Can you afford to not DIY invest

Grant Thornton has completed some research (free FT link or Google “How much do you really pay your money manager?”) which concludes that someone entrusting £100,000 for 10 years to a UK financial adviser or investment manager would pay an average 2.56% annually for financial planning services and financial product expenses.  Let’s look at what that might mean during both the wealth accumulation and drawdown (assuming no annuity is purchased) phases of a typical investor.

Wealth accumulation phase

When it comes to investment return, excluding expenses, I believe that active investing is a zero sum game resulting in average performance no better than that of the market average.  Of course there will be some winners and some losers, particularly in the short term, but that’s for another day.  Today let’s therefore assume that the investment return these money managers achieve is that of the market.  Let’s look at a couple of possible portfolios.

Unfortunately, the Vanguard LifeStrategy funds have only been around 5 years or so which isn’t enough time to use for this study as I need 10 years (or so) of data.  Vanguard does however have an interesting Asset class risk tool (h/t diy investor (uk))which allows you to input a period and an asset allocation.  Let’s create a reasonably balanced portfolio with 60% stocks, 35% bonds and 5% cash and run for a period of 10 years.

Click to enlarge, 10 year time frame, 60% stocks (FTSE UK All Share Total Return Index), 35% bonds (FTSE British Govt. Fixed All Stocks Total Return Index (1983 - 2013) and BarCap Sterling Aggregate Total Return Index), 5% cash (LIBOR 3-month average over the year)

The result is an average annual investment return of 5.59%.  So with this return what does our investor have left after a few subtractions.  Firstly, let’s subtract the erosion caused by inflation.  The RPI has averaged 2.87% over the last 10 years.  Subtracting that gives us a real return of 2.72%.  Now let our money manager and the investment products s/he is peddling take their cut of 2.56%.  Oops our real return is now 0.16%.  Looking at it another way our average money manager/investment product provider is taking 94% of our real return, leaving us with 6% only, which is hardly conducive to long term wealth building.  It also gets worse as that will be before portfolio turnover costs, taxes and trading costs to name but three.  After those we’ve probably nearly done no better, or maybe even worse, than matching inflation which might mean we’re actually even going backwards.

The power of AND

Putting the scores on the doors reveals that I progressed to my Financial Independence number at a rate greater than 0.9% per month.  In hindsight this wasn’t because of any one particular silver bullet but instead was made possible by focusing on the personal finance many, rather than a few, or even the one talked about so often, investment return.  Putting it another way I focused on the personal finance AND.  Mechanically that included earning more and spending less and an appropriate portfolio and minimising taxes and minimising expenses and investment return.  Psychologically that included starting and determination and accepting I’ll make mistakes and never becoming a victim to name a few.

Over the last couple of weeks I think I’ve shown this trait again by maximising pension contributions while also minimising expenses.

I have two low cost SIPP’s (two rather than one is for risk minimisation reasons) in which I buy low cost tracker products.  This is my method of minimising pension wrapper expenses and investment product expenses.  However, even though I have these and they would enable me to defer tax if I invested in them directly I choose not to use this route.  Instead all my contributions enter pension wrappers via my employer’s expensive defined contribution old school insurance company group personal pension.  I do it this way as in addition to deferring tax like I could also do in the SIPP this maximises my contributions in a few more ways:

• My company does an employer match up to a few percent, which of course I take advantage of, however I also contribute a lot more than this for the two reasons below;
• My company allows salary sacrifice which means I get an extra 2% contribution into my pension rather than it being lost to employee national insurance contributions;
• My company adds 10% of the 13.8% employer national insurance contributions that they save if I sacrifice into the pension. 

So I’ve maximised contributions but my employer’s pension scheme then has the big elephant in the room - Expenses.  I try and keep it to a minimum by buying into their tracker funds but even this means I’m paying annual expenses of between 0.6% and 0.87% depending on fund selected.  I can do much better than that in my SIPP’s.  So the trick is to complete a partial transfer into my SIPP when the pot becomes a reasonable size.  The last time I did this it could only be described as a palaver however this time the more appropriate description would be a doddle.

Naive, a victim or just plain irresponsible

Naive (adjective) – (Of a person or action) showing a lack of experience, wisdom, or judgement. Source

Irresponsible (adjective) - not thinking enough or not worrying about the possible results of what you do.  Source

My work day generally does not afford me a lunch break.  It’s generally scoff a sandwich, but not fast enough to give indigestion, between tasks.  A couple of weeks ago after a particularly rough morning I did however break away and joined the ranks of those at the ‘lunch table’ for a few minutes.  This is normally a place of general chit-chat, of what gadgets people are buying, of the latest sports news, of what people are doing on the weekend, but today in the wake of the BHS pension scandal the topic switched to investments, pensions and retirement plans.

When it comes to saving, investing and retirement planning I am very transparent on this blog but in the office I am the definition of a grey man.  After all an environment where your employer knows you have a decent FU stash or are only a few months from FIRE is hardly one where you are going to be able to ramp earnings at a rapid rate.  So I switched on my spidey sense but didn’t dive in with ‘my view’.

The more likely scenario

My financial independence and early retirement (FIRE) planning has been a pretty negative affair so far, with me always trying to focus on the worst case what if scenarios.  I’ve done this as I wanted to have a high confidence that work in the future really would be optional and based on a want to do it and not a need to do it.  With me now over the financial independence line it’s time for me to switch from glass half empty mode to one where the glass is half full.  I’m going to try and answer the question - based on historical data (which of course is not a predictor of the future) what is the more likely outcome for my wealth?  This then enables me to think about what could happen to my spending if I so choose.

I’ve used the cFIREsim tool many times in the past and I’m going to use it again for this analysis.  The negative of it is that it is US based which means if history repeats it will likely be a bit bullish.  The positive is that its data set goes back to 1871 meaning plenty of data points including plenty of bear/bull market cycles but also that it allows you to output data in real inflation adjusted terms which is important as I want to always think of wealth in terms of what can it buy in today’s pounds.

So let’s plug in the data.  Firstly, my financial independence day wealth of £799,000, planned spending of £19,973 (2.5% of wealth),  40 year FIRE period assumption and assumed annual investment expenses of 0.27%.

Now let’s plug in my FIRE financial strategy with one exception.  CFIREsim doesn’t allow you to input REIT’s so I’ll just split my allocation here 50% to Equities and 50% to Bonds.  So that’s 60% Equities, 29% Bonds, 5% Gold and 6% Cash (assuming 0% return on the cash).

Half 1 2016 – What a ride

July has been a month I will never forget.  Firstly, I joined the 2 comma club and then soon after joined the ranks of the financially independent (FI).  In all the excitement what I didn’t do was run my regular quarterly update on my year to date performance.  I’m going to belatedly do that today as I do want a record of my quarterly performance put down on paper (or pixels)

The first quarter of the year started well but the second half was one of the wildest financial rides I think I’ve ever been on.  To put it in pounds, shillings and pence by the end of quarter 1 I had added £55,000 to my wealth but by the half year mark that had leapt to £142,000.  That is more than my savings and investments have produced in any full prior year of my FIRE journey.

Click to enlarge, RIT Year on Year Change in Wealth (Saving Hard + Investing Wisely)

With strong contributions from both saving and investing let’s look at the detail.

SAVE HARD

I continue to define Saving Hard differently than most personal finance bloggers.  For me it’s Gross Earnings (ie before taxes, a crucial difference) plus Employee Pension Contributions minus Spending minus Taxes.  Earn more and one is winning.  Spend less or pay less taxes and you’re also winning.  Savings Rate is then Saving Hard divided by Gross Earnings plus Employee Pension Contributions.  To make it a little more conservative Taxes include any taxes on investments but Earnings include no investment returns.  This encourages me to continually look for the most tax efficient investment methods.

Click to enlarge, Where my earnings goes

That difference is significant and I think best shown graphically.  Measured my way and my Savings Rate since the start of 2013 has been 52.2% but at the same time I only actually spend 11.7% of my earnings.  If I measure it like most in the FIRE community, which substitutes Gross Earnings with Net Earnings, my Savings Rate jumps to 81.7%!

Maximising withdrawal rates in retirement

Wealth warning: This post should at best be taken with a pinch of salt and at worst should be likened to crystal ball gazing.  I’m posting it because this blog is about retirement and particularly early retirement so it is particularly relevant.

If in retirement, including early retirement, we decide to use a strategy that generates an income by drawing down on our wealth, as opposed to say buying an annuity for example, then there are 4 key decisions that we need to make.  They are what withdrawal rate are we going to make (which could be fixed, variable or fixed with an annual inflationary increase to name but three), how much risk (where risk is the likelihood of wealth depletion) are we going to take, what does our asset allocation look like (the equity : bonds ratio) and how many years do we want our wealth to last (the duration).  The aim is to settle on a combination that suits our needs while ensuring we don’t run out of wealth before we run out of life.  The one decision that is unfortunately out of our control is the sequence of returns that Mr Market is about to provide.

The 4% Rule is but one combination of these variables.  Based on historical returns it states that if you settle on a 50% US stocks : 50% US bonds allocation, accept risk that will historically fail 4% of the time and a 30 year time period then you can take a maximum withdrawal rate of 4% of your wealth on day 0 and then increase this by inflation annually.

This post, which for some reason received very little interest from readers but which was highlighted by somebody I respect very much, then shows the historic maximum withdrawal rate available to us for a given asset allocation, risk and duration.

The problem with all of this work is that if history repeats and we are reasonably prudent in selection a withdrawal rate it more than likely results in us leaving wealth on the table (or more inheritance than planned) at the end of the duration.  Historically that is also a very large sum in sum instances.  Take the 4% Rule for example.  Historically it fails 4% of the time which means it succeeds 96% of the time.

That’s it. I’m calling it. It’s my Financial Independence day!

“Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities. For financially independent people, their assets generate income that is greater than their expenses.” 

Source

3,186 days ago I started on a journey to early Retirement which at the time I defined as work becoming optional.  Only later did I discover that the more appropriate terminology for what I was chasing was FIRE – financially independent and retired early.  Every week since that journey started I’ve sat down and updated my financial position and progress to FIRE.  Today this stared back at me:

Click to enlarge, Path trodden towards financial independence

Yes you’re reading that right.  Today at age 43 I’m officially stating that I am financially independent (FI).  You’d think we’d be out celebrating but in the RIT household this week (and in the run up in recent weeks) there has been calm as I’ve actually been umming and ahing about whether I can actually call myself FI.  The main reason for this is that over the years I’ve diligently planned for just about every financial situation that I can think of however what in hindsight I’ve actually glossed over is the risk of politicians just blatantly changing the rules.  In the past few weeks we’ve seen some of this appear via the Brexit vote which for somebody who intends to emigrate to an EU country as soon as they FIRE has brought real risk.

One of these is the risk that my State Pension might not be triple locked or at least increased with inflation.  Now in my financial planning I’ve never assumed I’d be entitled but I’d always planned on continuing to pay in voluntarily as my insurance policy against financial Armageddon.  Now that insurance policy might be almost worthless as we all know the damage that inflation can inflict.  A second is the risk that at State Pension age I won’t be entitled to the same public healthcare as a local in my new adopted EU country courtesy of UK PLC.  This might mean private healthcare into our dotage but what if we do fall into poor health and our chosen private provider decides we’re no longer profitable enough for them.

At the other end of the scale we’ve seen the government of one of my potential homes, Cyprus, reduce Immovable Property Tax (IPT), which is the equivalent of Council Tax, by 75% in 2016 with a plan to then subsequently abolish it in 2017.  This is a country with so much debt that the Troika stepped in to bail them out only a few short years ago and now they’re cutting taxes by 75% or more.  Sure it plays into my hands for now but it’s not much good if it leads to bust and closed cash points later.

So in light of all of this what right do I actually have to call myself financially independent?  Below is my justification.

Sobering retirement income drawdown demonstrations – 9.5 years in

Unless you’re one of the lucky ones sitting on a defined benefit pension (although it’s likely you’ll also need some other income source in the early years if you’re going to FIRE) or you intend to buy an annuity (again, not likely for the early years of FIRE) or you’re just planning on living off the State Pension then income drawdown in FIRE (or even just plain old retirement) is relevant.

This is the annual update of a series of drawdown demonstrations that are now some 9.5 years in.  To put this in perspective we are now within a whisker of one third of the way through the period that the 4% rule is based upon and this simulation assumes retirement was taken on the 31 December 2006.  If this date sounds convenient then you’re right.  The date was deliberately chosen as it is the year prior to the commencement of the global financial crisis and so hopefully represents a modern worst case.  Someday it may even go down in history as one of the time periods which saw a poor sequence of returns however of course that will only become clear when we are firmly looking in the rear view mirror many years hence.

Over the years readers have suggested various alternatives for these demonstration portfolios however for long term consistency I want to make as few changes to the original assumptions as possible so will stick with them for now.

Where we left our retiree’s last year can be found here.  In brief, the key assumptions are:

• Our retiree’s are drawing down at the stated withdrawal rate plus fund expenses only.  This means any trading commissions, wrapper fees (eg ISA, SIPP fees), buy/sell spreads and taxes have to be paid out of the earnings taken.  For example, our 2% initial withdrawal rate retiree is actually drawing down at between 2.1% and 2.2% dependent on the asset allocation selected.  
• 6 Simple UK equity / UK bond portfolios are simulated for our retiree.  The UK equities portion is always the FTSE 100 where the iShares FTSE 100 ETF (ISF) is used as the proxy.  This fund currently carries expenses of 0.07% however this has been as high as 0.4% in the past.  For the bonds portion a simulation is run against UK gilts (FTSE Actuaries Government Securities UK Gilts All Stock Index) where the iShares FTSE UK All Stocks Gilt ETF (IGLT) is used as the proxy and the bond type I have preferred in my own portfolio, UK index linked gilts (Barclays UK Government Inflation-Linked Bond Index), where the iShares Barclays £ Index-Linked Gilts ETF (INXG) is used as the proxy.
• All calculations are in real (RPI inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today.
• The wealth accrued at retirement (the 31 December 2006) is £100,000.  To simulate a larger or smaller amount of wealth just multiple by a constant. For example if you want our retiree’s to have £600,000 just multiply all the subsequent pound values by 6.

A 4% Initial Withdrawal Rate

UK Retiree Real Portfolio Value, £100,000 Initial Value, 4% Withdrawal Rate, 30 June Value, Click to enlarge

I always start with a 4% withdrawal rate because of the often quoted 4% safe withdrawal rate rule.  The 50% equity : 50% gilts portfolios (the red lines on the chart) are the closest representations to the 4% rule with obvious differences being that:

• the 4% rule was for a US based investor with US based investments while I’m simulating UK investors with UK based investments; and
• the 4% rule doesn’t consider fees where I’m capturing the OCF’s of the ETF’s which makes my withdrawal rate very slightly higher.

2 Commas = £1,000,000

Today, as I have done pretty much every Saturday morning since October 2007, I again sat down and updated my wealth and progress to FIRE (financially independent retired early).  This morning was however a little different as when I usually look at the wealth column of my spreadsheet after entering the data I see 6 figures and a single comma.  Today, for the first time, I saw a second comma indicating that my wealth had passed the £1,000,000 mark.

Click to enlarge, Wealth spreadsheet snapshot

This number means I am now 98.9% of the way to FIRE.

Click to enlarge, RIT path trodden to Financial Independence