Calculating that Important Retirement Number

For anybody planning on a retirement, whether that’s Early Retirement Extreme, Early Retirement or a Typical Retirement not dependent on the whim of Government, based on a passive income stream generated provided by a portfolio which includes assets such as Equities and Bonds, then the amount of assets you need to accrue before pushing the retirement (financial independence) button is possibly the most important number that will be ever considered in your lifetime. 

Given the seriousness of the topic I must give the following Wealth Warning before we move on.  I’m just an average person on a DIY Investment journey to Financial Independence and am certainly not a Financial Planner.  The content of this post is for educational purposes only and is not a recommendation of any type.

For this post I am going to use a fictitious Average Joe who is in a similar position to me and is planning for Retirement.  This means he:

• doesn’t intend to purchase an annuity but instead intends to only use Income Drawdown to Generate Gross Earnings (Earnings before Tax) from the portfolio;
• doesn’t have the benefit of a Defined Benefit Pension or other income streams.  Therefore all of his Gross Earnings must come from the interest, dividends and capital growth of his portfolio;
• doesn’t have rich parents who are going to leave him an inheritance; and
• wants to maintain the same standard of living throughout retirement so will increase his Gross Earnings in line with inflation every year.

The actual calculation of the Retirement Number (how big a portfolio is required to retire) is actually very trivial and depends on only two numbers.  It’s getting those two numbers that is the difficult bit and where all the risk is.  The first number is what Gross Earnings do you want in retirement and the second number is what Initial Withdrawal Rate do you intend to start with.  The maths is simply Retirement Number = Gross Earnings / Initial Withdrawal Rate.

Let’s look at both of those numbers in detail.

What Gross Earnings do you want in retirement?

This is just a matter of sitting down and thinking about what expenditures you intend to have in retirement that will give you the standard of living you desire.  Here is a short inconclusive list of possible considerations:

• You’re no longer saving for retirement so don’t need that portion of your current salary;
• You’re possibly no longer working so may not need to be paying for transport to and from work plus other costs such as work clothes;
• You’re hopefully tax efficiently invested in wrappers like ISA’s meaning you need a lower Gross Earnings than Gross Salary to give the same amount of money in your hand each month.
• If you’re in the UK then the assets in your portfolio are taxed in a more friendly way than your current Salary meaning you also need lower Gross Earnings; and
• You possibly own your home by now meaning you won’t be making those current mortgage payments. 

I calculated my retirement Gross Earnings back when I was in my mid thirties and first started on my journey towards financial independence.  Every year I have then up rated this amount by inflation to ensure my standard of living will be maintained as the pound is devalued.  When I hit retirement I intend to continue with this strategy.

On Retirement Investing Today I never reveal my Gross Earnings target because it’s just irrelevant.  Everybody has different needs, wants, risk tolerance and portfolio type meaning we all have a different Gross Earnings requirement.  To enable us to run an example let’s assume that our Average Joe requires Gross Earnings of £25,000 when measured in today’s £’s. 

An Essential Guide to Offshore Investments*

As more and more people are deciding to either live a life of perpetual transience or retire to warmer climes, offshore investments are becoming increasingly popular. As well as taking advantage of some significant tax savings, investors are often keen to select just one investment opportunity instead of having their capital tied up in several different locations around the world. However, a little knowledge about how different offshore funds work will mean the logistical and financial obstacles that hinder many British expats can be removed.

What Does This Type of Investment Involve?

The modern offshore fund involves geographically portable products that offer consumers statutory protection and a wide range of investment choices. Contrary to popular belief, they are not based in shady, semi-legal rogue states, but they are based in established financial centres such as the Isle of Man, Ireland and Luxembourg. This gives consumers the peace of mind in knowing that their funds are protected by law-abiding and stable governments.

The Various Offshore Products

If a person wishes to invest a lump sum, they may do so with the help of an offshore investment bond. A bond can be used as the 'packaging' for a comprehensive range of investments, including open-ended investment companies and unit trusts. As these bonds are based offshore, they give consumers much more choice. Investment funds that are available include guaranteed return funds, managed future funds, stock market-linked funds and government bonds. Exactly which opportunities are best for the individual should be discussed with an experienced financial adviser, but the decisions will depend on factors such as the person's attitude towards risk, age and time-frames.

A detailed consultation with a financial adviser will ensure that investors know exactly much money needs to be injected into a fund every month. A person's disposable income will generally dictate exactly what the offshore investment will be composed of. Most of these products can now be managed closely online, so issues of time-difference and language are no longer obstacles to a lucrative investment.

Does Gold Protect UK Investors from Inflation

This post is a response to the brief exchange with Faustus on the last Gold Price in British Pounds post.  Today I’d like to attempt to answer the first question which is “whether gold is really as good a hedge against sterling inflation as is sometimes suggested.”

Let’s firstly review why in my opinion it is important not to forget about the damage that inflation can do to your savings.  The Bank of England has a remit “to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%.”  If January 2013 sees the Consumer Price Index (CPI) remain above 2%, and at 2.7% today I see no reason why this won’t be the case, then this will be the thirty eighth month in a row that they have missed their target.  This demonstrates that the Bank of England’s remit actually has nothing to do with the official line presented.  If it did they would have been made sacked for poor performance long ago.  I therefore take inflation seriously.

If you believe that the CPI provides an accurate measure of inflation, and had the Bank of England met their remit of inflation at 2%, then £1 three years ago would have had the purchasing power of £0.94 today.  Instead the current policy employed by the Bank of England, of keeping the patient flat lined at 0.5% combined with plenty of QE, means that your £1 actually only buys £0.90 worth of goods and services today.  That’s a 10% loss of purchasing power in only 3 short years.

I’ve already laid out some techniques I’m using to protect myself from inflation however let’s now look if gold could be added to that list for UK Investors.

UK House Value vs UK House Affordability – January 2013

This is the monthly UK House Affordability update, which is the metric that I believe is the key driver of UK House Prices.  It is also the update for UK House Value which is the metric I am using to assess when it is time to buy a UK home.  The last update can be found here.

Let’s first update the key data being used to calculate both UK House Value and UK House Affordability:

• UK Nominal House Prices.  In recent posts we have been comparing the different UK House Price Indices however for this analysis we will stay with the Nationwide Historical House Price dataset.  December 2013 house prices were reported as £162,262.  Month on month that is a fall of £1,591 (-1.0%).  Year on year sees a decrease of £1,560 (-0.9%).
• UK Real House Prices.  If we account for the devaluation of the £ through inflation (the Retail Prices Index) we see those falls accelerated.  Month on month that decrease of £1,591 changes to a decrease of £2,385 (-1.4%).  Year on year that £1,560 decrease grows to a decrease £6,625 (-3.9%).  In real terms prices are now back to those around December 2002 (from March 2003 last month). 
• UK Nominal Earnings.  I choose to use the Office for National Statistics (ONS) Average Weekly Earnings KAB9 dataset which is the seasonally adjusted average weekly earnings of both the public and private sector including bonuses.  November 2012 sees earnings at £472.  Month on month that is an increase of £1.  Year on year the increase is £7 (1.5%).  With inflation (the Retail Prices Index) running at 3.0% over the same yearly period the purchasing power of those that work continues to be eroded.
• UK Mortgage Rates.  The proxy I use to monitor mortgage interest rates is the Bank of England dataset IUMTLMV which is the monthly interest rate of UK resident banks and building societies sterling Standard Variable Rate (SVR) mortgage to households (not seasonally adjusted).  December 2012 sees this reach 4.35% which month on month is a tiny uptick of 0.01% and year on year is an increase of 0.23%.  We now need to be careful with this dataset and keep an eye on other mortgage types because the new Funding for Lending Scheme (FLS) is now starting to distort the UK mortgage market.  I’ll provide full details in a post soon however I will say that 2, 3 and 5 Year Fixed Rate Mortgages are now continuing falling.  

UK House Value

The stock market uses the Price to Earnings Ratio (P/E) as a possible valuation metric.  I choose to use the same metric to assess housing value and show this in my first chart below.  For Price I use Nominal House Prices and for Earnings I use the UK Nominal Earnings multiplied by 52 to convert to Annual Earnings.   This shows that today we are sitting on a P/E of 6.6 which down from 6.7 last month.  This means property is better value this month than last.  While being a long way off the peak value 8.3 we are also still a long way off of the 4.6 seen in January 2000.

Click to enlarge

Unfortunately, the Average Weekly Earnings dataset limits this analysis to January 2000.  I however want to look at longer term trends to try and judge where fair value may be and even what P/E lows we could expect going forward.  To get an indicator of this I use an older similar dataset which was discontinued by the ONS in September 2010.  This was the Seasonally Adjusted Average Earnings Index (AEI) for the Main Industrial Sectors.  This dataset goes back to 1990 which is sufficient to take us back through the last UK property bust.  I then convert the Average Weekly Earnings dataset to an index and overlay both on the chart below.  This shows that today we are still nowhere near fair value.

 

Click to enlarge

A Method to Calculate Historic Portfolio Performance

I find that in life if you want to succeed at something you must have a plan.  This plan in its most basic form will include a number of goals and a timeline detailing when you intend to meet those goals.  Once you have that plan in place you must then track progress against the plan and should you deviate you should put actions in place to get you back on track.  Personal Finance is no different.

Within the Invest Wisely portion of my strategy I have two distinct goals for my Low Charge Portfolio.  The first is to beat a Benchmark that I have set myself.  Everybody’s Benchmark will of course be different.  It could be to beat the FTSE100, the FTSE 250, the Barclays UK Government Inflation-Linked Float Adjusted Bond Index, a combination of these or something completely different.  Remember when you set your Benchmark you must ensure it has a similar risk profile to your investments and contains investments that are as close to yours as possible.  What good is it to spend time developing a Low Charge Portfolio and Strategy if you can’t at least match (for those of us where personal finance is a hobby) or beat a simple Benchmark (for those of us where personal finance is a hobby or chore).  If we can’t meet this goal then we’re probably better off just buying a Vanguard LifeStrategy Fund.

The second aim is for my portfolio to over the long term meet or exceed a Real Total Return goal that I have set myself.  This is defined as over the course of my investing career the sum of the capital gains within my portfolio and the dividends paid must exceed UK Inflation by a specific amount.  In the interests of full transparency I must point out that I am current not meeting my goal however by tracking progress I at least know why I am missing and have planned actions to recover.

Let’s look at the method I use to calculate the historic performance of my portfolio assuming I want to look at Total Return.  Calculating Real Total Return is then just a simple matter of subtracting your chosen inflation measure from the calculations for the period concerned.

Calculating Year to Date and Yearly Total Portfolio Return

To make this calculation you only need 4 things:

• Access to the XIRR function within Microsoft Excel.  This function is not typically part of the standard Excel install so if you have Excel and can’t find XIRR you may need to install what is called the Analysis Toolpak.  As every version of Excel is slightly different just type “Install Analysis Toolpak” into Excel’s Help and you should get the guidance you need for your version.
• The start date for the period you are interested in analysing and the value of your portfolio on that date.  This must be the earliest date entered into Excel.
• The end date for the period you are interested in analysing and the value of your portfolio on that date.  When running the calculation this value should be entered as a negative number.
• Any cashflows into or out of your portfolio.  Note that because I am calculating Total Return all of my dividends have been reinvested in my portfolio and so I don’t need to include any dividends within the cashflows.  Cash into the portfolio should be entered as a positive number and cash out should be entered as a negative number.

A worked example is shown in the image below.

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A couple of important points:

• The first column entry into the XIRR formula is the cashflows, the second column is the dates and the third piece of data you have to enter is a guess as to what the return might be.
• It doesn’t matter what the period you are using is, whether 1 month, 1 year or 10 years, the return will always be an annualised return.  So in the example above, which is only a 3 month period, were the year continue at the current rate of return then you’d see a return of 64.7%.  You have not achieved a 64.7% return over that 3 month period.

At this point if you only want to calculate your total return for a whole year, say 31 December 2011 to 31 December 2012, then you are done.  If however you would like to know what your return is year to date then you have a little more work to do.  I do this because I don’t want to wait a whole year to understand if I’m going off plan.  I update my financial position weekly and then update my portfolio performance on the first Saturday of every month.   To do this you now need to calculate your Personal Rate of Return (PRR) which is represented by the formula:

Let’s continue with our worked example and now calculate the Personal Rate of Return.

Click to enlarge

Another important point:

• Note how even though we are looking at a 3 month period the PRR is not equal to the XIRR value divided by 4.

So that’s how to calculate year to date and yearly performance.  Let’s move onto calculating performance over a number of years.