When I was working, I got a steady income. As two decades rolled by The Firm shifted about 10% of pay towards an annual bonus predicated on a stupid bunch of metrics to reduce pensionable pay, I always treated such bonuses as windfalls for investment – primarily in reducing the mortgage or as ISA feed later on. So I lived off a steady income.
Reading Monevator’s post on investment trusts there is an assumption that retirees need a steady income flow. I’ve always made the same assumption, but on reflection I think this assumption should be challenged, because a retiree’s life is different to their working predecessor. Two things change in a big way:
No dependent children
Retirees don’t usually have dependent children under 18, though this assumption is probably more true for people coming up to retirement now that those planning it in 20 years time. In this country people tend to have children between 20 and 35, with a peak at 30 according to the ONS. People[ref]these people are women, the stats don’t track the guys[/ref] had children earlier in the past, often in their 20s in the 1960s and 70s. It surprises me quite how nonchalant some people aiming for FI are about phasing this. For all the joyful Kodak moments etc, most people don’t deny that children are a big financial cost, and the sooner you get started the sooner you’re done with it – and indeed you will enjoy their company for longer too. A 25-year old having children will be 43 when the child reaches 18, a 35-year old will be 53. For the common two kids with two or three years gap that spans 46 to 56.
There seems to be a recent tendency for children to remain financially dependent beyond 18[ref]The torygraph is pumping this up a little bit. In the 1970s many more children left school at 16 and could find decent jobs, it isn’t so surprising that more children were financially independent when they start earning at 16 rather than at 21 – 11% of school leavers went to university when I was 21 compared to about half now. It isn’t so much the dependent children at 25 that flabbergasts me, it is the late twenties to early thirties crowd[/ref]- if they are dependent through university these ages move to 46/49 and 56/59. The early starter will be more employable, while the late starter could be well finished at fifty and in trouble financially if they want to retire early. They will need more money compared to the early starters just at the start of early retirement, at a time when money is particularly short because they can’t use pension savings – the earliest call on a SIPP is drifting up to 57 from 55 now. There is of course the opposing case to be made that having children impacts one’s career early on so you might accumulate more by delaying. If you’re okay with slightly early retirement (60 and up) then this may work out well, as you are into SIPP territory then.
Lower general running costs including housing
One of the things that clobbered me in my twenties was moving so often from one rented place to another – the Guardian’s Jenn Ashworth griped about this but I also had 14 addresses between leaving home and this house. I preferred flat/house-sharing, but that gets less possible as time goes by, because your pals tend to pair up, work elsewhere and so on. The instability of young life is expensive – you can’t accumulate tools and kit and you are always having to adapt – one place has enough kitchen paraphernalia, another doesn’t, all this incidental Stuff adds up.
Then acquiring the first house – you need tools, you need to learn a modicum of DIY, everything is dear. I have all this stuff now – I don’t need new lawnmowers and saws and shit except to replace what’s worn out. With housing I’ve paid down my mortgage. The costs of running Ermine Towers is so much less than it used to be, because there’s little capital spend. Depreciation on a house is about 1% of the capital value or a bit more – if I factor in that about £2000 of utility falls off the house every year in terms of Stuff that Wants Fixing or upgrading it is about right, whereas renting it would cost £7000, though obviously the landlord would get to eat the £2000 operation and maintenance costs[ref]These costs are shockingly lumpy – you need about five years of savings to smooth the costs. Presumably this afflicts BTL landlords too, particularly amateur landlords with just one BTL property – the statistics improve as the number of owned houses rises[/ref]
When I left early I looked at what my pension was going to pay after working for 30 years for The Firm (I made nearly 24) which was half final salary and targeted that as The Number I had to make up. Half to 2/3 of salary was a typical assumption of DB pensions and presumably this came from some acknowledgement that retirees would not have some of the big costs of their working selves. Often the pension commencement lump sum was there to clear the mortgage, though along with the kids dragging on their coat-tails into what used to be considered adulthood is a knock-on trend for people to have bigger mortgages later in life.
Does all of this income need to be steady?
Up until very recently there was a big assumption built into the UK pension system that a pension needed to be steady – hence you had to buy an annuity on retirement. In Broke, I read that this was the historical way the middle classes dealt with the income on retirement problem – the destitute poor ended up in the poorhouse.
Of my pension income I’ve lost about 25% by leaving work 8 years early. Unthinkingly, I fixated on a target income set by other people a long time ago. I lost my way in the details, and accepted two hidden assumptions, simply because that was how retirement was meant to look. One was that the amount needed to be half my final salary, and the other was that this needed to be a steady income.
And then I went on a crash course on how to eliminate unnecessary spending between 2009 and 2012 because I wanted to get out and never have to work again. Freedom was that much more valuable to me than consumer doodads and rushed experiences. It was tough, but in that experience I learned what mattered to me and what didn’t.
I used the experience to drive waste out of my non-discretionary spending[ref]non-discretionary spending is on Needs, discretionary is on Wants[/ref], but there has been a corollary – it skews the ratio of discretionary vs non-discretionary spending upwards. The former is more than half of the total. I have no income, so I am running down some cash savings. If I knocked out some of the discretionary spend I can easily meet TFS’s £10,000 a year target – this is largely because of the reasons given earlier – my running costs are lowered by fossil savings from my working life, particularly in terms of housing. I don’t have to pay rent and I don’t have to pay 32% tax and NI on earning the money to pay for the rent.
Despite this I am going to invest in delaying my pension to secure a more fixed income, front-running it with a 5 year SIPP. The 5 year term means I can use cash for that rather than equities, which then takes me to the thorny question of my equity investments. They were designed to make up the difference, but my HYP has already reached the target amount thrown off as dividends[ref]This is because I won’t draw the pension early, so the difference to make up is less[/ref]. The surrounding globally diversified passive index shell I can’t qualify in terms of productivity – it increases my networth but it contributes little to my investment income. Theoretically you can take income either by natural yield (the principle behind a HYP) or by selling off units from a fund that is giving capgain, but the problem is ‘how much of this damned volatile capgain may I spend this year’ which is a tough call to make.
Greybeard describes one way of smoothing the income across the business cycle. This is attractive to me, but since it turns out my equity holdings are entirely aimed at the Wants and not the Needs I wonder if I need the stability. Because I am child-free I have an option not open to those who want to leave money to their children, and that is of taking a joint annuity in 20 years time. Annuities get better value when you take them older because they’ll be paid for less time. This would address the stability problem, I would be in my seventies.
On the other hand, I might want to leave money I haven’t consumed to better the world somehow. There shifting to investment trusts in 15 to 20 years may make sense – it is a low-maintenance approach, something like luniversal’s basket of eight would work. Yes, I would be paying something for the management and the income smoothing across the business cycle. But not paying as much as for an annuity, which destroys all the capital in the interests of a steady income.
These are not decisions I have to take now. In general, in finance, I’ve come to the conclusion that it’s best to keep options open. Things change over time, unforeseen shit happens.
After all, I wrote this before wandering through the park to go to the library to pick up a copy of Nate Silver’s the Signal and the Noise precisely because shit happened but it broke me out of a rut where I could have been spending the next six years at The Firm staring at screens and every quarter having to dream up meaningless crap and lies to keep the performance management system happy because the top brass decided to manage by numbers and wouldn’t trust my boss to know if I am doing a good job or not. After leaving, had I closed off other options drawing my pension early, I would have been sore when Osborne’s changes altered the landscape giving me the front-running opportunities I can take now. Options are good, as long as they don’t depreciate the asset too much.
Or split stable and volatile incomes – and spend electively going with the flow
There’s a case to be made that a retiree should look for lower volatility income for their needs, and let the wants go with the flow. On a 100% DC pension that might favour investment trusts (and later on an annuity) for the needs part of the portfolio, with a decent amount of headroom for the unforeseen rises – after all any retiree quitting now really ought to allow for an increase of about 10 times in the real cost of the oil price across a 30-year retirement, with a corresponding knock on cost in domestic fuel.
The wants part of your income could be invested with a higher equity exposure – anything from stockpicking to a world index tracker, and here you sell off units/shares each year to cover your next year’s elective spend. If the stock market goes through a rough patch then go on fewer holidays and more staycations, if it does well then salt away a bit to live larger in future and take more exotic holidays and eat out more. A retiree is in a great position to vary their wants spending according the the volatility of the stock market – to some extent you can also manage needs by shifting running costs along the Châteauneuf-du-Pape with caviar [ref]yeah, I know you’re a barbarian if you have Châteauneuf-du-Pape with caviar, but sod it, being your own person is one of the joys of getting older – if Jenny Joseph can wear purple and red then if you want to drink red wine with caviar just do it[/ref] <-> tap water and ramen axis.
This sort of thinking probably benefits the extreme early retiree – quitting the rat-race at 40 or mid-forties. If you can live with the volatility, and let’s face it most UK extreme early retirees had some connection with the finance industry so are probably better qualified for this than the likes of me, you can probably do better spending electively with the ebb and flow of the market than going for stability across the whole income stream.
Smooth the volatility with a 3 year cash pipeline
If you don’t like the investment trust option you can soften the ‘how much of this damned volatile capgain may I spend this year’ question by pipelining it through a multi-year cash buffer. The only indicator you have is the market value – tie your elective spend to x% of that[ref]where x is your SWR of choice – typically 4 to 5%[/ref] and one year you are partying in Sydney, the next you are in a tent in North Wales.
I could use a three-year cash buffer and drip x% of the market value in at one end and spend a third of the buffer each year – that would make a three-year boxcar average which would probably soften the worst hits (bear markets tend to fall faster than bull markets crawl out from the wreckage, but three years is a long bear market. Just don’t mention Japan, okay?). That would be a lot of dead money if this were three years of my entire income but if it’s a part of it that’s not so bad.
Does the three-year pipeline being in cash cost on average more than the investment trust premium? Say you start with £1,000,000[ref]to make the numbers easier, for illustration. Consider paying an IFA if you start with that much – your time is worth more than mine[/ref] Your cash buffer, at three years of 4% SWR is £120,000
After all, let’s say on average equities give a real return of 5% and you lose 1% to the extra IT costs giving you a 4% p.a. real return with no cash buffer, or a 5% return on 88% of your capital, let’s be charitable to the Bank of England and say inflation is 2%, so you eat a 6% loss on the 4% going through your three-year buffer as it falls out the end. You therefore have to put 12.7% into that buffer, so in reality you’re getting 15% return on 87.3% of your capital.
Each year on average the ITs turn your £1M into 1,040,000 and you get to spend the 40,000. With the buffer, each year your index funds returning 5% p.a turn your £878,000 into £921,900, of which you now take 4.2% to top up your buffer, leaving you with £885,000. Although I confess it wasn’t the answer I expected, you’re better off using the cash buffer and keeping fees lower, as your capital slowly creeps up in real terms or you could spend a little more. Over two decades this ends up in a doubling of capital reserves taking the buffer route as opposed to the IT route.
Of course you can spend your retirement opening a bazillion current accounts and yomp the cash through the latest best paying account du jour to improve the return/lose less to inflation. Or pass the cash buffer through Zopa and a couple other P2P joints – don’t reinvest what your borrowers pay back but keep adding every year – this makes a pipeline well suited to the 3 year term and you will get your money from 3 years ago back, with interest.
Decumulation is a bastard to get my head round. Initially I am going to decumulate cash, and that isn’t particularly challenging. In the equity part I can take the natural yield of the HYP section easy enough. But working out what to do with the foreign index stuff I’ve used to diversify the HYP isn’t clear to me at all, so far the 3 year pipeline through 1/3 Zopa 1/3 some other P2P operation and 1/3 cash 3year term account is the best I can come up with for that. Fortunately I don’t have to start doing this on equity savings for another 5 years, some clarity may come out of the murk by then.