Managing retirement income is like navigating a dark tunnel with only a faint light guiding you to the end.
When I started drawing retirement income 5 years ago it was daunting. I had accumulated three decent pension pots from employment with Citigroup and State Street and had chosen to consolidate them with Hargreaves Lansdown. I had chosen investment funds that gave me the widest exposure to global equity markets and had decided to largely avoid bonds. I invested in ‘absolute return’ funds to dampen market volatility and further diversify sources of investment return. And, I built up a ‘cash buffer’ worth 3 years of my retirement income requirements to protect my income in the event of a market crash.
I wanted to ‘do-it-myself’ and to keep costs down. Most articles I read, and all the risk warnings from the FCA, said that what I was doing was very dangerous. But I decided there were few experts around and no real Income Drawdown products to buy off the shelf (this is still the case).
Fortunately, my friend Mark Fawcett from the National Employment Savings Trust was always willing to swap ideas over a beer in the King’s Arms. At our Spring Forum earlier this year he also presented a very useful 5-point slide which I have followed. These are the lessons I have learned from my review of Five Years and counting:-
The investment core of my Income Drawdown portfolio has remained the same over the last 5 years: mainly equity index-tracking funds in the major markets with around 25% in more actively managed funds investing in smaller companies and emerging economies like India.
Lesson learned: As noted in this bulletin recently, it took me 5 years to realise that 1) the ‘absolute return’ funds were not adding investment return and that 2) with a large cash buffer and my focus on long term investment return, market volatility was not a risk that I was worried about. So in recent weeks I have been selling these funds.
In 2013 when I started to manage my retirement income, the amount of income that could be drawn from a pension pot was ‘capped’ by legislation. By coincidence, the amount of income that I felt Sue and I needed was just below the capped maximum and was equivalent to around 4% of the total value of the pot.
It seemed reasonable to assume a 5% investment return could be achieved from a portfolio of diversified equities and cash. Drawing 4% income should therefore see the pot stay at the same level or even increase slightly over time.
Lesson learned: I had decided that 4% was a prudent level of income before discovering that the experts were writing about a ‘4% Rule’ as mentioned in Mark’s presentation in 2018. I see no harm in claiming that I was an early advocate of this rule!
How have I done? This is difficult for the DIY investor to work out. Adjustments need to be made for income taken out of the pot and, in my case, the calculation was complicated by additional contributions into a new pension pot that I have since consolidated. The big investment firms have clever software that measures the ‘time-weighted’ investment return having adjusted for portfolio changes but this is not available to the DIY investor.
However, my rough calculations indicate that my investment strategy has achieved a 5% compound rate of return after fees and costs over the 5 years to April 2018. Gratifying as this was my original target!
By comparison, the FTSE 100 achieved a 3% compound return over the same period. HOWEVER, what I knew (but had forgotten) was that the FTSE 100 is a ‘price’ index that ignores the dividends paid out by the companies represented in the index. A much better comparator is the rarely quoted FTSE 100 Total Return Index (‘TRI’); this index has achieved a 7% compound return over the same period.
Lessons learned: 1) a reminder that Dividend Income – in the case of FTSE 100 companies, around 4% per annum – is a very, very important part of investment return, and 2) My high allocation to cash and ‘absolute return’ funds, together with fees, had a negative 2% effect per year on my portfolio performance.
As described above my Investment Strategy has been a highly diversified equity portfolio with over 10% allocated to cash and cash equivalents. Keeping a high ‘cash buffer’ has ensured I can draw income without selling investments regardless of what is happening in the markets. It has also given great peace of mind.
In the early years and as the stock market continued to recover from the financial crisis of 2008 I was happy to pursue ‘growth’ whether by rising share prices or the dividends that companies pay.
But, in the last 2 years I have switched out of some funds seeking price appreciated or ‘growth’ and moved into funds seeking ‘income’ from company dividends.
As part of this 5 year review, I added up the dividend income received over the last 12 months from the more dividend-focused portfolio and found that it was equivalent to nearly 2% of the value of the portfolio.
Lessons learned: 1) I don’t need as much cash as I originally held. With dividend income of 2% being generated every year, I can reduce my cash buffer by up to 50%. However, 2) starting Year 6 with a high cash balance has allowed me to drip feed cash into the stock market in recent weeks at much lower levels than would have been the case in the summer. I will continue to do this over the next 3 or 4 months.
5. Review Income
In recent weeks, I followed George’s example (see this bulletin dated 2nd November) and took all the income I was allowing myself in the current tax year in one payment. We were making a significant purchase in Spain. This income flexibility is one of the great benefits of the changes to Income Drawdown made by the Government in 2015. I will take no more income until 2019/20.
After a long Bull run, equity markets have been soft in 2018. The FTSE 100 is down 11.5% in the year to date. In the US, the Dow Jones Index is down 1.4% having reversed early gains.
Lesson learned: What may have worked so far will not necessarily continue to work into the future. Equity markets seem more uncertain now than at any time in the last 10 years, My intention is to be brave and focus on purchasing funds as the markets fall. I will increase my focus on dividend income rather than price appreciation. By harvesting more dividend income I can reduce my dependence on a large cash buffer.