UK investor - long dated gilts to reduce SORR: what am I missing?!

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Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.

If our plans change and we retire later, maturing gilts would not be an issue since these gilts redeem without any capital gains tax liability. In this scenario we would just reinvest the proceeds in new long-dated gilts (thereby rolling the 10 year window).

I like this concept because it would seem to mitigate the risk that we come to our retirement date during an extended bear market - having a regular tranche of (tax free) cash via the maturing gilts would allow us to more or less avoid having to sell our equities for a significant period (hopefully sufficient time to see some market recovery).

I would love to hear the thoughts of the forum on this. This seems like a no regret move - which makes me worry that I am missing something!

Many thanks.

FP
Valuethinker
Posts: 48741
Joined: Fri May 11, 2007 11:07 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

Futureproofer wrote: Sun Feb 11, 2024 4:39 am Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.
American readers may not know that gilts are Capital Gains Tax exempt (the difference between the discount and the par value at redemption) - unique to gilts for a UK taxpayer.
(inflation adjusted)
This is a key problem with your plan. No one can accurately forecast inflation. Even over the short term. We have gone from near negative inflation (briefly, in 2008/9) to 10% inflation just recently. That devastates a financial plan based on nominal cash flows -- 2 years of 10% inflation and you lose over 20% of your buying power.

The UK had more than 20% inflation for several years in the 1970s. It's therefore not a good bet to assume that it could never have that again.
If our plans change and we retire later, maturing gilts would not be an issue since these gilts redeem without any capital gains tax liability. In this scenario we would just reinvest the proceeds in new long-dated gilts (thereby rolling the 10 year window).
If we repeated the 2010-2021 period, you would find returns keep falling as you roll the gilts forward. An extended period of low interest rates could really hurt.
I like this concept because it would seem to mitigate the risk that we come to our retirement date during an extended bear market - having a regular tranche of (tax free) cash via the maturing gilts would allow us to more or less avoid having to sell our equities for a significant period (hopefully sufficient time to see some market recovery).

I would love to hear the thoughts of the forum on this. This seems like a no regret move - which makes me worry that I am missing something!

Many thanks.

FP
You are, in effect, talking about an annuity - fixed payment, rather than inflation-linked. Use that to fund the first 10 years of retirement then have various inflation-linked investments post that-- as long as inflation stays low and predictable in that 10 years, you are OK.. But of course it's an annuity - it will expend your capital (and usually annuities are bought as longevity insurance ie for lifetime). Annuity rates were horrible, they have picked up - so again, interest rates when you retire are pretty important.

The plan to match cash flows to needs is attractive. But it has to be nominal cash flows, not real ones. You'd have to do it with index-linked gilts. And there are no zero coupon ones, AFAIK. And you should buy these now to match the longest duration of your need (27 years out) and work backwards. If ILGs go back to negative yields (they are, again, at the short end?) then you have another problem.

A related practical problem is there are not gilts redeeming in every year - you are going to have gaps - STRIPS are actually created by brokers with a Gilt Edged Market Maker licence, and do they do them for years when there's no gilt maturity? If they do (perhaps using gilt coupons) then great. BTW does the tax treatment remain? I vaguely remember with gilt ETFs it does not - you'd pay capital gains as normal.

We should also speculate about the creditworthiness of the UK government:

- if an unstable coalition came to power ((say in alliance with a nationalist party) OR on the other wing, in alliance with a populist party? Such a government could resemble the 1970s - unable to restrain spending or inflation, because of the electoral cost with its core constituencies. That would be consistent with Hungary, say, where ex the EU subsidies they would be in the soup

- if the United Kingdom ceased to be united

- if there was another gilt market crisis like what we experienced in Sept-Oct 2022, leading to much higher borrowing costs for the UK govt. Solution then is either to print money, devalue the currency, have inflation (the successive devaluations of the 30s, 40s, 50s, 60s, 70s) or to reschedule debt (which was done in the 1930s but in those days consols were actually annuities, so the UK government had that legal power)

Conclusion

- you'd have to do with with Index-Linked Gilts. And then the exact matching of timing of cash flows would be a problem. And you would have interest rate risk (ie reinvestment risk)

- I wouldn't advise anyone to be too dependent upon the single credit rating of any government, if that can be avoided
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Thank you Valuethinker for taking the time to reply. Lots of food for thought in your post.

To inflation adjust, one could perhaps take the historical annualised average for the UK over last century or so (~4.1%) and apply this to the GBP 70k/a target to try to reasonably estimate how much would be needed in future years to achieve ~GBP70k current spending power (e.g., this would require ~120k in 2041 money, 125k in 2042 money, etc).

All quite approximate but would that be a more reasonable way of mitigating the inflation risk issue without resorting to ILGs in your view? You are also right that it would not be possible to cash flow match entirely with gilts, so some years would be lumpier than others.

I certainly don't want to expend the capital via an annuity and am reasonably relaxed about the risk of UK government defaulting on redeeming these gilts upon their maturity dates.

Finally, other than an annuity, are you aware of any structure that a UK investor might exploe to achieve a similar cash flow matching effect?

Best,
FP
Valuethinker
Posts: 48741
Joined: Fri May 11, 2007 11:07 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

Futureproofer wrote: Sun Feb 11, 2024 9:02 am Thank you Valuethinker for taking the time to reply. Lots of food for thought in your post.

To inflation adjust, one could perhaps take the historical annualised average for the UK over last century or so (~4.1%) and apply this to the GBP 70k/a target to try to reasonably estimate how much would be needed in future years to achieve ~GBP70k current spending power (e.g., this would require ~120k in 2041 money, 125k in 2042 money, etc).

All quite approximate but would that be a more reasonable way of mitigating the inflation risk issue without resorting to ILGs in your view? You are also right that it would not be possible to cash flow match entirely with gilts, so some years would be lumpier than others.
The most powerful book about finance I ever read (other than Copeland, Weston & Shastri Financial Theory and Corporate Policy) was probably Benoit Mandelbrot The Misbehavio(u)r of Markets. The (re)discoverer of fractal mathematics, he showed that daily security returns obey a power law, not a Gaussian/ normal distribution. He uses the analogy of a blind archer firing at a wall - some arrows never hit the wall, some hit it at the closest point, where the previous ones landed don't tell you about the future landing point. We only make the latter assumption of Normal Distribution for the tractability of the mathematics.

(The Intelligent Asset Allocator by William Bernstein was maybe 3rd. Or 4th after A Random Walk Down Wall Street by Burton Malkiel).

And so what? We do not have enough inflation data, and inflation data is serially correlated, to tell us about the historic distribution of inflation. Even with centuries of price indices. Because it's clear that there is inflation regime change. Wars in particular - WW1 & WW2. But also the postwar era, and the 1970s, and the era of Orthodox Monetarism. Then inflation targetting. Then the Global Financial Crisis & Quantitative Easing. I'd say we are in another new one, now.

So past history, if you plot it, shows that there are periods of high, and low, inflation. It doesn't tell you what comes next, and it doesn't tell you what the magnitude of inflation will be. If you go back down my posts, you will find that I was derisive of the notion that we could again have double-digit inflation, given the independence of Central Banks. Oops.

So it's not like you have a data series of individual independent identically distributed annual inflation rates, hovering around 4.1% pa. You have decades of less than that, and intense bursts above that. With strong serial correlation.

So I would not rely on that 4.1%. Given Bank of England's inflation targeting regime, it *should* be OK.

Charles Goodhart's book is an argument (around aging populations, the end of the mass movement of production to low cost Far Eastern countries, etc) about why the disinflation we experienced in the 1990s and 2000s is a unique period in history. Not likely to be repeated.

I certainly don't want to expend the capital via an annuity and am reasonably relaxed about the risk of UK government defaulting on redeeming these gilts upon their maturity dates.
Historically the UK has opted to have devaluation/ inflation rather than default. Remembering that in 1924 the Chancellor, Winston Churchill, repegged the pound (trading had been suspended in 1914) at $4.85 to the US dollar. Which led to the General Strike in support of the coal miners "Not a minute on the day, not a penny off the pay" as the chant went at the time. Churchill later termed it his greatest mistake (the relatives of those who died at Gallipoli in 1915, or Crete in 1941, or Dodecanese Fiasco in 1943/44, might have other views).

We are a long way from $4.85 now.

If we had joined the Euro, as Blair wanted but Brown thwarted, then we might have had a Greece-like crisis post 2008. I would argue we are actually in a much more vulnerable situation now in many ways and it's entirely possible that we will see the pound at below dollar parity. (Although it's likely the next Parliament will see better economic news, at least in the short term: the political and economic issues are nonetheless pretty severe; I for one probably only think there's about 50% chance of the union surviving another 50 years).

So I agree with you that a default is very unlikely, at least whilst we have our own currency.
Finally, other than an annuity, are you aware of any structure that a UK investor might exploe to achieve a similar cash flow matching effect?

Best,
FP
I do not.

You have to weigh up in your mind whether an annuity + portfolio is a better option than more of your portfolio structured in an annuity-like fashion? Remembering that the capital preservation, in nominal terms, of a portfolio of bonds is something of an illusion- over say 30 years (and you are thinking 17 years + say 30 years in retirement) that will fall in half in real value with 2.5% inflation.

It is somewhat academic as AFAIK you cannot now, buy an annuity that pays from age 65, if you are 48? The only cases I know of that are "bulk buy" annuities where a Defined Benefit pension plan, in surplus, opts to hedge its future liabilities by buying annuities for all the members. In effect taking the balance sheet risk off the hands of the employer. Certainly the way a DB pension plan hedges interest rate moves & thus annuity rates when members retire is to buy medium term gilts. But they are bearing inflation risk then (by law, pension funds are indexed up to at least 5% inflation by memory, and some actually fully protect retirees against inflation).

I am not aware of any other structure. A pension fund would do it using gilts, but they would have the inflation problem. They might use inflation-linked swaps rather than the ILG market, for reasons of liquidity and market impact (ie a big pension fund could wind up driving the price of specific issues of ILGs against itself).

There are many posts here about TIPS ladders. TIPS is a US ILG. I would argue that your best and most practical hedge is a portfolio of ILGs with a duration below your target retirement. (I would suggest to anyone that they should hold 20% in global developed market equities, of their total portfolio). Note however that the way tax works, I think your ILG returns fall with higher inflation?
xxd091
Posts: 481
Joined: Sun Aug 21, 2011 4:41 am
Location: UK

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by xxd091 »

A £2000000 portfolio which you currently have in global index tracker would safely generate £60000 +pa now if structured as a simple 60/40 portfolio -you are nearly there already re your £70000 pa desired income !
Your investment in a global equities index tracker seems to have done the business so far
Why not keep things simple and just use a global bond index tracker hedged to the pound for your bond addition to your portfolio
You then will have 2 funds only-you also then have a simple cheap and easy to manage and understand portfolio
With 17 years still to go surely the £70000 would be easily achieved with a wide safety margin
Start adding bonds to your portfolio well before retirement so that you are not caught with the retirees nightmare of a stockmarket drop at retirement (though most retirees cover this eventuality by having 2-3 years of living expenses in cash)
It would be Total Return portfolio with you selling fund units as required once a year to top up your cash account
Get as much in tax free wrappers ie SIPPs and ISAs as you can
xxd09
StillGoing
Posts: 354
Joined: Mon Nov 04, 2019 3:43 am
Location: U.K.

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by StillGoing »

Futureproofer wrote: Sun Feb 11, 2024 4:39 am Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.

If our plans change and we retire later, maturing gilts would not be an issue since these gilts redeem without any capital gains tax liability. In this scenario we would just reinvest the proceeds in new long-dated gilts (thereby rolling the 10 year window).

I like this concept because it would seem to mitigate the risk that we come to our retirement date during an extended bear market - having a regular tranche of (tax free) cash via the maturing gilts would allow us to more or less avoid having to sell our equities for a significant period (hopefully sufficient time to see some market recovery).

I would love to hear the thoughts of the forum on this. This seems like a no regret move - which makes me worry that I am missing something!

Many thanks.

FP
From your post, it looks like you are considering nominal bonds. As others have said, this leaves you open to the effect of unexpected inflation between now and 2041. I think that the £70k you quote is in 2041 pounds (correct me if I'm wrong), so presumably you have taken an estimate of your current expenditure and adjusted it for some assumed value of inflation.

A different approach might be to use inflation linked gilts (ILG) instead. I note that those that mature between 2041 and 2050 currently have real yields of between 1.1% and 1.4% (closing values on 8 February taken from tradeweb). If your target income in today's pounds is T, then the total cost will be roughly T/power(1.01,17) - it'll actually be a bit less than this since the bonds maturing in 2050 have a higher yield and longer for compound interest to work its magic. This also assumes coupons are reinvested such that the total return is roughly equal to the yield - without reinvestment, the real price return for the gilt maturing in 2041 is just under 1%.

Since the coupon rates are relatively small on ILG (from 0.125% to 0.75% for those maturing between 2041 and 2050), then the number of bonds maturing in each year that need to be purchased can be approximated by T*(clean price)/(dirty price).

I assume you've based the first ten years on then receiving the state pension from 67 (or 71 or whatever it turns out to be!) onwards so that this will then reduce the demands on your portfolio. It might be worth considering purchasing additional income flooring either by extending the 10 year ladder (2071 is the longest ILG currently available, but the maturity dates are a bit sparse after 2058) or by purchasing an RPI annuity closer to the time (if they exist). The lack of a deferred annuity in the UK (of any sort, AFAIK), makes this sort of planning decision somewhat more awkward.

cheers
StillGoing
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Thanks again Valuethinker. Will look more cloesly into ILGs.

@xxd091 - always agree that it is preferable to keep things simple and I will look to move into a bond fund in due course. I suppose the issue with a two fund portfolio (which I was trying to mitigate with the gilt ladder) is the risk that bond/equity market correlation continues and we find ourselves retiring into a protracted bear market where both bonds and equities are materially down. As you also point out, I guess one way to mitigate this is to ensure we hold a few years' worth of expenses in cash/short dated gilts by the target retirement date.

We will be going entirely to cash early next year as part of a repatriation to the UK, once in the UK we will allocate our retirement assets afresh so it a nice natural juncture to re-jig allocations and take some equity market risk off the table. Thanks for the pointers which we will explore in the meantime!
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

StillGoing wrote: Mon Feb 12, 2024 4:06 am
Futureproofer wrote: Sun Feb 11, 2024 4:39 am Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.

If our plans change and we retire later, maturing gilts would not be an issue since these gilts redeem without any capital gains tax liability. In this scenario we would just reinvest the proceeds in new long-dated gilts (thereby rolling the 10 year window).

I like this concept because it would seem to mitigate the risk that we come to our retirement date during an extended bear market - having a regular tranche of (tax free) cash via the maturing gilts would allow us to more or less avoid having to sell our equities for a significant period (hopefully sufficient time to see some market recovery).

I would love to hear the thoughts of the forum on this. This seems like a no regret move - which makes me worry that I am missing something!

Many thanks.

FP
From your post, it looks like you are considering nominal bonds. As others have said, this leaves you open to the effect of unexpected inflation between now and 2041. I think that the £70k you quote is in 2041 pounds (correct me if I'm wrong), so presumably you have taken an estimate of your current expenditure and adjusted it for some assumed value of inflation.

A different approach might be to use inflation linked gilts (ILG) instead. I note that those that mature between 2041 and 2050 currently have real yields of between 1.1% and 1.4% (closing values on 8 February taken from tradeweb). If your target income in today's pounds is T, then the total cost will be roughly T/power(1.01,17) - it'll actually be a bit less than this since the bonds maturing in 2050 have a higher yield and longer for compound interest to work its magic. This also assumes coupons are reinvested such that the total return is roughly equal to the yield - without reinvestment, the real price return for the gilt maturing in 2041 is just under 1%.

Since the coupon rates are relatively small on ILG (from 0.125% to 0.75% for those maturing between 2041 and 2050), then the number of bonds maturing in each year that need to be purchased can be approximated by T*(clean price)/(dirty price).

I assume you've based the first ten years on then receiving the state pension from 67 (or 71 or whatever it turns out to be!) onwards so that this will then reduce the demands on your portfolio. It might be worth considering purchasing additional income flooring either by extending the 10 year ladder (2071 is the longest ILG currently available, but the maturity dates are a bit sparse after 2058) or by purchasing an RPI annuity closer to the time (if they exist). The lack of a deferred annuity in the UK (of any sort, AFAIK), makes this sort of planning decision somewhat more awkward.

cheers
StillGoing
Thanks SG. My initial post wasn't well expressed -apologies for that - I had meant we aim to realize future annual cashflows which are equal to GBP70k (gross) in today's money (e.g., applying an assumed annualised inflation rate of ~4%- to realise 70k in 2024 money would require us to realise ~120k in 2041 money, 125k in 2042 money, etc).
maxInfo
Posts: 27
Joined: Wed May 20, 2020 11:10 pm

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by maxInfo »

Have you factored in potential increases in living costs?
minimalistmarc
Posts: 1626
Joined: Fri Jul 24, 2015 4:38 pm

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by minimalistmarc »

Bit off topic but what is VWRD? I have a similar amount to you invested in VWRL or VWRP, which I understood to be the optimal holdings for a passive global equity holding for UK
investors.
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Hi maxInfo, no haven't really gone into that level of details for a couple of reasons (1) the GBP70K (gross) equivalent amount is actually ~10% more than we expect to need in practice, so there is a bit of a buffer baked in, (2) we would still keep ~1.5m in VRWD which should hopefully at least track inflation over next 17 years and therefore compound to a reasonable amount even without further contributions - so we would dip into that for any additional cash needed.
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

minimalistmarc wrote: Mon Feb 12, 2024 5:07 am Bit off topic but what is VWRD? I have a similar amount to you invested in VWRL or VWRP, which I understood to be the optimal holdings for a passive global equity holding for UK
investors.
Hi - It is the same fund, just USD denominated as we currently earn in USD. I haven't yet figured out whether it makes sense to return to the UK with GBP or liquidate current equity holdings and stay in USD. If the former we would re-purchase VWRL.
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Futureproofer wrote: Mon Feb 12, 2024 5:11 am
minimalistmarc wrote: Mon Feb 12, 2024 5:07 am Bit off topic but what is VWRD? I have a similar amount to you invested in VWRL or VWRP, which I understood to be the optimal holdings for a passive global equity holding for UK
investors.
Hi - It is the same fund, just USD denominated as we currently earn in USD. I haven't yet figured out whether it makes sense to return to the UK with GBP or liquidate current equity holdings and stay in USD. If the former we would re-purchase VWRL.
...or even purchase SWDA which would also seem to do the job!
StillGoing
Posts: 354
Joined: Mon Nov 04, 2019 3:43 am
Location: U.K.

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by StillGoing »

Futureproofer wrote: Mon Feb 12, 2024 4:37 am
StillGoing wrote: Mon Feb 12, 2024 4:06 am
Futureproofer wrote: Sun Feb 11, 2024 4:39 am Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.

If our plans change and we retire later, maturing gilts would not be an issue since these gilts redeem without any capital gains tax liability. In this scenario we would just reinvest the proceeds in new long-dated gilts (thereby rolling the 10 year window).

I like this concept because it would seem to mitigate the risk that we come to our retirement date during an extended bear market - having a regular tranche of (tax free) cash via the maturing gilts would allow us to more or less avoid having to sell our equities for a significant period (hopefully sufficient time to see some market recovery).

I would love to hear the thoughts of the forum on this. This seems like a no regret move - which makes me worry that I am missing something!

Many thanks.

FP
From your post, it looks like you are considering nominal bonds. As others have said, this leaves you open to the effect of unexpected inflation between now and 2041. I think that the £70k you quote is in 2041 pounds (correct me if I'm wrong), so presumably you have taken an estimate of your current expenditure and adjusted it for some assumed value of inflation.

A different approach might be to use inflation linked gilts (ILG) instead. I note that those that mature between 2041 and 2050 currently have real yields of between 1.1% and 1.4% (closing values on 8 February taken from tradeweb). If your target income in today's pounds is T, then the total cost will be roughly T/power(1.01,17) - it'll actually be a bit less than this since the bonds maturing in 2050 have a higher yield and longer for compound interest to work its magic. This also assumes coupons are reinvested such that the total return is roughly equal to the yield - without reinvestment, the real price return for the gilt maturing in 2041 is just under 1%.

Since the coupon rates are relatively small on ILG (from 0.125% to 0.75% for those maturing between 2041 and 2050), then the number of bonds maturing in each year that need to be purchased can be approximated by T*(clean price)/(dirty price).

I assume you've based the first ten years on then receiving the state pension from 67 (or 71 or whatever it turns out to be!) onwards so that this will then reduce the demands on your portfolio. It might be worth considering purchasing additional income flooring either by extending the 10 year ladder (2071 is the longest ILG currently available, but the maturity dates are a bit sparse after 2058) or by purchasing an RPI annuity closer to the time (if they exist). The lack of a deferred annuity in the UK (of any sort, AFAIK), makes this sort of planning decision somewhat more awkward.

cheers
StillGoing
Thanks SG. My initial post wasn't well expressed -apologies for that - I had meant we aim to realize future annual cashflows which are equal to GBP70k (gross) in today's money (e.g., applying an assumed annualised inflation rate of ~4%- to realise 70k in 2024 money would require us to realise ~120k in 2041 money, 125k in 2042 money, etc).
No worries - the phrase 'inflation adjusted' always allows for some ambiguity.

In that case, to inflation proof the first ten years of income using ILG will currently cost very roughly £560k (calculated as =70/power(1.01,17)+70/power(1.01,18)+... 70/power(1.01,26) ).

So a bit more expensive than using nominal bonds. I also note that that even at 0.125%, the coupons on this quantity of bonds would exceed current (UK) tax thresholds for allowable interest.

However, I also note that a nominal income of £70k would be worth about £42k on today's terms with 17 years of 3% inflation. But as you say elsewhere, the rest of your portfolio may make up for that (and presumably you will be able to add to it until you retire).

cheers
StillGoing
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Thanks SG.

One thought I had was to actually purchase nominal bonds now for the projected inflation adjusted amount in future - eg if (using a 4%/a inflation rule of thumb) 70k in 2024 money translates to 120k in 2041 money, buying 120k worth of gilts now (which trade at about a 35% discount to redemption value so would cost about 85k in today’s money).

Is that a completely wrong-headed way to look at the issue?
Valuethinker
Posts: 48741
Joined: Fri May 11, 2007 11:07 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

Futureproofer wrote: Mon Feb 12, 2024 9:28 pm Thanks SG.

One thought I had was to actually purchase nominal bonds now for the projected inflation adjusted amount in future - eg if (using a 4%/a inflation rule of thumb) 70k in 2024 money translates to 120k in 2041 money, buying 120k worth of gilts now (which trade at about a 35% discount to redemption value so would cost about 85k in today’s money).

Is that a completely wrong-headed way to look at the issue?
You are matching cash flows (except for interest coupons on the gilt).

But it's still nominal cash flows. You are taking a fairly enormous bet that inflation averages 4% pa or below for 17 years. OK that's within reason given the Bank of England's target rate of inflation but they have had little or no success in keeping to it.

I would not. Unless this was play money to you.

You could buy a property. Property prices are down about 13 per cent in real terms from the peak. Even if they fall another 12, say, and the UK still underbuilds new housing so badly that we have a permanent housing shortage - hurray for my home equity! Institutionally the UK is incapable of building the housing level to keep up with demand, let alone meet built up demand from before. People just love the green belt too much, and local authorities have too much power to refuse developments. Also housebuilders cannot increase their volume - there's not the construction labour in the UK (unless we allow mass immigration from places we are not going to allow mass immigration from).

A property with a long term fixed mortgage is bond-like. Granted much more hassle. Plus there is now SDRT (Stamp Duty) at quite a high level for non-residents? And property prices in the long run should track inflation. Even if we have a few more bad years.

But the safest and simplest option is Index Linked Gilts.
StillGoing
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by StillGoing »

Futureproofer wrote: Mon Feb 12, 2024 9:28 pm Thanks SG.

One thought I had was to actually purchase nominal bonds now for the projected inflation adjusted amount in future - eg if (using a 4%/a inflation rule of thumb) 70k in 2024 money translates to 120k in 2041 money, buying 120k worth of gilts now (which trade at about a 35% discount to redemption value so would cost about 85k in today’s money).

Is that a completely wrong-headed way to look at the issue?
I cannot add much more than valuethinker has already.

Except to note that buying nominal bonds assuming a 4% inflation rate will, using your figures, cost you £85k*10=£850k and will not necessarily protect you against inflation (although if inflation comes in below 4%, then you will end up with more in real terms). Cherry picking one of the worst 17 year periods in UK history (1970-1987), annual inflation averaged 9.6% (see https://www.bankofengland.co.uk/monetar ... calculator) and purchasing power declined by more than 75% over that interval. Conversely, if we enter a period of very low inflation then nominal bonds will do rather well.

The choice is that:
Inflation-linked gilts provide certainty in real terms
Nominal bonds provide certainty in nominal terms, but do not provide certainty in real terms. The real outcomes could be better, worse, or similar.

Personally, my inclination (I'm fairly risk averse) has been to gather sufficient RPI protected income* (currently DB pension, eventually state pension as well) to support our general expenditure with a stock/bond portfolio to cover ad-hoc spending using dynamic withdrawals (an approach based on ABW, see https://www.bogleheads.org/wiki/Amortiz ... withdrawal).

cheers
StillGoing

* This almost makes it sound like I had a plan... in fact, I just had a job that had a good DB pension for most of my career!
Valuethinker
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

StillGoing wrote: Tue Feb 13, 2024 4:07 am
Futureproofer wrote: Mon Feb 12, 2024 9:28 pm Thanks SG.

One thought I had was to actually purchase nominal bonds now for the projected inflation adjusted amount in future - eg if (using a 4%/a inflation rule of thumb) 70k in 2024 money translates to 120k in 2041 money, buying 120k worth of gilts now (which trade at about a 35% discount to redemption value so would cost about 85k in today’s money).

Is that a completely wrong-headed way to look at the issue?
I cannot add much more than valuethinker has already.

Except to note that buying nominal bonds assuming a 4% inflation rate will, using your figures, cost you £85k*10=£850k and will not necessarily protect you against inflation (although if inflation comes in below 4%, then you will end up with more in real terms). Cherry picking one of the worst 17 year periods in UK history (1970-1987), annual inflation averaged 9.6% (see https://www.bankofengland.co.uk/monetar ... calculator) and purchasing power declined by more than 75% over that interval. Conversely, if we enter a period of very low inflation then nominal bonds will do rather well.

The choice is that:
Inflation-linked gilts provide certainty in real terms
Nominal bonds provide certainty in nominal terms, but do not provide certainty in real terms. The real outcomes could be better, worse, or similar.

Personally, my inclination (I'm fairly risk averse) has been to gather sufficient RPI protected income* (currently DB pension, eventually state pension as well) to support our general expenditure with a stock/bond portfolio to cover ad-hoc spending using dynamic withdrawals (an approach based on ABW, see https://www.bogleheads.org/wiki/Amortiz ... withdrawal).

cheers
StillGoing

* This almost makes it sound like I had a plan... in fact, I just had a job that had a good DB pension for most of my career!
Wise advice.

State Pension for the UK is very small. It's important - I would reckon 1/2 the population will just not have significant other pension. So it is State Pension + means-tested benefits + possibly some 2nd State Pension (not sure how that works because I was contracted out for much of my career).

But for the sort of people who are on Bogleheads, State Pension is probably not going to be a major part of their retirement finances. Definitely worth having, but not make-or-break.
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Futureproofer
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Many thanks both. So great to be able to stress test these things with knowledgeable and impartial people! Sounds like ILGs are the way forward. Possibly with some real estate in the mix too.

I am also relatively risk averse and am using the opportunity of moving back to the UK to re-set asset allocations to reflect that. Securing some cashflows for the planned early years of retirement is part of that plan.
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Kinkajou82 »

Futureproofer wrote: Tue Feb 13, 2024 6:15 am Many thanks both. So great to be able to stress test these things with knowledgeable and impartial people! Sounds like ILGs are the way forward. Possibly with some real estate in the mix too.

I am also relatively risk averse and am using the opportunity of moving back to the UK to re-set asset allocations to reflect that. Securing some cashflows for the planned early years of retirement is part of that plan.
I've been educating myself by reading this thread, so thank you for asking the question because it helps other members on the board beyond just yourself!

Were you initially specifically trying to avoid the coupon payments for some reason, and that is why you started out looking at making nominal GILTs work?
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Futureproofer
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Kinkajou82 wrote: Tue Feb 13, 2024 6:29 am
Futureproofer wrote: Tue Feb 13, 2024 6:15 am Many thanks both. So great to be able to stress test these things with knowledgeable and impartial people! Sounds like ILGs are the way forward. Possibly with some real estate in the mix too.

I am also relatively risk averse and am using the opportunity of moving back to the UK to re-set asset allocations to reflect that. Securing some cashflows for the planned early years of retirement is part of that plan.
I've been educating myself by reading this thread, so thank you for asking the question because it helps other members on the board beyond just yourself!

Were you initially specifically trying to avoid the coupon payments for some reason, and that is why you started out looking at making nominal GILTs work?
Great stuff. I also find BH an invaluable education tool (that is, when I can avoid spending too much time on the "stocks are soaring" type threads!).

Re. coupon payments - yes I was specifically looking for low/zero coupon gilts because I expect to be a higher rate tax payer in UK for the foreseeable future and those coupon payments would be taxable as income. I am really focused on trying to capture capital gains vis the spread between sale/redemption value (since this is CGT free for nominal gilts). Not sure yet whether the same applies to ILG (will check and confirm my findings on this thread though!).
Valuethinker
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

Futureproofer wrote: Tue Feb 13, 2024 6:15 am Many thanks both. So great to be able to stress test these things with knowledgeable and impartial people! Sounds like ILGs are the way forward. Possibly with some real estate in the mix too.

I am also relatively risk averse and am using the opportunity of moving back to the UK to re-set asset allocations to reflect that. Securing some cashflows for the planned early years of retirement is part of that plan.
It is possible to hold some proportion of fixed gilts.

The main reason people should hold property is that they want to live in it. Or they think they can sell it and use the proceeds to buy somewhere they do want to live (you will pay Capital Gains Tax however). Rents tend to rise with (at least) inflation in the long run.

Obvious stuff if you've lived in the UK but just FYI:

- off plan flats tend to be significantly more expensive than "used" flats 1-2 years older
- you want to be careful about buying into developments that have not been built yet. What happens if the developer goes broke?
- new builds are, in any case, a litany of construction problems and trying to get them fixed under warranty - quality has really declined
- never believe anything an Estate Agent tells you that is not in writing - lying is part of their business model
- make sure you are fully conversant with the terms of any leasehold re future ground rents, common costs. The problem on the latter is so bad that I would tend to avoid leasehold - offshore management companies with completely opaque costings, etc
-- it's well worth reading some horror stories in the weekend press on this stuff
- what you would buy as an investor differs from what you would live in. Don't get confused. What has best value is well located (near transport, shops etc) 1-2 bedroom flats. Not too many expensive amenities. Smaller flats get higher yields. Some places small houses. Tenants don't want significant gardens or other things to take care of. And wear and tear will be high even if you don't get bad tenants.

Basically you hold a property to hedge rising UK housing costs. As an investment, I think it carries a lot of risks and hassles. And the law can be changed against landlords (is, already - end of no fault eviction).

So ILGs:

- capital gain arising from principal accretion due to inflation is not taxable
- I think the position if you own a fund or ETF is different - one advantage of direct holdings (you'd have to check that)

www.monevator.com is a very "Boglehead like" site, UK based, and they have some good articles on bonds
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by StillGoing »

Valuethinker wrote: Tue Feb 13, 2024 4:55 am
StillGoing wrote: Tue Feb 13, 2024 4:07 am
Futureproofer wrote: Mon Feb 12, 2024 9:28 pm Thanks SG.

One thought I had was to actually purchase nominal bonds now for the projected inflation adjusted amount in future - eg if (using a 4%/a inflation rule of thumb) 70k in 2024 money translates to 120k in 2041 money, buying 120k worth of gilts now (which trade at about a 35% discount to redemption value so would cost about 85k in today’s money).

Is that a completely wrong-headed way to look at the issue?
I cannot add much more than valuethinker has already.

Except to note that buying nominal bonds assuming a 4% inflation rate will, using your figures, cost you £85k*10=£850k and will not necessarily protect you against inflation (although if inflation comes in below 4%, then you will end up with more in real terms). Cherry picking one of the worst 17 year periods in UK history (1970-1987), annual inflation averaged 9.6% (see https://www.bankofengland.co.uk/monetar ... calculator) and purchasing power declined by more than 75% over that interval. Conversely, if we enter a period of very low inflation then nominal bonds will do rather well.

The choice is that:
Inflation-linked gilts provide certainty in real terms
Nominal bonds provide certainty in nominal terms, but do not provide certainty in real terms. The real outcomes could be better, worse, or similar.

Personally, my inclination (I'm fairly risk averse) has been to gather sufficient RPI protected income* (currently DB pension, eventually state pension as well) to support our general expenditure with a stock/bond portfolio to cover ad-hoc spending using dynamic withdrawals (an approach based on ABW, see https://www.bogleheads.org/wiki/Amortiz ... withdrawal).

cheers
StillGoing

* This almost makes it sound like I had a plan... in fact, I just had a job that had a good DB pension for most of my career!
Wise advice.

State Pension for the UK is very small. It's important - I would reckon 1/2 the population will just not have significant other pension. So it is State Pension + means-tested benefits + possibly some 2nd State Pension (not sure how that works because I was contracted out for much of my career).

But for the sort of people who are on Bogleheads, State Pension is probably not going to be a major part of their retirement finances. Definitely worth having, but not make-or-break.
It would take about £220k to purchase an income equivalent to the state pension (assuming a single life RPI annuity rate aged 67 of 4.8% and current state pension is £10600 - for 2024/25, the premium would be £240k). Taking a 3.5% 'safe' withdrawal rate for a UK based portfolio, the amount needed would be quite a bit higher.

According to somewhat out-of-date FCA data, of pots entering drawdown in Oct 2021-Mar 2022 (Table 3 in the downloadable data at https://www.fca.org.uk/data/retirement- ... is-2021-22), 44% of pots were smaller than £49k and 65% of pots were smaller than £99k and 85% were smaller than £249k. Of course, this excludes DB pensions and individuals may have more than one pot, while couples may have two or more, so it is difficult to gauge what the household total is (I think there are some figures somewhere on the ONS site, but I've been unable to find them this morning). However, assuming 3 pots per household, about 35% of households might be able to purchase income equal to an additional state pension.

Anyway, the upshot is that your estimate of 1/2 may be conservative (if we count 'significant' as having income from other sources equal to a state pension).

cheers
StillGoing
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Futureproofer
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Hello all,

Following on from the helpful pointers received, I spent some time looking at ILGs and am tending to the conclusion that a ladder of ILGs to secure our required future cashflow (in real terms) of the equivalent of GBP70k/year in 2024 money may be the way forward.

To that end, I visited the HL site to see how much such a ladder would roughly cost and it seems that I could construct a ladder of ILGs to cover the 10 year period 2041-2050 (inclusive) for a cost today of ~GBP 549,000. As Valuethinker pointed out, there aren't ILGs maturing each year thoughout this period so in practice some years we would receive "lumps" of 2-3 years' worth of cashflow, which we would need to manage in our bank acccounts. That should be fine.

Also as Valuethinker said, the amount received on maturity appears to be tax free (seems the redemption amount is treated as capital rather than income and any capital gain is zero rated for CGT). This is important because 2041 is not that far out and there is a fair chance we will both still be working as higher rate tax payers when the first tranches mature (in which case we would just roll them to extend the back end).

GBP549k would constitute about 25% of our retirement pot (the rest we would keep in equities via a low cost tracker such as VWRL/SWDA).

As ever though, the more I learn about bonds the more questions I have. The following spring to mind for now and I would love to hear the community's thoughts on these (or indeed on the general approach!):

1. Is a 25/75 split between ILGs/equity fund a reasonable "set and forget" retirement portfolio? With the ILG ladder, we would theoretically not need to touch our equity pot until 2050 which would leave the balance amount (~1.5m in 2024 money) to compound away for an extensive period.

2. ILGs seem like a great hedge against inflation but what about deflation risk - is my understanding correct that in a deflationary environment ILGs can mature below par?

3. Would it make sense to diversify the bond portion of our asset allocation further (e.g., by purchasing a mix of nominal gilts/ILGs, or a mix of ILGs with an intermediate global bond fund)? I generally try not to overcomplicate things unneccessarily.

Finally - I really do appreciate the feedback received to date. Being able to sanity check these things is so helpful and it feels like I am finally homing in on a strategy thanks to BH.

FP
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

Futureproofer wrote: Wed Feb 14, 2024 8:28 pm Hello all,

Following on from the helpful pointers received, I spent some time looking at ILGs and am tending to the conclusion that a ladder of ILGs to secure our required future cashflow (in real terms) of the equivalent of GBP70k/year in 2024 money may be the way forward.

To that end, I visited the HL site to see how much such a ladder would roughly cost and it seems that I could construct a ladder of ILGs to cover the 10 year period 2041-2050 (inclusive) for a cost today of ~GBP 549,000. As Valuethinker pointed out, there aren't ILGs maturing each year thoughout this period so in practice some years we would receive "lumps" of 2-3 years' worth of cashflow, which we would need to manage in our bank acccounts. That should be fine.

Also as Valuethinker said, the amount received on maturity appears to be tax free (seems the redemption amount is treated as capital rather than income and any capital gain is zero rated for CGT). This is important because 2041 is not that far out and there is a fair chance we will both still be working as higher rate tax payers when the first tranches mature (in which case we would just roll them to extend the back end).

GBP549k would constitute about 25% of our retirement pot (the rest we would keep in equities via a low cost tracker such as VWRL/SWDA).

As ever though, the more I learn about bonds the more questions I have. The following spring to mind for now and I would love to hear the community's thoughts on these (or indeed on the general approach!):

1. Is a 25/75 split between ILGs/equity fund a reasonable "set and forget" retirement portfolio? With the ILG ladder, we would theoretically not need to touch our equity pot until 2050 which would leave the balance amount (~1.5m in 2024 money) to compound away for an extensive period.
Eminently. You might consider the duration in years of your portfolio -- which (rule of thumb) should be less than or equal to your need for the funds. Thus you actually need some of the money further out than just when you retire?
2. ILGs seem like a great hedge against inflation but what about deflation risk - is my understanding correct that in a deflationary environment ILGs can mature below par?
I believe that is possible. However if you look at the index ratio of most ILGs (RPI now/ RPI at issue) - they are way above par in terms of calculated redemption value. In other words, even if there is deflation, it's unlikely you will get back to par.

(US TIPS have par value protection - you cannot redeem at less than par. I believe other index-linked bonds have copied that. But I do not think that ILGs have).

Read Monevator.com -- anything on ILGs (and bonds generally). Very handy resource. ILGs are price volatile. Very volatile (because the cash flows are back weighted to the maturity date). For example they got totally pounded in 2022. As an investor, those higher yields that resulted are a good thing (ILGs were trading at negative real yields).

3. Would it make sense to diversify the bond portion of our asset allocation further (e.g., by purchasing a mix of nominal gilts/ILGs, or a mix of ILGs with an intermediate global bond fund)? I generally try not to overcomplicate things unneccessarily.
You are right to try to be as simple as possible. That's a sign of a certain sort of (very practical) intelligence.

If you said to me "I want to have some certainty, I want to hold some nominal bonds". I would not object strenuously. Something like 25% ILGs and 10% straight 10 year gilts? OR 20 + 10 straight + 70 equities?

A global bond fund (intermediate term) is not a bad hedge against a portfolio which will have 25% in UK government gilts. You ideally want a sterling hedged fund (most global bond funds are hedged) but failing that probably USD hedged.

You can use the bond fund as a form of cash, for rebalancing purposes.

One caveat, AFAIK it is only direct holdings of gilts which have the Capital Gains Tax exemption on principal.

Don't underestimate the volatility of equities. You can wake up with half the equity portfolio value that you had 12 months ago. Because they are subject to "black swans" (overused term since Nicholas Taleb wrote a book about it) but basically things like 2008/9 Crash, Covid crash etc can be pretty brutal. So was the dot com crash bear market 2000-03 which took 35% off the market -- but just went on forever (or so it seemed). You have to think things like a repeat of the 1918/9 flu (H5N1 is still out there) ie like Covid but we don't develop a working vaccine. Or Russia v NATO in a shooting war. Coronal Mass Ejection (solar flare) takes out all our computers and telecoms (wikipedia on the "Carrington Event" of the 1850s which melted telegraph keys).

And there's a "lost decade" for stocks 1966-1981. US market lost roughly 40% adjusted for inflation.

The UK market in the early 70s lost over 80% (inflation was running at 20% pa, so a 60% drop in the then FTSE 30, plus inflation). Without any war or other major civil disruption (but the government lost a battle with the coal miners).

2022/23 was like 1994 in that bonds went down (a lot) and stocks went down (quite a bit). Gilts especially due to the abortive unfunded budget promises of the short-lived PM Liz Truss. In other periods, bonds (nominal) have tended to do OK when stocks have gone down. Last previous bond bear market was 1980-81 (when interest rates in US & UK went over 20%).
Finally - I really do appreciate the feedback received to date. Being able to sanity check these things is so helpful and it feels like I am finally homing in on a strategy thanks to BH.

FP
It is good to be able to help someone. As I near retirement, I realise that there is great pleasure in that. My spouse is doing some volunteer work with refugees, which particularly in the current political climate, is very rewarding.
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Futureproofer
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Valuethinker wrote: Thu Feb 15, 2024 1:35 am Read Monevator.com -- anything on ILGs (and bonds generally). Very handy resource. ILGs are price volatile. Very volatile (because the cash flows are back weighted to the maturity date). For example they got totally pounded in 2022. As an investor, those higher yields that resulted are a good thing (ILGs were trading at negative real yields).
Thanks Valuethinker - does this volatility point apply if the intention is to buy and hold ILGs to maturity? With plain gilts I don't think this would be the case.

Fully agree with the sentiment re equities volatility and I always try to distinguish between financial wealth (such as equities, which can drop very quickly) and real wealth (primary residence, cash or cash equivalents). I would love to de-risk equities allocation further but I think at my age (39) I need to (and can) take a certain amount of risk - at least for next 10 years or so.
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Bernmaster »

Futureproofer wrote: Sun Feb 11, 2024 4:39 am Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.
While I am not able to contribute much to the discussion regarding gilts I would like to point out that in 17 years your 100% equity portfolio will probably be much larger than now. Even with mediocre returns and no further contributions the dividends alone will almost certainly be much higher than the ~GBP 70kpa (inflation adjusted) you plan on spending in retirement.

You have enough wealth that there is no SORR risk because your withdrawal rate in retirement will probably be less than 2% per year.
"The unsophisticated investor who is realistic about his shortcomings is likely to obtain better results than the knowledgeable professional who is blind to even a single weakness” ― Warren Buffett
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

Futureproofer wrote: Thu Feb 15, 2024 3:26 am
Valuethinker wrote: Thu Feb 15, 2024 1:35 am Read Monevator.com -- anything on ILGs (and bonds generally). Very handy resource. ILGs are price volatile. Very volatile (because the cash flows are back weighted to the maturity date). For example they got totally pounded in 2022. As an investor, those higher yields that resulted are a good thing (ILGs were trading at negative real yields).
Thanks Valuethinker - does this volatility point apply if the intention is to buy and hold ILGs to maturity? With plain gilts I don't think this would be the case.

Fully agree with the sentiment re equities volatility and I always try to distinguish between financial wealth (such as equities, which can drop very quickly) and real wealth (primary residence, cash or cash equivalents). I would love to de-risk equities allocation further but I think at my age (39) I need to (and can) take a certain amount of risk - at least for next 10 years or so.
If you hold to maturity in theory you are indifferent to volatility with a nominal gilt. In practice, you have interest rate risk (reinvestment of coupons). But higher interest rates (lower gilt prices) also means your coupons are reinvested at a higher yield, and that's a good thing.

ILGs agree your final nominal value is uncertain. That's why people don't like them. But this is money illusion. What counts is real buying power, not nominal. I was just cautioning that, at times, it's going to feel very painful. (note RPI = CPI after 2030). It sure did in 2022 (I think at my worst, my gilts were down 30%). ILGs are very long duration, ie very sensitive to changes in *real* interest rates (duration for ordinary gilts is relative to nominal interest rates), because the cash flows are so back-ended compared to a normal bond.

Property your risk is that UK housing prices rise faster than your portfolio. The only real hedge is a property you intend to live in, or that rises in price equivalently. I keep thinking property prices have to plummet, they are so out of whack against incomes. But of course that never happens in the UK. Although the indices are currently showing about -13% real, which is consistent with my observations of unexceptional suburban London (house prices are really pretty similar to 2019). I think because government policy (land use, tax etc) is so pro home owner we tend to see real housing price rises over time. Suffice it to say if you have your eye on a nice retirement location (generally southern) the prices don't usually fall a lot.

Your own property is really a rent substitute. It's an asset because it covers part of your consumption (your housing expenditure). In our travels we have met Brits abroad who want to return (eg from Canada) but the housing prices have just gone up so much that whilst they could afford someplace in NE England, they can't afford to live on the South Coast. They are trapped in exile, as it were. It's not an easy conundrum to solve -- see my earlier post about the hazards of rental property in the UK -- caveat emptor. And never believe anything an Estate Agent tells you verbally.

I would also warn you about the NHS but you've probably heard. Doubtless by that time we shall all have private insurance.
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Futureproofer
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Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Valuethinker wrote: Thu Feb 15, 2024 4:46 am
Futureproofer wrote: Thu Feb 15, 2024 3:26 am
Valuethinker wrote: Thu Feb 15, 2024 1:35 am Read Monevator.com -- anything on ILGs (and bonds generally). Very handy resource. ILGs are price volatile. Very volatile (because the cash flows are back weighted to the maturity date). For example they got totally pounded in 2022. As an investor, those higher yields that resulted are a good thing (ILGs were trading at negative real yields).
Thanks Valuethinker - does this volatility point apply if the intention is to buy and hold ILGs to maturity? With plain gilts I don't think this would be the case.

Fully agree with the sentiment re equities volatility and I always try to distinguish between financial wealth (such as equities, which can drop very quickly) and real wealth (primary residence, cash or cash equivalents). I would love to de-risk equities allocation further but I think at my age (39) I need to (and can) take a certain amount of risk - at least for next 10 years or so.
If you hold to maturity in theory you are indifferent to volatility with a nominal gilt. In practice, you have interest rate risk (reinvestment of coupons). But higher interest rates (lower gilt prices) also means your coupons are reinvested at a higher yield, and that's a good thing.

ILGs agree your final nominal value is uncertain. That's why people don't like them. But this is money illusion. What counts is real buying power, not nominal. I was just cautioning that, at times, it's going to feel very painful. (note RPI = CPI after 2030). It sure did in 2022 (I think at my worst, my gilts were down 30%). ILGs are very long duration, ie very sensitive to changes in *real* interest rates (duration for ordinary gilts is relative to nominal interest rates), because the cash flows are so back-ended compared to a normal bond.

Property your risk is that UK housing prices rise faster than your portfolio. The only real hedge is a property you intend to live in, or that rises in price equivalently. I keep thinking property prices have to plummet, they are so out of whack against incomes. But of course that never happens in the UK. Although the indices are currently showing about -13% real, which is consistent with my observations of unexceptional suburban London (house prices are really pretty similar to 2019). I think because government policy (land use, tax etc) is so pro home owner we tend to see real housing price rises over time. Suffice it to say if you have your eye on a nice retirement location (generally southern) the prices don't usually fall a lot.

Your own property is really a rent substitute. It's an asset because it covers part of your consumption (your housing expenditure). In our travels we have met Brits abroad who want to return (eg from Canada) but the housing prices have just gone up so much that whilst they could afford someplace in NE England, they can't afford to live on the South Coast. They are trapped in exile, as it were. It's not an easy conundrum to solve -- see my earlier post about the hazards of rental property in the UK -- caveat emptor. And never believe anything an Estate Agent tells you verbally.

I would also warn you about the NHS but you've probably heard. Doubtless by that time we shall all have private insurance.
I am already preapring my wife for the trials of the NHS and putting all of us through a full medical MOT before we leave our current place!

Regarding your point about interim volatility in value of ILGs, I think if I do buy these I will mentally "put them in the drawer and forget about them". Since they are only thereto secure cashflows and would always be held until maturity date I would ignore what happens to them between now and then.
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

Bernmaster wrote: Thu Feb 15, 2024 4:32 am
Futureproofer wrote: Sun Feb 11, 2024 4:39 am Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.
While I am not able to contribute much to the discussion regarding gilts I would like to point out that in 17 years your 100% equity portfolio will probably be much larger than now. Even with mediocre returns and no further contributions the dividends alone will almost certainly be much higher than the ~GBP 70kpa (inflation adjusted) you plan on spending in retirement.

You have enough wealth that there is no SORR risk because your withdrawal rate in retirement will probably be less than 2% per year.
Hi Bernmaster,

You are possibly right about the compounding effect of equities over 17+year timeline (I certainly hope so!) but I am just a bit concerned that all of this equities wealth is "fragile" financial wealth - like Valuethinker said - it could quickly be materially reduced in a bear market (and the portfolio value could stay low for a long time). That would be fine if it happens whilst we are in our 40s but less good if it happens around the time we retire and could be really bad if we had to start drawing from the diminished pot.

Best,
FP
xxd091
Posts: 481
Joined: Sun Aug 21, 2011 4:41 am
Location: UK

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by xxd091 »

There is actually no “safe” hiding place for investors depending on an investment portfolio to provide an income
However if a cataclysm happens everybody will be in the same boat-skint!
Buying annuities from various insurance companies replicating a DB pension a la government employees could be done -very expensive
So you pays your money and makes an intelligent choice-hoping the world is not coming to an end!
Equities,bonds,cash and some annuities when you get older
From a practical point of view I retired 21 years ago at age 57 in a similar position to you with a 30/70 portfolio-conservative type!
Currently 34/60/6-equities/bonds/cash
Worked so far!
xxd091
Valuethinker
Posts: 48741
Joined: Fri May 11, 2007 11:07 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

Futureproofer wrote: Thu Feb 15, 2024 5:51 am
Bernmaster wrote: Thu Feb 15, 2024 4:32 am
Futureproofer wrote: Sun Feb 11, 2024 4:39 am Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.
While I am not able to contribute much to the discussion regarding gilts I would like to point out that in 17 years your 100% equity portfolio will probably be much larger than now. Even with mediocre returns and no further contributions the dividends alone will almost certainly be much higher than the ~GBP 70kpa (inflation adjusted) you plan on spending in retirement.

You have enough wealth that there is no SORR risk because your withdrawal rate in retirement will probably be less than 2% per year.
Hi Bernmaster,

You are possibly right about the compounding effect of equities over 17+year timeline (I certainly hope so!) but I am just a bit concerned that all of this equities wealth is "fragile" financial wealth - like Valuethinker said - it could quickly be materially reduced in a bear market (and the portfolio value could stay low for a long time). That would be fine if it happens whilst we are in our 40s but less good if it happens around the time we retire and could be really bad if we had to start drawing from the diminished pot.

Best,
FP
30% in bonds is not being excessively cautious. It's saying "if there is a 50% drop in equities, which is well within the realm of historic possibility, then I still have a viable financial plan for retirement.

Main concern with the bonds is that if you are trying to preserve standard of living, they have to be inflation linked. Nominal bonds are taking a bet on inflation and although there *should* be a premium for expected inflation built into the bond yield (there is) that does not mean the market's inflation expectations are correct. As the past 2 years has shown in a very brutal and direct way. Unexpected inflation is what an ILG hedges against, and that's what kills you.

The main other problem is the historic tendency of housing prices to rise much faster than inflation. About 4% real pa since 1994 in the UK, I believe. But with huge regional variation. Can this go on? Logic tells me no. But I've been thinking that since 2000 :oops: :oops:

Just remember flooding when buying property in Britain. Anything at all close to sea level. And also, with the kind of extreme weather events that are now regular, anything else as well. Environment Agency has flood maps, but not entirely up to date or accurate.

William Bernstein's books on personal investing, and particularly the one on "Deep Risk" are worth a consideration.
randomguy
Posts: 11271
Joined: Wed Sep 17, 2014 9:00 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by randomguy »

Valuethinker wrote: Thu Feb 15, 2024 7:54 am
Futureproofer wrote: Thu Feb 15, 2024 5:51 am
Bernmaster wrote: Thu Feb 15, 2024 4:32 am
Futureproofer wrote: Sun Feb 11, 2024 4:39 am Hello Bogleheads community,

I am a 40yo with an existing retirement portfolio of ~GBP 2m (comprised solely of VWRD).

My wife and I plan to retire (or at least be in a position to slow down) in 17 years, when our last child finishes uni. So from 2041 onwards.

I am looking into funding the first 10 years of our retirement (period 2041 - 2050) using long dated gilts. We estimate we would need ~GBP 70kpa (inflation adjusted) from 2041 - 2050 (i.e., GBP 700k over the 10 year period) and I could secure this today by purchasing zero coupon gilts which redeem over this period for ~GBP 385k.
While I am not able to contribute much to the discussion regarding gilts I would like to point out that in 17 years your 100% equity portfolio will probably be much larger than now. Even with mediocre returns and no further contributions the dividends alone will almost certainly be much higher than the ~GBP 70kpa (inflation adjusted) you plan on spending in retirement.

You have enough wealth that there is no SORR risk because your withdrawal rate in retirement will probably be less than 2% per year.
Hi Bernmaster,

You are possibly right about the compounding effect of equities over 17+year timeline (I certainly hope so!) but I am just a bit concerned that all of this equities wealth is "fragile" financial wealth - like Valuethinker said - it could quickly be materially reduced in a bear market (and the portfolio value could stay low for a long time). That would be fine if it happens whilst we are in our 40s but less good if it happens around the time we retire and could be really bad if we had to start drawing from the diminished pot.

Best,
FP
30% in bonds is not being excessively cautious. It's saying "if there is a 50% drop in equities, which is well within the realm of historic possibility, then I still have a viable financial plan for retirement.

Main concern with the bonds is that if you are trying to preserve standard of living, they have to be inflation linked. Nominal bonds are taking a bet on inflation and although there *should* be a premium for expected inflation built into the bond yield (there is) that does not mean the market's inflation expectations are correct. As the past 2 years has shown in a very brutal and direct way. Unexpected inflation is what an ILG hedges against, and that's what kills you.

The OP is either going to be so conservative that SORR will not matter or the situation will be so bad that you aren't going to feel comfortable with any scheme. Handwaving about contributions and the like but a pretty conservative assumptions get you to 6m+ real in 17 years and with a 70k withdrawal, you aren't worried about life. Now imagine we have the worst cases. Would you be ok retiring with say this 10 year ladder of gilts (ignore the inflation issues) and only like 1m in equities? It is easy to say after a 17 years bear market we are overdue for a bull market. Will you believe enough to actually do it? I wouldn't it. Now factor in unexpected inflation, and your Gilt ladder is returning half as much as you expect and your portfolio also hasn't grown and you aren't going to feel good. Granted this is the worst case.

Personally I think the OP is at the stage where they should be derisking a bit. If that is sinking 400k into Gilts or just move to say a 90/10 allocation is debatable. When you look at bond tents/bucket schemes, they don't really do much about SORR. Not selling down stocks is only half the issue with the other have being missing returns. I like the simplicity of just holding a bond fund versus the ladders but I am not sure it makes a huge difference. I also like derisking (moving more to bonds as I get richer) as my need for money drops. I am trading average terminal wealth at death for a bit of safety. Now there is a line (say 15 years of expenses in bonds) where I don't need more safety. You need to make a judgement call on that.
Topic Author
Futureproofer
Posts: 15
Joined: Fri Jul 05, 2019 12:24 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Futureproofer »

randomguy wrote: Thu Feb 15, 2024 9:43 am ow imagine we have the worst cases. Would you be ok retiring with say this 10 year ladder of gilts (ignore the inflation issues) and only like 1m in equities? It is easy to say after a 17 years bear market we are overdue for a bull market. Will you believe enough to actually do it? I wouldn't it. Now factor in unexpected inflation, and your Gilt ladder is returning half as much as you expect and your portfolio also hasn't grown and you aren't going to feel good. Granted this is the worst case.
Hi randomguy,

This is exactly the scenario I am trying to plan for - idea being that with a 10 year ladder of ILGs paying GBP70k real/year we could wait 10 years before we need to tap into the equities portfolio at all - which would hopefully allow us to sit out some/all of a market downturn and/or keep working a bit longer and re-invest the maturing ILGs at the back end to extend the ladder out further.

Either way, having secure inflation protected cashflow means we can be a bit more relaxed about the state of the equities market hopefully.

I guess we could try to get to the same place using a bond fund but wouldn't we need to put in an awful lot more money to be assured of a similar level of cashflow (and you always have the issue that bonds and stocks are both tanking at the same time when you want to start making drawdowns).

Perhaps I am missing the point on a bond fund, only just starting to educate myself on the bond market.
Valuethinker
Posts: 48741
Joined: Fri May 11, 2007 11:07 am

Re: UK investor - long dated gilts to reduce SORR: what am I missing?!

Post by Valuethinker »

Futureproofer wrote: Fri Feb 16, 2024 12:33 am
randomguy wrote: Thu Feb 15, 2024 9:43 am ow imagine we have the worst cases. Would you be ok retiring with say this 10 year ladder of gilts (ignore the inflation issues) and only like 1m in equities? It is easy to say after a 17 years bear market we are overdue for a bull market. Will you believe enough to actually do it? I wouldn't it. Now factor in unexpected inflation, and your Gilt ladder is returning half as much as you expect and your portfolio also hasn't grown and you aren't going to feel good. Granted this is the worst case.
Hi randomguy,

This is exactly the scenario I am trying to plan for - idea being that with a 10 year ladder of ILGs paying GBP70k real/year we could wait 10 years before we need to tap into the equities portfolio at all - which would hopefully allow us to sit out some/all of a market downturn and/or keep working a bit longer and re-invest the maturing ILGs at the back end to extend the ladder out further.

Either way, having secure inflation protected cashflow means we can be a bit more relaxed about the state of the equities market hopefully.

I guess we could try to get to the same place using a bond fund but wouldn't we need to put in an awful lot more money to be assured of a similar level of cashflow (and you always have the issue that bonds and stocks are both tanking at the same time when you want to start making drawdowns).

Perhaps I am missing the point on a bond fund, only just starting to educate myself on the bond market.
For a UK investor, gilts (directly held) are unique as to tax - no CGT if bought at a discount to par. No CGT on inflation indexed gains on ILGs. This does not apply to other bonds. This is why the Financial Times still gives the price of some individual gilts.

I don't think those benefits apply if you hold a fund?

Otherwise it's almost always better to hold a bond fund. You get credit diversification over thousands of different bonds. The thing with a bond fund though is it is always buying and selling to track the benchmark. Generally selling the bonds that are coming due soon (say down to 1 year to maturity) and buying new bonds at the upper limit of its range. So your duration and weighted average maturity move with the index/ benchmark.

Many examples have shown here that in the long run your returns even out between holding the bonds individually and holding a fund.

Bond funds serve as good "ammunition stores". Rebalancing forces you to sell equities on the way up (except for CGT issues) and buy them on the way down. You do that with a bond fund as the flip side (since tax issues are not usually so difficult).

You could use a cash fund. However because of the shape of the yield curve (upward sloping with x axis as years to maturity ie increasing) is normally upward sloping, in the long run bond funds provide returns 1-2% above cash, typically. Compound that over 30 years.

For that reason we normally suggest investors only hold enough cash or other financial resources to deal with a personal financial crisis such as a period of unemployment. Typically 6m to 12m. You can find a post by me in 2008 where I suggest increasing that to 18 months, and given what happened to unemployment (the recovery was much slower than normal recoveries) that may, actually, have been good advice.

If we repeat the 1970s then the asset class performance was cash & Treasury Bills > stocks > bonds. It was a disastrous decade for investors (although 2000-2010 wasn't much fun either). If one does think we risk runaway inflation, then cash is likely to outperform.
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