The Pensioner’s Dilemma

by George Hatjoullis

An increasing number of pensioners are retiring with a pot of capital from which to generate some income. The investment opportunity set bears little resemblance to the one pensioners faced when the present crop started to save for their pension. Annuity rates have been crushed by longevity and low gilt yields. In any event, IHT considerations make annuities less interesting to the better off pensioner. So, what to do?

In the 1980s and 1990s I traded government bonds at a deep discount to par. For the uninitiated, fixed coupon bonds mature at 100. They are issued at or close to 100. The coupon is fixed, so if interest rates rise the current price of the bond falls to bring the yield on the bond in line with underlying market rates. Many of the bonds that I traded were issued in the immediate post war period at very low coupons. I seem to recall that a favourite for my own account was the UKT 3.5% 2004. I used to wonder what idiots invested in bonds at such ridiculously low yields. My experience was high inflation and double-digit bond yields. I could not imagine a world in which it made sense to invest in debt at such low yields. I can now.

It may make sense for someone to invest in, say, the UKT 6% 2028 but I am not sure for whom. The present yield is 1.38% and the price 151. So you are sure to lose 51% of your investment at maturity in 12 years. You cannot even treat this as a CGT loss. In effect you are withdrawing a % of your investment as income each year and paying income tax on it. It is effectively a fixed-term quasi-annuity. Not a very tax efficient way to earn 1.38%. Only institutions and funds with particular tax conditions can make use of this bond or perhaps it is the Bank of England as part of its QE programme.

So, does nominal fixed-income make sense for the pensioner retiring today? In the UK it probably does not. The Uk’s Brexit gambit has changed the inflation outlook. Sterling has collapsed and this constitutes an inflationary impulse of some magnitude. The big question is will this be damped or amplified? The changing labour and product market conditions implied by Brexit suggest there is a reasonable risk that it will be less damped than it might have been. It may even be amplified. In lay persons language, we may be seeing the return of inflation in the UK. The Bank of England has a target of 2% in any event and it has said it will tolerate an overshoot. The problem with overshooting is one can lose control of the situation. Nominal fixed yields of around 1.3% do not sound too exciting in this context.

What about index-linked? The UKT 1/8% 2068 is offering you a negative real yield of 1.76%. It may yet prove preferable to a nominal fixed income bond but it is hardly attractive. Bonds offer little joy for the current crop of pensioners and there is a danger that some cocky bond trader 20 or 30 years down the road will wonder what sort of idiot invested in them at such yields. So, what to do?

Two asset classes that offer nice yields are commercial property investment trusts and equities. The problem is that they are risky asset classes and hardly immune to rising interest rates. There is a somewhat imprecise prospect that they are a better hedge against inflation but in the short-run it may not quite work out that way. My 6 month ISA report tells me I have an average yield of 4.8%. The weights of my holdings are more the outcome of history than logic but the portfolio value seems to slowly accrue. The strategy has been to only consider adding stocks with yields over 3.5%. The drop in sterling has helped. There are two questions: what will happen to the value of the portfolio and what will happen to dividends paid if interest rates rise and long-term interest rates rise more than short-term rates?

I would expect the value of my portfolio to fall in the short-term and some dividend pay outs to be cut. This does not bother me. Why? Because many of the stocks in my portfolio date back to the start of the last decade. I have seen dividends cut, restored and grown. My only concern is will the entity stay in business as only then am I a long-term loser. I have seen a few go out of business over this time frame but fortunately they have not had heavy weights. Other holdings have done very well and dividends have grown. In short, by holding a diversified portfolio and pursuing a simple but specific, strategy I have achieved my aims without being an expert in stock picking.

So what is the strategy? First, will the entity stay in business? This gives the portfolio a large capitalisation bias. Second what is the current yield? My cut off is 3.5% but I might vary it if I expect growth. Third, is the yield likely to be maintained? A difficult call so I look for evidence that the entity thinks paying a dividend is important. Many companies give this information as they have declared dividend policies (you have to look for it). I do not look at dividend cover  as this does not seem to correlate with payouts (which is odd). Finally, I keep cash to invest.

The biggest mistake amateurs, like myself, make is to over invest. Sometimes they do this by accident. They put all their money in a fund which is always 95% invested. At other times they get excited and feel they are missing something and put too much in. If you find yourself discussing investments with taxi drivers or barbers/hairdressers it is time to liquidate everything! So what is the best ‘asset allocation’ strategy? In part it depends on how much you have and how much you need, whether you wish to leave a legacy etc. However, this is very complicated and even financial advisers get lost in this quagmire. Let us keep it simple.

It is not how much you need that is relevant (in my view) but what you can sustain. Even if you do not intend to leave a legacy it is best to plan this way since you do not know how long you will live or what care you will need towards the end. My plan attempts to at least maintain the real value of my current pot so it needs to grow in line with inflation.Looking at equities historically I can see that they tend to go up but can also have severe cycles in which 50% declines are unknown. A simple rule of thumb is a 50/50 cash/equity (or risky asset) ratio. Each year you add it all up and check the ratio. If equities have done well the ratio will have moved overweight equities and you sell some to restore your cash. If equities have done badly you invest some cash to restore the ratio. It is not difficult to come up with a scenario in which even this cautious approach proves problematic so 60/40 might be even more suitable for pensioners. Assuming bear markets end and equities tend to go up over time, this should work.

Let us assume you have £500k to invest (a generous assumption I suspect) and you use the 50/50 then your current annual income can be £3250 plus £12000 which equals £15250. This assumes cash at 1.35 and equities at 4.8%. This is just over 3% return. This is less than an annuity might pay but the £500k is available for your estate. It should also grow as should the income. If you have it in an ISA it is also tax-free. The purpose of the exercise is to illustrate what sort of real return is realistically available with acceptable risk and without giving up hope of a legacy. I hope it helps.

By way of illustration let us look at how the 50/50 strategy might have worked in recent years. We consider a worst case scenario in which the initial investment took place on 1/12/2007. I will use the FTSE 100 as the equity proxy and closing futures prices as the cost of investment. On this date you might have bought the FTSE 100 at 6456. Assuming a lump sum of £500k and 50/50 your £250k would have bought 38.72 units of FTSE (£250000/6456). You now ignore the portfolio spending the interest and dividends until 1/12/2008.

The FTSE 100 fell to 4434 on the 1/12/2008. Your portfolio is now worth £250k+£171.685=£421.685. In order to rebalance you buy another 8.83 units of FTSE at 4434 costing £39.158k. Your cash position is now £210.842k and your equity holding 47.55 units at 4434=£210.837k (rounding will make the figures slightly imprecise) giving a total of £421.678k. I am of course ignoring transactions costs and rounding up. Again ignore the portfolio until 1/12/2009 and collect interest and dividends.

On  1/12/2009 the FTSE is 5412. Your portfolio is now worth £210.842k+£(47.55 x 5412=£257.341k)=£468.183k. In order to rebalance you sell 4.3 units of FTSE, leaving 43.25. This yields £23.250k in cash. The cash holding rises to £234.091k and the value of equity falls to £234.069k (again ignore rounding discrepancies). Ignore portfolio and wait until 1/12/2010, collecting interest and dividends.

On 1/12/2010 the FTSE 100 rises further to 5538. Portfolio value is now £234.091k + £ 239.518k = £473.609k. It is almost 50/50 again so let us leave it for another year until 1/12/2011. At this date the FTSE 100 is 5551 and portfolio value is £234.091k + £(43.25 x 5551 = £240.081k) = £474.172k. Once again it is almost balanced (you need not be pedantic in the 50/50 rule) so let us run it until 1/12/2012, all the time collecting interest and dividends. At this date the FTSE 100 is 5937. The portfolio value is £234.091k + £ 256.775k = £490.866k. A rebalancing is now warranted so sell 1.91 units of FTSE to yield £11.342k. The cash rises to £245.433k and the equity holding falls to 41.34 units which has a value of £245.436k.

Finally we get to 1/12/2013, 6 years after the initial worst case entry point. The FTSE 100 is now 6767. The portfolio value is £245.433k + £ 279.748k = £525.181k. After 6 years the portfolio value has recovered even though we started from a worst case initial condition. Throughout this period the interest and dividends have been earned. By definition, not everyone initiates at the worst time and better initial conditions will result in much better outcomes. The 50/50 rule is quite robust but you can use 60/40 to reduce volatility further. The moral of the story is just because you have fixed pot and are not earning do not be afraid of equities simply because of ‘risk’. There are simple ways to manage risk and equities presently offer attractive dividends whilst lower risk assets do not.