincts during a crash, to draw our claws in and halt unneccessary spending. A cash buffer or gilts ladder brings some certainty of income. (Though it is unclear whether continually topping up a buffer once retired would bring any further benefits.)

The main thing is that you don't feel that you must automatically abandon your stocks and buy bonds permanently. There are good alternatives which can be used instead.

The £30 a month retirement plan

I recently made the mistake of reading the comments on a newspaper story about financial independence. The trolls were wallowing in their self-imposed misery, saying that it's all very well for rich people, blah blah blah. So I thought that I'd take a look at how very ordinary people can make a difference to their retirement.

I looked at what it would take to boost an ordinary, state pension retirement by 50%.

In case you'd like to play along, this was done using the compound interest calculator here: www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php

A full State Pension gives you just about £12k income, and it looks like it'll begin at around age 68 for most of us. Under the current rules, that will basically use up your tax-free Personal Allowance, meaning that any additional income is likely to be taxable. This gave me the target of £6k extra income, after tax, to find.

£12k a year sounds pretty meagre to me, and boosting it to £18k sounds like it would make quite a difference in lifestyle. I think it would make the difference between a couple running a car and going on some holidays, or using the bus and struggling to afford any travel.

We'd need a little more than £6k, to account for income tax. Let's work out roughly how much. Maths isn't my strong point so a bit of trial-and-error is required here for me to estimate that £7k is needed. Here's my reasoning. If this income is coming from a personal pension, 25% of the withdrawal is tax-free and then the rest will be taxed at 20%. £7k - 25% leaves £5,250 to be taxed at 20%, meaning £1050 of tax coming off the £7k to leave about £6k.

If we use a safe withdrawal rate of 4% per year, we'll want a retirement pot saved up of 25 x £7k, or £175,000.

Time to fire up the compound interest calculator to see what it will take to reach that target, using some more trial-and-error.

I'm assuming someone begins earning at age 20, so they have 48 years of saving and compounding, to take them to age 68.

My assumption here is that they'll invest in a global index tracker fund, giving them the market's average return without the risk of investing in individual companies, so that they don't have investing decisions to make.

Ignoring inflation, so that we can keep everything in today's pounds (to make the spending figures make sense to us in terms of buying power), these index funds have given a long-term average return of 7% per year.

£30 per month invested into a SIPP will give an additional £7.50 from the government - we get our income tax money back on pension contributions.

Over our 48 years that monthly contribution builds into a total of £177,878. And just look at the chart to see how much of that total is actual contributions from work, and how much is from compound growth - ie money that we haven't had to go out and earn! 

Long time coming

More than 80% of the pot has come from compounding. This just goes to show the power of time with compounding, and the advantages of an early start.

Unfortunately, most of us aren't starting from age 20. We have less time for compounding, so we'd need to throw more money at the problem to reach the same result.

I realise that some people struggle to make ends meet through no fault of their own, but I think most of us would be able to find £30 a month if we set our minds to it. Many of us fritter considerably more money than that on things which we don't particularly value. But this is the cost of a more comfortable future. I think it's a pretty reasonable sacrifice to make.

In fact, these are the sort of numbers which the government have in mind with auto-enrolment into workplace pensions. They want to give us the nudge to save for our own retirements, not at any particularly high level, but just this sort of boost from £12k a year to £18k, where we will be looking after ourselves a bit more.

Unfortunately that has been done poorly, with a lot of our money misdirected so that the typical workplace pension doesn't give anything like as good a return as a simple global tracker, and the people miss out on much of that power of compounding as a result. But that's a soap-box for another day.

I think that most people reading this will be throwing considerably more energy at their retirement than £30 a month, and they'll be seeking an earlier retirement than at state pension age. But the next time someone grumbles "it's all right for the rich", remember what a small step like the one illustrated here would achieve. We can all make use of the power of compounding, in order to secure a better future for ourselves.

Want to read more of my ideas? I have a new book out - Build Your Retirement, 5 ways to improve your wealth in retirement.

The Two Pot Stratagem*

This is an idea I've been kicking around for a while, with the aim of freeing people from some of their fear of spending from their portfolio. 

The problem with using a normal portfolio is that we have a tendency to chase safety. We look for the lowest withdrawal rate which, historically, has always been successful.

However, success is not always about holding onto our money. It is also about getting to use that money to live out our dreams - having fun experiences, seeing loved ones, etc.

And sometimes we are too careful, after years of conditioning ourselves to save and invest, to spend this money.

Here is my solution. Two investment pots. Your "core" pot can be as safe as you like. Go the whole hog and draw a measly 3% per year, safe in the knowledge that nothing can ever hurt you. Your core living costs are covered, and by this I mean the utilities bills and the groceries, plus your "normal" minimum social spending. This pot needs to pay for everything that you'd want to spend even during a stock market crash.

Then create a second pot, for "fun" spending. Adventures, travel, a new hang-glider - whatever floats your boat. And go crazy with it - withdraw 10% a year. Or perhaps 8% or 12%. This is the spare money for fun things, a pot of money which you want to be sure to spend during your active lifetime. 

This started life with my desire to travel during retirement, before I expect to slow down, which will perhaps be in my 70s. I wanted to create a pot which needed to be spent - I wanted the experiences, not the capital preservation. I wanted to burn through it during the first years of retirement, at a rate which meant it would be exhausted at about the same time that I slow down.

With that in mind, maybe 10% isn't the right figure for you. I just played with a compound interest calculator and figured that, on average, a 10% withdrawal is likely to exhaust the pot in around 13 years. If you anticipate more years of active retirement, shoot for a slightly lower figure.

For ease of maths, you could hold your core pot in one global index fund, and your fun pot in a different global index fund. Then you won't have any doubt about which units are allocated to which fund.

Inflation handling

As usual, start out retirement with a chosen percentage withdrawal from your pot, giving you an actual figure in pounds. Then each year you do not then withdraw that same percentage from whatever the pot has grown to! Instead, you take your pounds figure and apply an inflation increase to it. If you began with £15k and inflation has been 3.5%, you can withdraw £15,525.

Apply your inflation increase to both pots.

Risk

What happens during a crash? Do you need bonds for a rainy day?

Your core pot, at a 3% withdrawal rate, is safe. No, really safe. It would not ever have run dry in the history of the world. If there's a crash, you can keep on drawing. (Which is fortunate, because this doesn't contain much elective spending - this is all necessities.) Your withdrawal rate may temporarily peak at 5% or 6%, but you've been cautious along the way and should have plenty of padding in here to help it cope.

With your fun pot, you need to remember that when it's gone, it's gone. During a crash, this is the pot which you can easily protect, by reducing your withdrawals.  It's entirely up to you what rule you choose for cutting withdrawals - maybe halve it during a dip of up to 20% from the recent high, and cut the fun spending to zero during a deeper crash than that. Equally, during the normal years and good years, you can afford to spend some of the actual growth and capital. You don't need to use a wiggle factor and only draw part of the pot's earnings - no 4% from 10% growth.

Overflow

Your core pot will probably grow a lot. In an average year, you'd be spending less than half of the growth. (Average growth around 10% including inflation, around 7% net of inflation.)

Some of this padding is necessary, and it is what keeps you safe. But there comes a point where your actual withdrawal rate is dropping, in terms of your current pot. Let's say you begin drawing £15k a year from a £500k pot. Then let's say you have a great year and the fund doubles in size. Your £15k now represents a mere 1.5% withdrawal rate from your actual £1M pot. (Or your inflation-adjusted £15,525 is a mere 1.55% from your £1M pot.)

This actual withdrawal rate is too low. If you were starting out your retirement today, it's too cautious a figure, and you could safely spend more.

Here's where the overflow pipe comes in. Each year, you set a minimum withdrawal rate. Maybe a reasonable minimum would be 2%, that's allowing 50% growth in your pot size. If the pot has grown so much that your withdrawal rate is lower than this, well, you need to shift some of the money into your fun pot.

You can either actually sell one fund and buy another, or maybe it would be simpler to just withdraw the overflow to spend.

This is true excess wealth. You may already be living the life you want, in which case maybe this is the point at which you begin to address any other priorities that you have in the background - gifting to the next generation, or supporting charity.

(Your fun pot doesn't need an overflow, because in there, every day is already party day with a high withdrawal rate that is close to typical growth rates.)

Conclusion

You don't need to use a separate platform or account for your second pot. You can just do this in your current SIPP or ISA, simply by owning a second index fund. To take inspiration from the funds suggested on Rebel Finance School, you could have Vanguard FTSE Developed World Ex-UK as your core pot, and Vanguard FTSE Global All-Cap as your fun pot.

If you are struggling to allow yourself to spend, after years of frugality training during your accumulation phase, maybe this idea will help?

* I like the word "stratagem". It sounds like a cunning plan from evil aliens in a 1970s Doctor Who story.

Want to read more of my ideas? I have a new book out - Build Your Retirement, 5 ways to improve your wealth in retirement.