SWR 4%: An Investigation. Month 5

Recap

Back to the beginning.  It’s now a whole five months into the experiment where Mr Z in Parallel Universe Number 1 pulled the trigger on early retirement.  This is a completely fictitious portfolio and just a little experiment for me, hopefully giving some insight on what it would actually be like through the ups and downs of living off an investment portfolio.
Each month I am going to assume that Mr Z has lived true to his word and spent every penny of his last drawdown and is ready to drawdown once again from his retirement fund, bang on the end of the month.  The drawdown is assumed to be taken from the overweight allocations.

This should be prudent, as in reality you would cut back when the markets are down, you may have some months where you do a little bit of work and get a little bit of side income, you might not spend the full withdrawal amount, etc

At the start of this experiment the fund was £625,000 split 75% to equity and 25% to cash and bonds.  That should be enough to withdraw £25k a year (and increase this annually along with inflation) if the 4% Safe Withdrawal Rate is to be trusted.

A couple of people asked if a yearly withdrawal into a cash position would be a better, or more normal, way of doing things.  Perhaps and certainly a cheaper way to do it.  But the point of this wasn’t to find a perfect withdrawal strategy, asset allocation or even anything to do with 4% really.  It is more to see how it would pan out, blindly following some mechanical rule, that happens to be a 4% withdrawal rate.      

Position at 31/5/2015
At the end of May the position of Mr Z’s portfolio before any drawdown, would be;


Things are bouncing around for Mr Z and overall the portfolio is back up nearly £7k before any drawdown.  All positions up at the end of May with cash up the most due to a yearly distribution from the LifeStrategy Fund.

Income
A doozy of a month on the income front;
– £2,545 from the LifeStrategy Fund (VGOV)
– £183 income from the U.K. Government Bond UCITS ETF
– £44 in interest on a Cash ISA.
All of the funds are the income type and so distributions are assumed to be paid into the cash account before we look at any withdrawal.

Withdrawal
We will follow some mechanical rules, based on the initial asset allocation of 75% Equity and 25% Bonds&Cash.

Any distributions will be taken directly and then any remaining withdrawal will be taken to re-balance towards the 75:25 allocation with any dealing costs picked up by poor Mr Z himself out of his £2,083.  This should then skim off any parts of the portfolio that are doing well and hopefully give any flagging parts of the portfolio catch up while avoiding drawing on capital unnecessarily.


There is enough in income this month due to a chunky annual distribution from the LifeStrategy fund, so there would be no selling of units to generate the adequate income in the month.  
The remaining portfolio
Following withdrawal the portfolio looks like;

An easy month, with distributions covering the withdrawal amount for the month.  Would be far easier if it was like this every month.  If the income would cover the expenses each month, but it is hard to achieve a yield of 4% without taking on a fair amount of Ye Olde Riske.

So, in the current environment, that would leave you with the choice of selling down capital or reducing the withdrawal rate and so increasing the amount of capital you would need to hold.

Some musings on income

In the current low interest environment it hard to get a yield of 4%, without taking a lot of risk.

My personal plan during accumulation is to utilise the easy diversification offered by global tracker funds, throw in some emerging market and small-cap trackers, combine with some cash/bonds and then largely leave it.  Combined with some occasional rebalancing I’m hoping that this will offer me the best chance of generating a sufficient total return.

At some point I will need to make a decision on what investments I will be using once the ‘drawdown’ phase is reached.  

It would sure be nice to cover expenses with income alone, with a bit of a buffer on top.

Options could include;

Annuitisation 
Considered bad value currently, but with gilts offering such low yields at the moment (the typical assets that would back these insurance products) that’s no surprise.  Who know’s where these products will be in 10-15 years time, I do think it is an area that will be developed over the next few years following recent pension freedom.  Variable annuity type products could take off and perhaps become the next with-profits whirl wind.      

On a single life RPI linked annuity with a 5 year guarantee you are looking at c£2.2k a year on a £100k, so 2.2% +RPI.  Seems expensive, but that is reflective of increasing longevity and shitty risk-free rates available.  

It would be awesome (in a massively sad way) to be able to annuitise against a basic level of living expenses, say £10k a year.  You run the risk of croaking it just after purchasing the annuity, to the massive profit of the insurer.  But it would provide a base level of stress-free income and free up the other capital for more risky ventures, like stock picking or bear wrestling.  

At todays rates, £10k of annual annuity income would need around £465k of capital to invest, which does seem expensive.


A high yield dividend approach
Either in a fund/ETF format or through selecting individual stocks myself.  But despite what the current dividend investing hype seem to suggest, the dividend income on a certain stock isn’t guaranteed each year just because a company has paid a dividend for the last 20+ years.  I think it is more risky than many give it credit for.  Not that it is the wrong approach 🙂
I also have a certain distaste for the assertion that investing in a global tracker is the route for the financially illiterate and once you have done your learning the more active approach is better.  But that’s for another time perhaps.
Unlike choosing a few trackers and being done with it, it is a more interesting approach.  It provides a narrative to the process if you have chosen individual stocks yourself.  If used in the accumulation phase as well it does provide a real measure, and far less volatile than the capital return of the markets in general, of how far you are along the yellow brick road of Financial Independence – “Oh hell yeah, dividends this month covered 50% of my expenditure”.
But as an approach to income that I could rely on?  Certainly not by itself, in isolation it feels too risky, selecting individual stocks from an already depleted set (i.e. from only dividend paying companies).  As part of a more diversified approach?  Sure.
It’s hard to remember that not too long ago relatively safe gilts and bonds provided a nice real yield.  Currently bonds seem to be over priced and offer a crappy yield.
Directly purchasing bonds provide a fixed income but are still exposed to interest rate risk and inflation risk (if they are not index linked).  At the moment I can’t bring myself to buy into a bond exposure despite the diversification benefits.
But in 10-15 years time things will no doubt be different and hopefully bonds or bond funds will offer a nice source of stable income.

Active income funds
You could choose to invest in active funds that are focused on providing an income, leave it to the professionals while you swan about drinking gin and chasing seagulls.  There is no guarantee that the fees you pay will be justified as it seems choosing a good active manager is as difficult, if not more so, than choosing a good individual stock.
Diversification would seem key here, both in terms of a number of active funds and as part of a diversified portfolio.  Still, not one for me.

Rental property
It’s a ‘real’ asset, and for many that is enough to convince them that is is safer that it is.  Lots tend to underestimate the costs and time involved.  And I suspect that I would too.
But people do make this work, including the wizards that are Mr Money Mustache and the Financial Samurai, as part of a portfolio to provide income to fund their Financial Independence.
I had a look into the possibility of keeping our current house when we move on as a buy to let, but it didn’t look to offer a particularly amazing yield.  And the idea of having so much capital tied up into one nondivisable asset that can suffer from damp didn’t seem great.
Still, this will be one option to keep looking into.

Drawdown
I could leave my fund in a broad allocation of somewhere between 50% equity and 50% bonds & cash or 75% stocks and 25% bonds&cash.  Rebalance once a year (or every 2-3 years), use my cash holdings to live off and trust the markets to do their thing.
Only I suspect many people wouldn’t trust the markets and would spend a lot of their free time gibbering over daily charts.  The prospect of having to sell down capital does seem fraught with stress and anxiety.  Potentially not the freedom I’d be hoping for.  Freedom from The Man at work straight into the shackles of Mr Market, arguably more a schizophrenic master.  

Flexibility would be key here, if your drawdown was at the absolute minimum you could live off and you had nowhere to go if things went south, it would be a strategy that could leave you sleeping under a bridge in the sour years.  A larger drawdown amount (not percentage) with flexibility to be reduced in the lean years would be the way to go.

Jlcollins has a well thought out article on the subject here, with some good comments as well.  Well worth a read.

This is the way I was thinking of going, with a portfolio largely dominated by a world equity tracker and bonds.  I still struggle with the withdrawal rate. Some claim 4% is fine as long as you are flexible and others take a much more prudent approach, say 2.5%-3%.

Rebalancing into income producing assets
As we batter our way forwards towards Financial Independence it is an accepted principle that not only do we rebalance periodically towards our ideal asset allocation but our asset allocation itself changes to reduce exposure to riskier assets.  So we typically look to increase our cash&bond holdings whilst reducing our equity exposure.  

Makes sense, we don’t want volatility that we can’t handle just as we start to rely on our capital for sustenance.  

But perhaps we need to start moving, away from assets that provide the expected return that we need to meet out capital goals, towards assets that provide the income that we want.  A slow shift towards HY holdings from a world equity tracker perhaps that could look something like;

The Start;

75% – World Equity Tracker & Emerging Market Trackers
25% – Cash & Bonds

The End;

30% – World Equity Tracker
30% – HY Portfolio
40% – Cash&Bonds

Time for work
Gone off on a little bit of a tangent and starting to over complicate things perhaps.  The best course of action for now, for my good self, is to stick to my plan and carry on saving hard for the next few years and see where we are.  

Any thoughts on how you are planning to change your asset allocation or what you will do to generate the withdrawal/income needed to live off?

Time to head to that (hopefully temporary) thing called work.

Mr Z

6 thoughts on “SWR 4%: An Investigation. Month 5

  1. thefirestarter.co.uk

    Interesting musing on the options for income there Mr Z!

    I agree with you on the "nose turning up" that index funds seem to get from more "advanced" investors. Now I am fully stating that I am not an advanced investor in the slightest but the overwhelming evidence seems to be that you cannot beat them by picking your own stocks so I don't really see the point in wasting my already very limited time attempting to do that. If Warren Buffett advocates them, that's good enough for me – http://www.telegraph.co.uk/finance/personalfinance/investing/funds/11390520/Buffetts-1m-bet-pays-off-as-index-tracker-beats-hedge-funds.html

    Also agree on rental properties. Way too much hassle, and I HATE damp! You could look at REITs if you wanted some low hassle exposure to properties. Also there is crowd funding companies like The House Crowd, I just invested £2K into that myself so will try to do a post on my thinking behind that soon.

    Cheers and hope work isn't too bad for you right now 🙂

    Reply
  2. weenie

    I continue to read your posts on this experiment Mr Z, even though I don't think the 4% rule will apply to me largely due to my defined benefit pension. However, I will at some point have to draw down on my investments and getting the right allocation will be important and likely to be quite different from my current allocation.

    The trackers I'm invested in are all accumulation so I'd be likely to switch those to income at the very least.

    Individual shares paying dividends are unlikely to form more than 20% of my entire portfolio ultimately, although I do like the idea of regular income in this way. However, as you point out, the income is not guaranteed but my trackers could go down as well as up, so I just see this as 'investment risk'.

    Reply
  3. MyRichFuture.com

    Very interesting experiment.

    Investment Trusts might be the way to go in retirement. But so too could be a 50% global equity trackers, 25% bonds, 25% equity income split. Maybe even as much as 50% just in bonds.

    There are so many strategies. It must be hurting your zombie braaaains…

    Reply
  4. Mr Zombie

    Thanks TFS, a bit of a brain dump.

    I wonder how many people confuse luck with skill.

    Yeah, damp is a bastard. The House Crowd does look interesting.

    Mr Z

    Reply
  5. Mr Zombie

    Yeah, I'm guessing that income funds would be a cheaper way to extract money.

    I think just trusting trackers to do their thing is a skill in itself, especially when it seems so simple. So I imagine I will have something similar, a smallish portion that I can tinker with.

    Mr Z

    Reply
  6. Mr Zombie

    Haha it sure is a pain in the brain. Choosing an IT would be as hard a choosing an individual stock… 50/25/25 could be a good way to go.

    Keeping it simple has to be a good thing!

    Mr Z

    Reply

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