Capital erosion: dangerous descents
It’s possible that Edmund Hilary and Tenzing Norgay weren’t the first people to make it to the top of Everest. When George Mallory’s body was discovered on the slopes of the mountain 75 years after he disappeared in 1924, it was apparent he was descending, having been last seen 800 vertical feet from the summit, on the ascent.
We will never know. But what we do know is that, like with Mallory, 85% of fatalities on Everest happen in the descent, not the ascent. It’s a similar story when it comes to pensions: the hazards are not so much with the accumulation phase – real and present though they are – but when you are drawing on that pension pot: or decumulation, as it’s rather clunkily called.
There are two fundamental reasons for this: the often invisible effects of inflation, and when people ‘optimistically’ underestimate their life spans. The latter is a far from trivial point. Average male life expectancy, once you reach 65, is 84 years old; the average for women being 86. That means you have a 50% chance of living beyond this date – sometimes by a significant amount. Unless you plan to occupy yourself in retirement by binge-drinking, chain-smoking and free-climbing, it may be wise to allow for this. So your portfolio needs to deliver for you over 20, 30 or even 40 years. Over such a time-frame, the stability of a portfolio is extremely sensitive to what may seem like small changes in behaviour, or relatively minor fluctuations in the inflation rate.
Impact of 2.3% inflation on purchasing power of £1
Source: UK inflation Calculator, whatsthecost.com, as of August 2017
UK Consumer Prices Index, 1990 – 2017 (average 2.3%)
Source: Office of National Statistics, as of July 2017
Inflation has been off the radar for many over the past decade. But even with the modest levels we have experienced in recent years, cumulative effects have been significant: as can be seen in the graph above, the value of £1 in 1991 had fallen to 54p by 2015. If we were to look at the impact of inflation before that in the 1970s and 1980s, the situation would have been far worse.
Since the Brexit vote, we’ve seen inflation increase. Whether this is a short-lived currency effect, or set to become a structural trend is unclear, but one should not ignore the heightened potential danger this poses to your savings. You therefore need enough growth in your portfolio to at least partially compensate for this. While not many can inflation-proof completely, as this means taking a much lower income, conversely one must be careful not to take too much, as this risks depleting one’s savings very quickly.
One rule of thumb used to be not to take more than 4% on a balanced equity/bond portfolio. However, investment information provider Morningstar has warned that “financial advisers and retirees in the United Kingdom should use lower initial safe withdrawal rates… towards 2.5% or 3.0% and not the previous 4.0%.” Lower yields, in other words, mean a lower withdrawal rate. However, being this defensive is challenging when you need to take a decent income to fund the retirement that you want. This is why institutional pension funds are increasingly looking to alternative assets such as private debt for enhanced yields – which is the solution offered to individuals by ThinCats and other alternative lending platforms. Investors receive an enhanced yield through what’s known as the ‘liquidity premium’ – the price of having one’s money tied up for longer.
Diversification is an indispensable tool in the investor’s kit. Having equities alongside fixed income in the portfolio, for instance, allows the potential for growth that bonds and the like cannot provide. So why not fill your boots with equities? Capital growth, plus dividends, seem an attractive option. The first problem is that is you are likely to have to sell assets to fund withdrawals as equities are unlikely to generate sufficient dividend income for you after taking account of fund, platform and adviser charges. Secondly, equities can go down in the short term even if they typically grow in value in the longer term – they can be volatile. When you are saving, a dip in the market just means that your next purchase of equity is cheaper. The problem with taking income however is that you are likely to have to sell equities in the dips to fund your withdrawals and so you never get a chance to recover the lost value.
Global equity markets fell by about 40% during the financial crisis (similarly with the 2000 dotcom bust), while developed market government debt rallied. Such equity volatility has important implications for those drawing income: fund performance tables are based on accumulation for savers. The top performing funds for savers may not be good for income takers, if better total returns have been achieved at the expense of lots of volatility which is deadly for income takers.
Ah, some might say, but equity markets bounced sharply within two years of the crash, and made the ground back shortly after. While that’s true, a market that falls 50% and then rises 50% is not back where it was, but at 75% of its original value. What’s more, you still need the same income while the invisible hand of the market does the (hoped for) repair work. The bigger the drop, the proportionally more your portfolio needs to grow after (see graph).
Source: OMGI, as at May 2016
Needing to withdraw income from a portfolio, a corner stone of whose value is in freefall, will empty like a bath empties after dropping a wrecking ball through it, rather than using the plug. Not many people can afford maximum inflation protection by taking very low income levels, so it is quite likely that high amounts of equity in the portfolio will mean selling down assets to fund withdrawals. This addresses one problem at the expense of creating a potentially worse one.
With inflation on the increase, holding cash functions poorly as a buffer, as the real value of this will be increasingly eroded over time.
Broadly speaking, your need for income is fixed to a far greater degree than the value of the basket of assets you draw that income from. So, while it’s prudent to have growth potential within your portfolio, it’s even more important to have a diversified basket of assets to mitigate losses, while paying a level of income compatible with your needs. The most reliable way of achieving this is to generate income from income received, not selling down capital.